Tuesday, 31 December 2019

SEC plans update to auditor independence rules; Clayton and others issue audit committee reminders

By Mark S. Nelson, J.D.

The SEC proposed to amend the auditor independence requirements contained in Rule 2-01 of Regulation S-X to improve efficiency and effectiveness, said an SEC press release. The changes address five specific aspects of Rule 2-01, which was last significantly updated in the early 2000s but which the SEC press release said does not address recent evolutions in capital markets. Separately, SEC officials, including Chairman Jay Clayton, issued a statement reminding market participants of the role of audit committees, especially regarding year-end considerations. There will be a 60-day comment period after the Regulation S-X release is published in the Federal Register (Amendments to Rule 2-01, Qualifications of Accountants, Release No. 33-10738, December 30, 2019).

Rule 2-01. The proposal, if adopted, would remove the existing preliminary note and replace it with a new introductory paragraph that contains the same admonitions. More significant changes would be made to the following subsections of Rule 2-01:
  • Amend “affiliate of the audit client” (Rule 2-01(f)(4)) and “Investment Company Complex” (Rule 2-01(f)(14)) regarding affiliate relationships, including common control issues.
  • Amend “audit and professional engagement period” (Rule 2-01(f)(5)(iii)) to shorten the look-back period for domestic first time filers in assessing compliance with the independence requirements.
  • Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.
  • Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationship rule with the concept of beneficial owners with significant influence.
  • Replace transition and grandfathering provisions contained in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of merger and acquisition transactions. 
Statement on audit committees. Clayton, SEC Chief Accountant Sagar Teotia, and William Hinman, Director of the SEC's Division of Corporation Finance, issued a separate statement on the role of audit committees. According to these SEC officials, the “observations and reminders” are intended to emphasize that audit committee requirements set forth in the Sarbanes-Oxley Act are among that Act’s most effective provisions. The officials also said firms should consider the areas cited in the statement while ensuring that their audit committees have adequate resources.

Several general observations include: (1) ensuring that the tone at the top promotes the integrity of the financial reporting process; (2) encouraging audit committees to mull the monitoring practices of the auditor and the issuer; (3) encouraging audit committees to proactively engage with management and auditors regarding new accounting standards, such as those for revenue recognition and leases; (4) ensuring that audit committees have sufficient information about a firm’s internal controls over financial reporting; and (5) facilitating communications from auditors to audit committees under the PCAOB’s AS 1301 standard for such communications.

The SEC officials also provided several more targeted reminders regarding non-GAAP financial measures, the transition from LIBOR to a new reference rate, and the communication of critical audit matters.

The release is No. 33-10738.

Monday, 30 December 2019

CFTC awards whistleblower more than $1 million despite potential hurdles

By Lene Powell, J.D.

A whistleblower award of more than $1 million highlighted the CFTC’s support for internal reports and cooperation with other regulators. In granting the award, the CFTC overcame several procedural wrinkles, including that the whistleblower reported different wrongdoing than that ultimately charged and that the whistleblower’s Form TCF was not filed until after the CFTC’s investigation concluded.

Internal report to another regulator. According to the award, the whistleblower "initially submitted his/her information to another regulator through his/her company’s internal reporting procedures." The other regulator then passed the information along to the CFTC. The whistleblower subsequently gave an interview to Division of Enforcement staff and provided documents through the employer’s counsel.

The report states that the "employer acted as [the claimant’s] representative in submitting the information to the other regulator." The report to the other regulator was not considered mandatory.

"We have also decided to give credit to Claimant 1 for causing the case to be opened, because the information that Claimant 1 provided, albeit up through his/her compliance process and then over via the other regulator, was sufficiently specific, credible, and timely to cause the Commission to open an investigation," the report stated.

According to CFTC Director of Enforcement James McDonald, the CFTC is committed to working with other regulators to maximize enforcement effectiveness. "Today’s award shows how referrals from other regulators can have a meaningful impact on the Commission’s enforcement program, and lead to whistleblower awards from the CFTC," said McDonald.

Different misconduct reported. The CFTC noted that whistleblowers are eligible for award for a tip that leads to evidence of a violation the CFTC ultimately charges—even if the reported conduct itself does not form the basis for those charges.

"As the specific facts and circumstances of this matter demonstrate, the whistleblower does not have to identify the exact wrongdoing the CFTC ultimately charges—it is enough for their information to lead CFTC investigators directly to evidence of one or more of the agency’s claims," said CFTC Whistleblower Office Director Christopher Ehrman. "Here, the whistleblower identified a problem in one area, and our Division of Enforcement used that knowledge and the whistleblower’s subsequent assistance to uncover illegality in another."

Form TCR timing. Another wrinkle that could have potentially derailed an award was that the whistleblower filed a Form TCR to perfect his/her status as a whistleblower after the CFTC’s investigation concluded.

"[W]e find that Claimant 1 complied with the form and manner requirements of the Rules per the language of Rule 165.3(a), which does not require a whistleblower to submit information on a Form TCR in his/her initial submission," the report stated.

Award. The CFTC did not name the precise amount of the award, describing it as "more than $1 million."

A second claimant had also applied for an award, but that claim had previously been denied in a preliminary determination that subsequently became final.

Friday, 27 December 2019

Court tries to resolve long-running ‘securities’ misnomer under state precedents

By Mark S. Nelson, J.D.

An en banc opinion by a Florida district appeals court concluded that a trial judge erroneously entered judgment against a party asserting that a stock purchase agreement was a security and on a related counterclaim because that court was bound to apply defective Florida precedents which had relied on a flawed understanding of the U.S. Supreme Court’s Howey opinion. The appeals court explained that the Howey opinion set forth a test for determining if something is an investment contract and, thus, a security, but that Florida courts had used Howey in a logically untenable manner beyond this specific purpose (Githler v. Grande, December 20, 2019, Rothstein-Youakim, S.).

Lower court ruling. The case arose out of a deal by one investment advice radio program to acquire another such program. Marta Grande and her husband wanted to retire from the business of hosting their program and, through a number of friends and acquaintances, met Charles Githler, who hosted a similar program. The acquisition was to be done through Spot Link, Inc., and required the divvying up of hundreds of shares in the company, plus agreeing to various contingencies and issuing a note. Githler sued the Grandes after he was terminated as managing member of Spot Link, following the company’s conversion from an S corporation into an LLC. The trial court, relying on Florida precedents, concluded the stock purchase agreement at issue did not satisfy the Howey test and, thus, no securities were involved.

Howey in Florida. According to the appeals court, however, the Securities Act and Florida law use roughly the same definition of "security" and the question here was whether Howey should apply at all. The U.S. Supreme Court in Landreth (1985) had, explained the appeals court determined that Howey was inapt regarding a stock purchase agreement because application of Howey would undermine the Securities Act’s listing of many types of instruments that can be securities. As the appeals court would further explain, Florida courts had employed Howey to "define an entire category by one of its members."

The logic problem in Florida precedents was of somewhat recent origin. The Second District, where the Githler case was heard, had misapplied Howey in 1997 and 2002, 12 and 17 years, respectively, after Landreth; two other Florida appellate districts had applied Howey in a similar mistaken manner, but before the U.S. Supreme Court had decided Landreth. The Second District appeals court receded from its two prior opinions misapplying Howey and noted the conflict with other Florida appellate districts.

On remand, the trial court will have to apply the appellate court’s clarified approach to understanding the definition of "security." The trial court then will have to determine if the stock purchase agreement at issue in the case was a "security" and, if so, must it be registered or is it subject to a registration exemption.

The case is No. 2D17-4963.

Thursday, 26 December 2019

CorpFin issues guidance on technology risks associated with international business operations

By Joanne Cursinella, J.D.

The Commission’s Division of Corporation Finance has issued Disclosure Guidance: Topic No. 8, which discusses the disclosure obligations that companies should consider regarding intellectual property and technology risks that may occur when they engage in international operations. The SEC disclosure regime recognizes that a variety of new risks may arise over time and each of these risks may affect different companies in different ways. This guidance is a continuation of the Commission’s effort to guide public companies both in assessing materiality of risks and in drafting related disclosure that is material to an investment decision.

According to the guidance, the increased reliance on technology, coupled with a shift in the composition of many companies’ assets from traditional brick-and-mortar assets toward intangible ones, may expose companies to material risks of theft of proprietary technology and other intellectual property. Companies that conduct business in certain foreign jurisdictions; house technology, data, and intellectual property abroad; or license technology to joint ventures with foreign partners may have more significant exposure.

These companies should consider their disclosure obligations regarding risks related to the potential theft or compromise of data, technology, and intellectual property within the context of the federal securities laws and its principles-based disclosure system. The Commission has made it clear that its disclosure requirements apply to evolving business risks, even in the absence of specific requirements, but existing rules may also require such disclosure regarding the actual theft or compromise of technology, data, or intellectual property if it pertains to assets or intangibles that are material to a company’s business prospects. The guidance provides, as an example, that disclosure may be necessary in management’s discussion and analysis, the business section, legal proceedings, disclosure controls and procedures, and/or financial statements.

Sources of risk. One source of risk is a direct intrusion by private parties or foreign actors, including those affiliated with or controlled by state actors. But a company’s technology, data, and intellectual property may be subject to theft or compromise via more indirect routes as well, the guidance points out. For example, companies may be required to compromise protections or yield rights to technology, data, or intellectual property to conduct business or access markets in a foreign jurisdiction, either through formal written agreements or due to legal or administrative requirements in the host nation. The guidance provides four specifics: (1) when patent license agreements pursuant to which a foreign licensee retains rights to improvements on the relevant technology; (2) foreign ownership restrictions, such as joint venture requirements and foreign investment restriction; (3) the use of unusual or idiosyncratic terms favoring foreign persons; and (4) regulatory requirements that restrict the ability of companies to conduct business unless they agree to some type of arrangement that involves the sharing of intellectual property.

Assessing and disclosing risk. The Division encourages companies to assess the risks related to the potential theft or compromise of their technology, data, or intellectual property in connection with their international operations and how these risks may impact their business. When risks are deemed material to investment and voting decisions, they should be disclosed and specifically tailored to a company’s unique facts and circumstances.

When a company’s technology, data, or intellectual property is being, or previously was, materially compromised, stolen, or otherwise illicitly accessed, hypothetical disclosure of potential risks is not sufficient to satisfy a company’s reporting obligations, the guidance warns. It advises that companies should continue to consider this "evolving area of risk" to evaluate its materiality on an ongoing basis. As companies assess these risks and their related disclosure obligations, there are questions to consider with respect to their present and future operating plans. The guidance provides 12 bullet points of specific matters to consider.
  • Is there a heightened risk to your technology or intellectual property because you have or expect to maintain significant assets or earn a material amount of revenue abroad?
  • Do you operate in an industry or foreign jurisdiction that has caused, or may cause, you to be particularly susceptible to the theft of technology or intellectual property or the forced transfer of technology?
  • Have you directly or indirectly transferred or licensed technology or intellectual property to a foreign entity or government?
  • Have you entered into a patent or technology license agreement with a foreign entity or government that provides such entity with rights to improvements on the underlying technology?
  • Are you subject to a requirement that foreign parties must be controlling shareholders or hold a majority of shares in a joint venture in which you are involved?
  • Have you provided access to your technology or intellectual property to a state actor or regulator in connection with foreign regulatory or licensing procedures?
  • Have you been required to yield rights to technology or intellectual property as a condition to conducting business in or accessing markets located in a foreign jurisdiction?
  • Are you operating in foreign jurisdictions where the ability to enforce rights over intellectual property is limited as a statutory or practical matter?
  • Do you conduct business in a foreign jurisdiction or through a joint venture that may be subject to state secrecy or other laws?
  • Have conditions in a foreign jurisdiction caused you to relocate or consider relocating your operations to a different host nation?
  • Do you have controls and procedures in place to adequately protect technology and intellectual property from potential compromise or theft?
  • What level of risk oversight and management does the board of directors and executive officers have with regard to the company’s data, technology and intellectual property and how these assets may be impacted by operations in foreign jurisdictions where they may be subject to additional risks?

Tuesday, 24 December 2019

CorpFin issues guidance on confidential treatment applications

By Amy Leisinger, J.D.

The SEC’s Division of Corporation Finance has issued guidance on how to submit and what information to provide when filing an application objecting to public release of information otherwise required to be filed. When requesting confidentiality pursuant to Securities Act Rule 406 or Exchange Act Rule 24b-2, the staff states that an applicant should file the exhibit on EDGAR without the confidential information and thereafter submit a written application for confidential treatment. According to the staff, applicants should thoroughly consider the materiality of the omitted information and take care to avoid excessive omissions.

The guidance replaces and supersedes that provided in Staff Legal Bulletins 1 and 1A.

Confidential treatment. Rule 406 and Rule 24b-2 provide the means by which companies may object to public release of confidential information. Generally, applications for confidential treatment pursuant to the rules relate to material contracts required to be filed as exhibits. In March 2019, the Commission changed several exhibit filing requirements to allow companies to omit immaterial, competitive information without having to provide the SEC with the information and request staff approval. However, the process described in the rules is still available for confidential treatment applications, and, in some cases, remains the only available method to protect private information in filed exhibits.

Filing guidance. In the guidance, CorpFin staff notes that, to apply for confidential treatment under Rules 406 and 24b-2, an applicant must file the required exhibit and omit all confidential information while indicating where it has omitted information. The filing also must note that confidential information was filed separately with the Commission. Thereafter, the applicant must file a written application with the SEC’s Office of the Secretary objecting to public disclosure of the confidential information. As part of the process, the applicant needs to file one unredacted copy of the contract with the confidential portions identified and specifically cite the Freedom of Information Act exemption on which it relies. In addition, the applicant must justify the time period sought for confidential treatment and provide a detailed explanation concerning why disclosure of the information is unnecessary for the protection of investors. The applicant also must consent to the furnishing of the confidential information to other government entities, among other things.

The guidance notes that the staff also considers the materiality of the omitted information. If it is clear from the text that the information is not material, the staff will not object. However, the staff notes that, if materiality is unclear, it will discuss its concerns with the applicant and request an amended application and/or filing amendment as appropriate.

CorpFin reviews all applications for confidential treatment to determine whether the applicant has provided all information necessary to warrant a grant of confidential treatment and will request additional information as needed, according to the guidance. If the application is granted, the staff will issue an order and post it with the company’s filing history; if the applicant does not adequately respond, the application may be denied. A denial may be appealed to the Commission, the guidance explains.

A company that previously has obtained a confidential treatment order must file an application to continue to protect the confidential information, the guidance notes. The Division provides a short form application to extend the time for confidential treatment, and an applicant can affirm that the most recently considered application remains accurate and is not required to refile unredacted documents or provide the prior supporting information if the analysis remains the same. If the applicant reduces the extent of omitted information, it must file the revised redacted version of the exhibit on EDGAR when it submits the extension application, according to the staff.

Monday, 23 December 2019

Kirkland & Ellis partner examines the uncertain future of M&A litigation

By Matthew Solum, Kirkland & Ellis, LLP

M&A lawsuits, once predominantly filed in Delaware and other state courts, have shifted to federal court under Exchange Act Section 14(a) in the wake of the Delaware Chancery Court’s 2016 decision in In Re Trulia Stockholder Litigation, according to Matthew Solum of Kirkland & Ellis. In this article, he notes that the shift has raised a number of questions, including to what extent Section 14 provides a private right of action, what pleading standards attach to such an action, and whether Section 14 presents a viable theory of recovery for most plaintiffs once the transaction has closed and the threat of disruption to the deal is gone. He examines recent cases that address these questions, as well as whether freewheeling settlements that have become common in Section 14 cases may be facing a backlash from courts.

To read the entire article, click here.

Friday, 20 December 2019

PCAOB offers revised approach to quality control standards

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

The Public Company Accounting Oversight Board has approved a concept release presenting a potential approach to revising the agency's quality control (QC) standards. At its open meeting on December 17, 2019, the board voted to issue the concept release, which is aimed at strengthening requirements for audit firms' quality control systems and ensuring consistent, high-quality audits. The potential approach is based on the International Standard on Quality Management 1 (ISQM 1) that has been proposed by the International Auditing and Assurance Standards Board (IAASB), with certain modifications as appropriate for firms that are subject to PCAOB standards and rules.

"The input we receive from the public through this concept release will play an important role in the Board's consideration of an approach to revising our quality control standards," said PCAOB Chairman Duhnke in a news release. "We encourage all interested parties to review our release and share their views with us."

The PCAOB noted that agency adopted its current quality control standards in 2003, based on standards originally developed and issued by the American Institute of Certified Public Accountants (AICPA). Given the significant changes in the auditing environment that have occurred in the intervening years, however, the PCAOB's current standards do not reflect relevant developments affecting audit and assurance practices and firms' quality control systems. For example, firms have made a greater use of technology in performing engagements, and some firms have also significantly increased their focus on governance and leadership, incentive systems and accountability, and monitoring and remediation.

ISQM 1. In remarks on December 12 at AICPA’s Conference on Current SEC and PCAOB Developments, Board Member Duane DesParte observed that the PCAOB does not operate in a vacuum and continues to assess developments of other standard setters and regulators, such as the IAASB. The proposed ISQM 1 serves as a good starting point, stated DesParte, because many firms that conduct audits in accordance with PCAOB standards also conduct audits in accordance with international standards. Thus, it would not be practicable to have fundamentally different frameworks for those firms to follow. Moreover, unnecessary differences in QC standards could detract from audit quality by diverting firms' efforts from focusing on matters of fundamental importance to effective QC systems, according to the fact sheet summarizing the concept release.

As discussed in the concept release, proposed ISQM 1 is designed to focus firms' attention on proactively identifying and responding to quality risks that may affect engagement quality. Proposed ISQM 1 describes a firm’s system of quality management as consisting of eight components, which are designed to be highly integrated: (1) Governance and Leadership; (2) Firm’s Risk Assessment Process; (3) Relevant Ethical Requirements; (4) Acceptance and Continuance of Client Relationships and Specific Engagements; (5) Engagement Performance; (6) Resources (Human, Technological, and Intellectual); (7) Information and Communication; and (8) Monitoring and Remediation. The components of proposed ISQM 1 cover the elements of a QC system under the PCAOB’s current standards, although in some cases more broadly, while also including components not currently included in PCAOB standards.

The concept release notes, however, that while the PCAOB seeks to avoid unnecessary differences between a future PCAOB QC standard and a finalized international standard, incremental or alternative requirements may be necessary for firms performing engagements under PCAOB standards. For example, different requirements may be needed to:

  1. align with federal securities laws, SEC rules, and other PCAOB standards and rules;
  2. retain important topics in the PCAOB’s current QC standards that either are not covered in Proposed ISQM 1 or are not covered as specifically; 
  3. address specific emerging risks and problems observed through the PCAOB’s oversight activities; and
  4. provide more definitive direction to promote appropriate implementation of certain requirements by firms that are subject to PCAOB standards and rules. 
The agency also believes that any future QC standard should be scalable, so a firm can tailor its QC system appropriately based on its size and complexity and the nature of the engagements performed, commensurate with applicable risks to quality.

The Board requests comments on the concept release by March 16, 2020.

Thursday, 19 December 2019

Merits briefing begins in Lui case challenging SEC disgorgement power

By Mark S. Nelson, J.D.

Charles Liu and Xin Wang have filed their merits brief challenging the authority of the SEC to seek, and of federal courts to award, disgorgement in civil enforcement proceedings. The case highlights the importance of footnotes in Supreme Court opinions and the context of Supreme Court precedents. Here, the Supreme Court in Kokesh left open the question of federal court authority to award disgorgement in SEC cases via footnote, but that opinion also appeared to limit its reach to the specific question presented regarding whether disgorgement was a penalty for purposes of the general federal limitations period. Regardless of the outcome, Congress has begun the process of advancing legislation that, if enacted, would clarify the SEC’s disgorgement authorities. The justices are scheduled to hear oral argument in Liu’s case on March 3, 2020 (Liu v. SEC, December 16, 2019).

Government’s equity theory disputed. By way of background, the Supreme Court in Kokesh limited its opinion there to the specific question presented about whether the SEC must abide by the federal limitations period contained in 28 U.S.C. §2462 when it seeks disgorgement. Said the court in footnote three: "Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context[.] The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462’s limitations period."

Liu’s merits brief opens by positing that the SEC lacks statutory authority to seek and the federal courts likewise lack such authority to award disgorgement. Liu asserts that the federal securities laws are devoid of explicit authorization for the SEC to obtain disgorgement in federal court. Liu also points to changes made by the Dodd-Frank Act that explicitly allowed the CFTC and the Consumer Financial Protection Bureau to seek disgorgement but which did not speak to the SEC’s ability to seek this type of remedy. Elsewhere in the brief, Lui argues that the SEC still has potent tools for enforcement cases even if it were found to lack authority to seek disgorgement.

One area of especially strong dispute between Liu and the government is the reach of Exchange Act Section 21(d). Specifically, Section 21(d)(5) states: "In any action or proceeding brought or instituted by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors."

Liu argues this provision should be understood to apply only to administrative proceedings, not federal court cases. Liu also asserts that the Supreme Court in Kokesh was clear that disgorgement "bears all the hallmarks of a penalty," while also suggesting that penalties are beyond a court’s equitable powers. Thus, according to Liu, it is impermissible to read the SEC’s injunctive authority to include disgorgement.

The government’s certiorari-stage brief in opposition in Liu, by contrast, argued that disgorgement was consistent with Kokesh. The government noted multiple statutory sources for the SEC’s authority to seek, and for federal courts to grant, disgorgement, including as injunctive relief allowed by the Securities Act and the Exchange Act (i.e., "enjoin" would include disgorgement). The government also said that the Sarbanes-Oxley Act amended Exchange Act Section 21(d) to permit courts to order equitable relief and that related Supreme Court precedent suggests that disgorgement is equitable. The government also noted additional securities law provisions that refer to "disgorgement funds" and laws governing still other practice areas that provide for special treatment of disgorgement.

Moreover, the government theorized that "penal" and "penalty" (similar to the terms of the general federal limitations period statute, can be "elastic in meaning" such that a remedy can be both equitable or penal depending on the circumstance. The government further disputed a reference in Liu’s certiorari petition suggesting that Justice Kavanaugh, while he was still a D.C. Circuit judge, had concurred in a case involving the SEC to suggest limits on disgorgement. The government said the Kavanaugh concurrence did not suggest that disgorgement was beyond the authority of the SEC to seek, or a federal court to grant, such remedy in enforcement cases.

Potential for legislative reversal. Congress can legislatively reverse Supreme Court opinions in cases where the court’s interpretation of a statute does not match lawmakers’ intentions. In the current session to Congress, for example, legislation has been introduced to reverse the Supreme Court’s decision limiting Dodd-Frank Act whistleblowers and to clarify the SEC’s authority to obtain disgorgement. With respect to disgorgement, the bills introduced to date would explicitly authorize the SEC to seek, and for a federal court to order, disgorgement in SEC enforcement cases. The House bill would allow for a generous 14-year limitations period. The Senate version, by contrast, would also authorize the SEC to seek restitution in enforcement cases within a limitations period far more generous than the five-year limitations period it would apply to disgorgement (S. 799). The House passed its disgorgement bill by a vote of 314-95, while the Senate bill awaits further action.

Given that the disgorgement bills have broad bi-partisan support, it is at least remotely possible that Congress could enact such legislation before the Justices decide Liu’s case, which, as mentioned, will not be argued until March 2020, and which could be decided as late as June 2020. If a disgorgement law were enacted before a Supreme Court decision, the court could dismiss the case as moot. Several terms ago the court had been presented with the question of whether the government was entitled to a warrant to access Microsoft’s non-U.S. servers. The court would eventually order the case dismissed as moot after Congress enacted the Cloud Act, which clarified the government’s authorities. Even if the court issues an opinion in Liu’s case and Congress has not acted at that time, lawmakers could later statutorily reverse a decision that curbs the SEC’s authority.

The case is No. 18-1501.

Wednesday, 18 December 2019

Texas proposes cybersecurity incident notification procedures for dealers/investment advisers

By Jay Fishman, J.D.

The Texas State Securities Board has proposed certain procedures that dealers and investment advisers must undertake when a cybersecurity incident is triggered.

Cybersecurity incident procedures. Definitions. A "cybersecurity incident" would be the unauthorized acquisition of computerized or electronic data that: (1) compromises the security, confidentiality, or integrity of sensitive personal information being maintained; (2) jeopardizes the security of the information system or the information the system processes, stores or transmits; or (3) violates the information system owner’s security policies, security procedures, or acceptable use policies to the extent the occurrence results from unauthorized or malicious activity. An "information system" would be a set of applications, services, information technology assets, or other information-handling components organized for collecting, processing, maintaining, using, sharing, disseminating or disposing of electronic information, which is maintained by the dealer, investment adviser, an affiliate, or a third party at the dealer’s or investment adviser’s direction.

A "triggering event" would be a cybersecurity incident pertaining to the information system a dealer or investment adviser maintains (or that is maintained on the dealer’s or investment adviser’s behalf). The triggering event would require the dealer or investment adviser to either submit a notice to a state or federal agency, law enforcement or self-regulatory body, or send a data breach notification to the dealer’s customers or to the investment adviser’s clients under applicable state or federal law, including Business and Commerce Code Section 521.053 (or a similar law of another state).

Notice filing. A dealer or investment adviser would file a notice with the Texas Securities Commissioner when a triggering event occurs that does or may affect the dealer’s Texas-located customers or that does or may affect the investment adviser’s Texas-located clients. The dealer or investment adviser would specifically forward to the Securities Commissioner a copy of the above-mentioned "triggering event notice or notification" or a substantially similar document containing the same information. The dealer or investment adviser would include with the "notice document" the number of Texas-located customers or clients affected by the triggering event (if this information is available).

Tuesday, 17 December 2019

DOJ and CFTC seek a complete stay in civil action against metals traders charged with spoofing

By Brad Rosen, J.D.

The Department of Justice and the CFTC are urging a federal court to issue a complete stay in a related CFTC civil enforcement action against former J.P. Morgan precious metal traders Michael Nowak and Gregg Smith which charges the defendants with engaging in illegal spoofing activities. The DOJ argued that a complete stay is needed to preclude Nowak and Smith from impermissibly taking advantage of the civil discovery process to circumvent the limitations on criminal discovery that protect the integrity of criminal prosecutions. Echoing these concerns, the CFTC rejected the defendants’ proposed alternative to a complete stay, asserting that it would unfairly allow them to obtain discovery from the Commission and third parties far beyond what they would be entitled in the related criminal case. At the same time, the defendants would be shielded from any discovery if they believed those actions might touch upon their Fifth Amendments rights (CFTC v. Nowak, December 13, 2019).

Law enforcement pools resources as part of major anti-spoofing campaign. In September 2019, the CFTC and federal prosecutors announced civil and criminal charges against five individuals who, from as early as 2007 to as late as 2016, engaged in spoofing and other manipulative practices in precious metals futures markets. All the defendants had been worked at the precious metals desk of J.P. Morgan. The defendants were charged with placing thousands of orders with the intent to cancel them in order to send false signals of interest to the market. They also allegedly engaged in spoofing with the intent to manipulate market prices and create artificial prices, enabling their orders to be filled at better terms than they otherwise would.

Three individuals were charged by both the CFTC and DOJ: Michael Nowak, Gregg Smith and Christian Trunz. Trunz entered into a formal cooperation agreement with the CFTC and settled the charges with the agency. He also pleaded guilty in the criminal proceeding.

Defendants contend granting a complete stay will result in prejudice. In his response to the DOJ’s brief supporting a complete stay, defendant Nowak argued that courts have uniformly held that a stay is appropriate only in unique circumstances and where necessary to avoid significant prejudice. Moreover, he asserted that the defendants’ use of civil discovery rules to obtain the discovery to which they are entitled—solely as a result of the CFTC and DOJ’s concerted decision to charge them both civilly and criminally—does not pose a risk of cognizable prejudice or harm to the government. Moreover, it does not justify the extensive stay the DOJ seeks. Nowak concluded that a complete stay would prejudice the defendants by substantially delaying the time-consuming process of discovery in the CFTC case and would prolong and delay a resolution of that action.

As an alternative to a complete stay, the defendants have suggested that the court should stay the action but allow for document discovery, including third party discovery, to proceed. In support of this approach, the defendants pointed to CFTC v. Vorley, a recent case in the Northern District of Illinois where the court considered a similar situation to the matter at hand. In that case, the court ruled to stay the action but allowed document discovery to proceed.

Defendant Smith, for his part, desires to clear his name without further undue delay. Smith noted that he has lived under a cloud of suspicion related to his trading for the past six years as a result of CME, CFTC, and DOJ investigations and now the current charges. Smith asserted that all along the way, he has maintained his innocence and now stands ready and eager to defend himself. He argued that the DOJ’s motion, if granted, would substantially delay his ability to do so. Furthermore, he asserted, the government seeks a blanket stay of all discovery in this action pending resolution of a complex, multi-defendant criminal case against him and others for which no trial date, or even pre-trial motion schedule, has been set. Accordingly, he joined with co-defendant Nowak, arguing that the DOJ’s motion should be denied.

DOJ assets prevailing law supports a complete stay. In its reply memorandum to the defendants, the DOJ asserted that a complete stay of the case is supported by the prevailing case law and is warranted given the circumstances. Moreover, it contended that the defendants’ arguments in opposition to a stay have no merit. Additionally, their proposed alternatives to a complete stay would unfairly allow them to obtain discovery from the CFTC and third parties far beyond what they would be entitled to in the related criminal case, while at the same time shielding them from having to produce any discovery, respond to pleadings, answer interrogatories, or sit for depositions if they believed those actions would touch on their Fifth Amendment rights. Accordingly, they argued that the court should reject the defendants’ proposals as transparent attempts to obtain one-sided discovery without having to actually assert their Fifth Amendment rights against self-incrimination and incur the resulting adverse effects in this civil case.

As for the CFTC, it did not oppose the DOJ’s motion for a complete stay of the civil enforcement action while the criminal proceeding is pending. However, the CFTC squarely opposes the defendants’ suggestions to partially stay the action on asymmetrical terms that, it asserts, are contrary to applicable rules, unfair to the Commission and to nonparties, and inconsistent with the defendants’ purported desire to avoid unnecessary delay.

The defendants are entitled to file replies to the CFTC’s brief supporting the DOJ’s motion for complete stay of discovery by December 20, 2019. The court indicated that it will issue a ruling and set a further status hearing at that time.

The case is No. 1:18-cv-0663.

Monday, 16 December 2019

SEC chairman, chief accountant emphasize role of audit committees at AICPA conference keynote

By Amanda Maine, J.D.

The AICPA’s Annual Conference on Current SEC and PCAOB Developments featured a conversation with SEC Chairman Jay Clayton and Chief Accountant Sagar Teotia as its keynote address. Clayton and Teotia discussed a number of issues relevant to the SEC’s recent initiatives, including the importance of audit committees, auditor independence, and international issues.

Audit committees. Both men highlighted the work of audit committees in ensuring auditor independence. Clayton advised that the role of audit committees is sometimes taken for granted and that they undertake a lot of responsibility when it comes to auditor independence. Independence, Clayton stressed, should be at the front of audit committee members’ minds. He encouraged audit committee members not just to look at compliance with auditing standards, but also to take a step back and make sure they are getting an independent assessment of management’s work.

Clayton also said that he believes that of the Sarbanes-Oxley Act’s reforms, the biggest "bang for the buck" was the independent audit committee requirement. It is important that high-quality people sit on audit committees, he advised. Audit committee members should also have a robust relationship with the audit team to ensure that a candid dialogue is maintained, according to Clayton. One of the audit committee’s most important roles is to be proactive, Clayton stated.

Teotia noted that the staff of the Office of the Chief Accountant (OCA) frequently speaks with audit committee members. According to Teotia, if the audit committee is committed to its mandate, it can have a massive effect on the tone at the company. As a real-life example, he cited the recent standards on revenue and leases. If the audit committee was committed to challenging the company on difficult questions and judgments on the new standards, there has been a clear impact on the tone, Teotia explained.

International issues. Regarding international issues relevant to audit quality, Clayton noted that investors are more exposed to international companies and international financial reporting than they were 10 to 20 years ago. These include investors in a U.S. company with non-U.S. subsidiaries as well as investors in non-U.S. companies. Investors expect the financials to be the same, Clayton said. It is important that there be consistency in reporting as well as consistency in audit quality. Clayton acknowledged that financial reporting is not uniform, but regulators are working to get it as close to uniform as possible because many investors are not adept at making distinctions between multiple jurisdictional differences in financial reporting standards. Clayton advocated "raising everybody to a level where investors can reasonably rely."

Teotia agreed with Clayton, stating you cannot do the domestic job properly if you do not look at it through an international lens. OCA would be unable to give the right input or advice without knowing international standards, which requires a lot of the staff’s time, he said. Teotia praised the work of IOSCO’s Monitoring Group, of which he is a co-chair. The Monitoring Group requires time, effort, and meetings which are important because there are so many participants that provide input on international auditing standards and audit quality, Teotia said.

Teotia also noted that the SEC has been proactive concerning the phaseout of LIBOR, expected to happen in 2021. In July, OCA staff issued guidance on the transition away from LIBOR, he pointed out, which involved working with other divisions and offices within the Commission.

Clayton warned that the consequences and complexities presented by the phaseout of LIBOR are "greatly underestimated." The earlier stakeholders consult with the SEC and other relevant parties, the better the staff will be able to help them through the transition, he said. It will be a challenge, and the staff will be having a robust dialogue to meet that challenge. "Hope is not a strategy," Clayton cautioned.

Friday, 13 December 2019

Baker Donelson attorneys examine how Mylan settlement illustrates disclosure obligation risks

By Michael E. Clark, Robert Hauberg, and Mark Schnapp, Baker Donelson

Publicly traded companies that operate in highly regulated industries often face difficult decisions about what information (if any) to disclose to investors, as well as when and how to disclose it, according to Baker Donelson’s Michael Clark, Robert Hauberg and Mark Schnapp. They believe that Mylan NV’s recent settlement with the SEC offers a reminder about what constitutes best practice, and other important considerations for listed companies facing a disclosure decision. In this article, they examine the implications of the Mylan settlement and offer practical suggestions for how public companies, including those under investigation, can manage their disclosure risks.

To read the entire article, click here.

Thursday, 12 December 2019

Conspiracy chicken must come before fraud egg in price-fixing case

By Rodney F. Tonkovic, J.D.

A Second Circuit panel affirmed the dismissal of a fraud complaint where an underlying antitrust conspiracy was not alleged with the required particularity. The complaint alleged that a poultry processor engaged in price fixing that was not disclosed in its filings, rendering them false and misleading. The court held, however, that where a fraud complaint claims that statements were rendered false through the concealment of illegal activity, the underlying illegal acts must be pleaded with particularity, and the complaint failed to do so (Gamm v. Sanderson Farms, Inc., December 10, 2019, Winter, R.).

Pullet pricing. The action was brought by shareholders in Sanderson Farms, Inc., a processor of fresh and frozen chicken. The market for the type of chicken at issue—ready-to-cook chicken available at grocery stores, or "broilers"—is marked by boom and bust cycles in which rising prices lead to an oversupply of chicken, while demand stays stable, forcing down the market price and leading to supply cuts until the price eventually rises and the cycle repeats. In 2008, however, Sanderson, and several other large chicken producers, colluded to manipulate the chicken price index by coordinating supply reductions.

According to the complaint, the producers agreed to keep supply low while chicken prices were high, thus extending the "boom" portion of the cycle. For its part, Sanderson destroyed breeder hens and eggs and dumped excess inventories in foreign markets. Sanderson and its co-conspirators also allegedly worked to inflate the price of chicken reflected in an index known as the Georgia Dock. The index price eventually departed so significantly from the pricing reflected in other indexes that it was permanently suspended in December 2016.

The shareholders asserted that Sanderson's failure to disclose the conspiracy rendered various statements issued between December 2013 and November 2016 misleading. The company's SEC reports and accompanying press releases during this period noted that it competed with other firms but failed, the complaint alleged, to disclose the collusive conduct and the potential litigation and regulatory scrutiny that could result. The matter came to a head when several antitrust complaints were filed against Sanderson and other producers in late 2016, leading ultimately to a significant drop in share prices.

Wings clipped by lower court. This case is one of several shareholder suits against chicken producers that followed the antitrust suits and subsequent share price drops. The second amended complaint, filed in mid-2017, alleged that Sanderson made statements that were false and misleading because they failed to disclose material adverse information and misrepresented the company's finances. The district court, noting that the case was similar to an unsuccessful suit against Tyson Foods, dismissed the complaint because it failed to support the conspiracy allegation with particularized facts.

Conspiracy and fraud claims are yoked. At issue on appeal was whether the facts of the underlying price-fixing conspiracy were required to be pleaded with particularity or whether the merely needed to meet FRCP Rule 8's lower plausibility standard. It is well-established that when making securities fraud allegations on information and belief, a party must plead material misstatements and omissions with particularity. The court held that the clear language of the PSLRA, the existing case-law, and the stated intent of the securities laws all indicate that, "when a complaint claims that statements were rendered false or misleading through the non-disclosure of illegal activity, the facts of the underlying illegal acts must also be pleaded with particularity." The district court's judgment was accordingly affirmed.

In this case, the court explained, the alleged fraud and the alleged anticompetitive conspiracy were inseparable. The nondisclosure claims were entirely dependent on the predicate allegation that Sanderson participated in an antitrust conspiracy, so particularized facts about the conspiracy were required to explain what made the statements false or misleading. The court pointed out here that district courts in the Second and other circuits have all concluded that antitrust schemes must be pleaded with particularity in follow-on securities actions. Continuing, the court said that this pleading standard also comports with the intent and public policy rationale behind the PSLRA of deterring strike suits and other actions of dubious merit.

In this case, the shareholders alleged that Sanderson engaged in anticompetitive conduct, but did not explain how that conduct occurred and if it affected trade, the court said. Specifically, there were no facts alleging that Sanderson or its peers actually reduced supply and that any reduction was through a tacit or express agreement; the mere parallel conduct that was alleged was insufficient to show an antitrust conspiracy. There were also no facts pleaded showing that Sanderson provided the Georgia Dock with any false information. In sum, the court said, the complaint attempted to establish fraud by innuendo, and its pleadings were, thus, insufficient.

The case is No. 18-0284-cv.

Wednesday, 11 December 2019

Former SEC officials offer insights into FY2019 enforcement program

By Anne Sherry, J.D.

Highlights of the SEC’s enforcement program for fiscal year 2019 included the Share Class Selection Disclosure Initiative, an emblem of the agency’s focus on retail investors under Chairman Clayton’s leadership, said former SEC officials at a Securities Docket webcast. The panelists also offered insights into the whistleblower program, cybersecurity, and internal controls before looking ahead to next year.

The panel featured Bill McLucas, who was the Director of the Division of Enforcement for eight years in the 1990s, the longest tenure in that role in the SEC’s history. Doug Davison is a former Enforcement supervisor and counsel to Chairman Arthur Levitt. Martin Wilczynski was with the SEC for six years, five of those within Enforcement, and Steven Richards was an assistant chief accountant in the Division as well as an advisor to the PCAOB’s enforcement director and its chairman.

A big year for enforcement. Summarizing the SEC’s enforcement activity during the last year, McLucas first noted that the Division’s co-directors, Stephanie Avakian and Steven Peikin, believe the best measure of efforts is the quality and nature of enforcement cases rather than the bare numbers. However, he said, when the fiscal year-end approaches, other departments of the SEC take an interest in the numbers. By this measure, the enforcement program was quite active in 2019, with an increase both in the number of actions and the amount of disgorgement and penalties. McLucas emphasized that the increase occurred despite the Supreme Court’s decision in Kokesh restricting disgorgement and the SEC’s 35-day closure due to the government shutdown.

McLucas observed that the increase may in part be due to an emphasis by the agency on accelerating the pace of investigations and resolutions. He believes that this is a healthy approach because speed and finality are usually good for a respondent or the subject of an investigation. The Division also expects to see an increase in its appropriation and the lifting of its two-year hiring freeze, both of which suggest an active year ahead in 2020.

A win-win self-disclosure program. Davison emphasized the success of the SEC’s Share Class Selection Disclosure Initiative, which encouraged 95 investment advisory firms to come forward and return $135 million to advisory clients. The program made a lot of sense even from a defense perspective, he said: there was a defined process, a standard settlement procedure, and no civil penalties. He relayed that Peikin was surprised by the success of the initiative and said that a few broker-dealers even tried to apply even though the program was limited to investment advisers.

McLucas said the response was similar to an initiative in the mid-1970s through which hundreds of public companies came forward to admit to making illicit payments overseas or to domestic political candidates. This resulted in a report to the Senate Banking Committee that was the predicate for the Foreign Corrupt Practices Act. Davison added that given the success of the latest initiative, there may be something new in the coming year. Although both Enforcement directors have said they don’t have anything in mind, Avakian also said that they are looking at other undisclosed conflicts like sweep arrangements, unit investment trusts, and teacher retirement plans. This may suggest that the Commission is taking efforts to protect groups such as the military and teachers and to use enforcement matters as teaching tools.

Cybersecurity. Another focus in 2019 was cybersecurity, Davison said. He said the Commission tends to view an issuer as a victim in the event of a cyber attack and will only take enforcement action where it’s warranted, such as when Yahoo failed to disclose what was at the time the largest cyber breach, despite having known about it for years. Although not related to cybersecurity, the SEC’s case against Facebook last year is instructive in terms of the company’s disclosure: it was misleading, in the SEC’s view, to talk about the risk of misuse of personal data in terms of hypotheticals when the company knew that data had in fact been misappropriated and misused. Finally, Davison said that the SEC’s report of investigation at the very beginning of FY2019 is worth a read because it describes internal control failures that allowed bad actors to misappropriate funds by posing as corporate executives or as vendors. The Section 21(a) report allowed the SEC to educate issuers without taking specific enforcement action.

The whistleblower program. Wilczynski observed that the number of whistleblower tips dropped slightly in the past year and the number of awards as well. While he said there was no question that whistleblowers have an impact on enforcement, there is some criticism that the process for whistleblowers and their counsel takes too long—as long as 8 years. McLucas called himself "at a minimum a skeptic" of the whistleblower program and said he would like to see a cost-benefit analysis. After the Madoff scandal, he said, SEC staff live in fear of missing something, so there is an obligation to track down every tip, and there are thousands of tips every year. He called the award program a self-fulfilling prophecy because by offering an incentive, the SEC gets more and more tips, and only a fraction of them are actionable. Wilczynski said that at least in some cases, the staff can do a bit more investigation and then close out the inquiry if there is not enough to it, saving themselves from investing a lot of time chasing a lead.

What to watch for 2020. Looking forward to fiscal year 2020, the panelists discussed the future of the disgorgement remedy and other potential legislative acts. McLucas said that the Supreme Court’s decision in Liu v. SEC will likely be a close case, but no matter what side the Court comes out on the availability of disgorgement in district courts, there will likely be a legislative fix. Speaking of legislation, the Insider Trading Prohibition Act passed overwhelmingly in the House. There is a good chance some legislation will come out, McLucas said, adding that it’s curious that securities law should be the basis for agreement within Congress.

Tuesday, 10 December 2019

Discovery battle between CFTC and Chicagoland software developer heats up

By Brad Rosen, J.D.

In a recent filing, defendants Jitesh Thakkar and his firm, Edge Financial Technologies, Inc., renewed their motion for summary judgment which was initially filed in September 2019. At that time, the court ruled the motion was premature but indicated the defendants were free to raise it later in the proceeding. The renewed motion alternatively seeks relief in the event the CFTC claims that it needs additional discovery to respond to the defendants’ motion such that the agency should be required to provide a declaration or affidavit explaining what discovery is needed and for what purpose (CFTC v. Thakkar, December 4, 2019).

For its part, the CFTC filed its response and objection to the defendants’ renewed motion on the following day. The agency argues that the defendants prematurely filed their renewed motion for summary judgment in a transparent attempt to block the CFTC from pursuing legitimate and reasonable discovery. The Commission also took issue with what it describes as the defendants' "mischaracterization of the discovery record." Moreover, the CFTC now seeks to depose four former Edge Financial employees who, it claims, helped develop and test the software application program at issue in the case.

Thereafter, the defendants filed a reply to the Commission’s response in which they contend that the CFTC has all the information it needs to respond to the defendants’ motion for summary judgment. Moreover, they assert that the agency should not be permitted to delay a ruling on the defendants’ motion by seeking further document discovery.

Evidentiary record in the criminal proceeding serves as a basis for granting a summary judgment in the administrative matter. In the underlying motion for summary judgment, the defendants asserted that, based on the entire record compiled in the parallel criminal case as well as in the CFTC’s joint investigation with the DOJ, there is no evidence to support a factual dispute on the issue of their knowledge or intent. That criminal case resulted in a hung jury after a full trial in April 2019. With a 10-2 to vote in favor of Mr. Thakkar’s acquittal, the DOJ decided not to retry him. The defendants had argued that the undisputed material facts showed that they did not know that Navinder Sarao (referred to as "Trader A" in the complaint and the perpetrator of the 2010 "flash crash" in the E-mini S&P futures contract) planned to use the program for spoofing or for manipulative or deceptive practices, and did not intend to aid Sarao’s violations of the Commodity Exchange Act. Accordingly, the defendants asserted they were entitled to judgment as a matter of law.

Subsequent developments support granting the summary judgment. The renewed motion for summary judgment identified new developments that support moving forward with the motion at this time. These include:
  • At the CFTC’s insistence, Mr. Thakkar’s counsel agreed to obtain permission to produce for the CFTC the documents that Thakkar had received from the DOJ in the criminal case and which the DOJ would not provide to the CFTC. As a result, Thakkar, at his own expense, filed a motion in the criminal case to modify the protective order in that case so that he could provide the CFTC with all the documents the DOJ produced to him in discovery in the criminal matter.
  • Mr. Thakkar incurred significant expense to copy and produce to the CFTC more than 800,000 pages of documents that the DOJ produced to him in the criminal case.
  • The defendants responded to the CFTC’s interrogatories and document requests in this case, producing another 1,068 pages of documents in addition to the voluminous documents previously produced by the defendants to the CFTC in response to its voluntary request for documents in May 2015.
Less than two weeks after defendants’ production of discovery responses and documents, the CFTC sent defendants’ counsel notice of the CFTC’s intention to take depositions of four former Edge Financial employees. The CFTC offered no explanation as to why these depositions were necessary for the CFTC to respond to the defendants’ motion for summary judgment. Moreover, the defendants noted that they were unable to determine any reason why the CFTC would need these depositions to respond to the motion.

CFTC claims renewed summary judgment motion is premature. In its response, the CFTC stated that the defendants' renewed motion for summary judgment was filed prematurely. The agency also took issue with the defendants’ arguments and conduct with regard to its discovery obligation. Some of the CFTC’s points and objections include:

The defendants stated that "document discovery issues have been resolved," when that is not the case. The CFTC asserted that it requested for the defendants to meet and confer on two outstanding document discovery issues: (1) the accessibility of data reflecting defendants’ extensive testing of the software application; and (2) the existence of any instant message communications discussing the software application the defendants programmed and whether the defendants’ search and collection of relevant documents included instant message communications. The CFTC claims that defendants’ renewed motion should not relieve them of their duties to meet and confer.
The defendants are using the renewal motion to delay depositions properly obtained through Rule 45 subpoenas. The CFTC asserts that although it notified the defendants of these subpoenas weeks ago, the defendants have refused to discuss the CFTC’s proposed depositions in any way or confirm their availability on the CFTC’s requested dates. The CFTC also claimed that the defendants’ decision now to file the renewed motion should not be a basis for preventing any properly served deposition from going forward as scheduled.

The CFTC’s requested depositions of former Edge Financial employees who helped develop the program for Sarao are highly relevant and proportional to the needs of the case.

The CFTC should not be permitted to delay the summary judgment motion by seeking unnecessary depositions. In its reply to the CFTC’s responsive pleading, the defendants assert that if the CFTC had more closely reviewed the documents the defendants produced in this matter, it would be have realized that it already has all the documents it needs to respond to the defendants’ motion for summary judgment.Additionally, the defendants contend there is no need for taking the depositions of the four former Edge Financial employees as requested because the CFTC already has been provided with the testimony and statements of key witnesses in this case from transcripts of the criminal trial, transcripts of interviews with witnesses, as well as from the CFTC’s own notes from interviews with witnesses.

The next hearing date in this matter is scheduled for December 10, 2019. At that time and given the events over the past three months, Judge Andrea Wood will be better able to evaluate whether the CFTC is pursuing a fishing expedition with respect to its discovery, a potential concern she articulated at the last status hearing in this matter held in September.

The case is No. 1:18-cv-00619.

Monday, 9 December 2019

SEC’s Small Business Forum report includes 14 recommendations for securities policy

By John Filar Atwood

The SEC released its report on the 2019 Government-Business Forum on Small Business Capital Formation in which it addresses suggestions for recalibrating the securities laws to better assist small businesses and their investors. The policy recommendations were made by participants at the August meeting and address issues facing emerging businesses, mature and later-stage private companies, and small reporting companies.

Emerging businesses. Participants discussed issues facing these entities, which the report notes generally raise capital through some combination of bootstrapping, self-financing, bank debt, friends and family, crowdfunding, angel investors, and seed rounds. The funding is typically used to get companies off the ground and through early prototypes.

The first recommendation in this area was to revise the definition of accredited investor. Specifically, participants suggested that for natural persons, in addition to the income and net worth thresholds in the definition, there should be a sophistication test as an additional way to qualify. Tribal governments should be provided parity with state governments, and the dollar amounts to scale for geography should be revised to lower the thresholds in states/regions with a lower cost of living.

The Commission responded that the Division of Corporation Finance is currently considering recommending propose amendments to expand the definition of accredited investor under Securities Act Regulation D. Part of the SEC’s concept release on the harmonization of the exempt offering framework seeks public comment on whether current rules that limit who can invest in certain offerings should be expanded to focus on criteria other than wealth of the investor. The concept release also seeks feedback on whether the Commission should consider rule changes to expand the types of entities that may qualify as accredited investors.

A second suggestion for emerging business concerned finders. Participants recommended that the SEC, and possibly FINRA, look into who finders are, and what the different categories might be for participation in transactions. They said that rules should be explicit and clear for purposes of determining the categories of finders and what constitutes "engaging in the business of effecting transactions in securities" that triggers classification as a broker.

The Commission noted that the Division of Trading and Markets is considering recommending proposed rules concerning the status of finders for purposes of Exchange Act Section 15(a). According to the report, the staff will consider the forum participants’ recommendation in connection with the initiative.

Participants also recommended that Regulation Crowdfunding rules be revised to allow accredited investors to make unlimited investments and raise the maximum limit on the overall deal. The Commission said that the staff will consider this suggestion in connection with the initiative on ways to harmonize and improve the exempt offering framework. The concept release specifically seeks comment on the overall offering limit and individual investment limits contained in Regulation Crowdfunding, the Commission noted.

Later-stage private companies. The report states that later-stage private companies generally are those that are growing and looking for larger amounts of capital that can fund operations of scale, ventures into new verticals, and preparation for public markets. The report notes that most often these investors are institutional, whether syndicate groups, venture capital, private equity, or public funds.

For these types of companies, the participants suggested a federal preemption for all resales of securities sold in a Regulation A Tier 2 offering, provided that the issuer is current in its Tier 2 reporting. They also suggested that there be an unconditional exemption from Exchange Act Section 12(g) for all Regulation A Tier 2 reporting companies, provided that the issuer is current in its Tier 2 reporting.

The Commission replied that in its 2015 final release adopting amendments to Regulation A, the staff undertook to study and submit a report to the Commission no later than five years following the adoption of the amendments on the impact of both the Tier 1 and Tier 2 offerings on capital formation and investor protection. The final release indicated that the report will include, but not be limited to, a review of: (1) the amount of capital raised under the amendments; (2) the number of issuances and amount raised by both Tier 1 and Tier 2 offerings; (3) the number of placement agents and brokers facilitating the Regulation A offerings; (4) the number of federal, state, or any other actions taken against issuers, placement agents, or brokers with respect to both Tier 1 and Tier 2 offerings; and (5) whether any additional investor protections are necessary for either Tier 1 or Tier 2.

The Commission stated that the Division of Corporation Finance will consider the forum recommendations, and the findings from the staff’s report on Regulation A, in connection with the exempt offering harmonization project. The Commission noted that the concept release specifically seeks comment on whether the Commission should extend federal preemption to additional offers and sales of securities and whether the conditional Section 12(g) exemption for Regulation A Tier 2 securities should be modified.

The forum participants also suggested that the Commission provide a series of Investment Company Act exemptions for diversified funds selling securities under Regulation A, Regulation Crowdfunding, and Regulation D. The Commission said that although it did not request public comment on providing potential exemptions under the Investment Company Act for offerings by pooled investment vehicles under Regulation A, Regulation Crowdfunding, and Regulation D in the harmonization concept release, staff in the Division of Investment Management will consider this forum recommendation in connection with that initiative.

Small reporting companies. The report states that these companies are those that can access broad pools of investors when they conduct public offerings, allowing companies to raise large amounts of money to fund activities such as research and development, capital expenditures, or debt service. The public offerings also provide liquidity to early-stage investors and publicity for the company.

The major forum recommendation for these entities was that the Commission reform the rules governing the proxy process by, among other things, providing for effective oversight of proxy advisory firms under Rule 14a-2(b), with a focus on conflicts of interest, accuracy, transparency, and issuer-specific decision making. They also suggested amending the submission and resubmission thresholds for shareholder proposals under Rule 14a-8.

The Commission noted that in November it proposed amendments to its rules governing proxy solicitations to, among other things, condition the availability of certain existing exemptions from the information and filing requirements of the federal proxy rules for proxy voting advice businesses upon additional disclosure and procedural requirements. At the same time, the Commission proposed amendments to certain procedural requirements and the provision relating to resubmitted proposals under the shareholder-proposal rule.

The proposed amendments would, among other things, replace the current ownership requirements with a tiered approach that would provide three options for demonstrating an ownership stake through a combination of amount of securities owned and length of time held. The Commission said that the Divisions of Corporation Finance and Investment Management considered and will continue to consider the forum recommendation in connection with those initiatives.

Friday, 6 December 2019

House passes potentially historic bill that would codify law of insider trading

By Mark S. Nelson, J.D.

The House passed the Insider Trading Prohibition Act in an attempt to clarify the law of insider trading by codifying key definitions in a manner that could also expand insider trading liability. Because insider trading law is largely judge made, it has at times produced confusing judicial decisions regarding the elements of the offense, a trend most recently exemplified by a series of opinions issued by the Second Circuit. The Supreme Court, however, has recently reaffirmed its approach to insider trading, a point underscored by the lone amendment to the bill adopted by the full House. The Insider Trading Prohibition Act passed by a vote of 410-13. The bill now goes to the Senate, although it is at least remotely possible that the bill could be attached to other must-pass legislation.

Bipartisan call for codification. The Insider Trading Prohibition Act may be a rare example of compromise given that it sailed through the House Financial Services Committee by voice vote amid promises by lawmakers on both sides of the aisle to improve the bill as it moved to the House floor. The final product includes an amendment by House FSC Ranking Member Patrick McHenry (R-NC) that clarifies language regarding the personal benefit requirement. However, a second Republican amendment that would have narrowed the bill faltered. The one remaining issue not addressed by the bill deals with whether federal law should be the exclusive law of insider trading in the U.S.

House FSC Chairwoman Maxine Waters (D-Cal) noted that a web of court decisions currently spells out the law of insider trading and has produced much uncertainty about who is and is not liable for insider trading. She said the bill would codify existing law and that the McHenry amendment was a "reasonable bipartisan compromise."

The bill’s sponsor, Rep. Jim Himes (D-Conn), told members on the floor that market place uncertainty about insider trading liability spurred Congress to act. In a later press release, Rep. Himes added: "There is currently no bright line statutory prohibition against insider trading, forcing the SEC and DOJ to rely on more general anti-fraud statutes and decades of case law, subject to interpretation by individual judges. It is past time for Congress to provide direction in this area, as there exists a clear and fundamental disadvantage in prosecuting a crime that has never been properly defined."

Ranking Member McHenry offered an amendment that would achieve three goals: (1) clarify bill text regarding the personal benefit requirement; (2) replace "relating to the market" language contained in the bill that he said was too broad in scope; and (3) strike a rule of construction regarding the application of Exchange Act Sections 10(b) and 14(e). According to Rep. McHenry, codifying a large body of law in a single bill is a difficult task and the result is imperfect, but the end result, in his view, will lessen uncertainty among market participants and reduce the possibility that "activist judges" could expand the law of insider trading.

A day earlier, Rep. Ed Perlmutter (D-Colo) had urged adoption of a resolution under which the Insider Trading Prohibition Act would be considered by the full House. He said that Democrats and Republicans had made good on their mutual pledges to negotiate amendments that would permit the bill to move forward. According to Rep. Perlmutter, the McHenry amendment had the early backing of House FSC Chairwoman Waters and the bill’s sponsor Rep. Himes.

Representative Rob Woodall (R-Ga), speaking on the resolution, explained that the bill, if enacted, would take the courts out of making insider trading law and instead allow Congress to directly exercise its Article I responsibility to define insider trading. Ranking Member McHenry also would emphasize this point while urging adoption of his amendment. Rep. Woodhall had hinted that a Rules Committee compromise resulting in consideration of two Republican amendments would yield greater Republican support for the bill than was previously expected, a prediction that was later reflected in the House’s overwhelming approval of the bill.

Bill mechanics. The Insider Trading Prohibition Act (H.R. 2534; House Rep. No. 116-219; Rules Committee comparative draft), sponsored by Rep. Himes, would codify much of existing insider trading law. A Congressional Budget Office report noted that the bill would expand the SEC’s authorities such that the SEC could bring more insider trading cases, but that the bill also could have a deterrent effect that might result in the SEC bringing fewer such cases.

The bill would provide that it is unlawful for a person to buy, sell, enter into, or cause the purchase or sale of a security (including security-based swaps) while aware of material, nonpublic information (MNPI) relating to the security, or relating to the market for the security, if the person knows, or recklessly disregards, that the information was obtained wrongfully, or that the purchase or sale would be a wrongful use of the information (emphasis added).

One provision in the McHenry amendment would replace the phrase "relating to the market" in the above subsection text with language that emphasizes materiality. Specifically, the amendment provides: "any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on the market price of any [security]." The House approved the McHenry amendment by voice vote.

It is noteworthy that the Rules Committee Print of the bill replaced the discussion draft’s use of the word "possession" with the word "aware" in this part of the bill. An amendment submitted by Rep. Bill Huizenga (R-Mich) would have replaced "aware" with "using." Unlike with the McHenry amendment, the Huizenga amendment drew strong opposition from Democrats. Chairwoman Waters said the amendment would weaken the bill and hinder the SEC’s ability to pursue those who engage in insider trading. Representative Himes explained that, at the request of Republicans, the word "possession" had already been changed to "aware" because of the possibility that one might possess information without being aware of this fact. Representative Himes also said that a further change to "using" could require prosecutors to probe why someone made a trade. The Huizenga amendment failed by a vote of 196-231.

The bill also prohibits the wrongful communication of MNPI where a person, whose own purchase or sale of a security would violate the general ban on insider trading, wrongfully communicates MNPI to another person who: (1) buys or sells a security to which the communication relates; or (2) communicates the information to another person who makes or causes a purchase or sale of a security while aware of the MNPI; and (3) the purchase or sale while aware of the MNPI was reasonably foreseeable.

Under the bill’s proposed standard, the obtaining or communicating of the MNPI would be wrongful only if such acts fell into one of several categories: (1) breach of fiduciary duty; (2) unauthorized and deceptive takings (e.g., conversion or misappropriation); (3) theft, bribery, misrepresentation, or espionage; or (4) the violation of federal laws regarding computer data, intellectual property, or computer privacy.

Some of these provisions would expand the types of acts that may result in insider trading liability to acts that may not currently be within the general antifraud authority of Exchange Act Section 10(b). Presumably, this would make it easier to bring charges against persons who engage in theft, computer hacking, and related offences.

Another provision in the McHenry amendment would further define the bill’s fiduciary duty language to include breaches "for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend)". Thus, the amended bill would eliminate any ambiguity about whether it retained a personal benefit requirement and instead attempt to codify Supreme Court precedent, in particular the Salman opinion (reaffirming and quoting extensively from the Dirks opinion):
"we instructed courts to ‘focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.’ This personal benefit can ‘often’ be inferred ‘from objective facts and circumstances,’ we explained, such as ‘a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.’ In particular, we held that ‘[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.’ (emphasis added). In such cases, ‘[t]he tip and trade resemble trading by the insider followed by a gift of the profits to the recipient’ (internal citations omitted, but with the original emphasis retained).
The bill also includes a knowledge requirement. As a result, a person trading while aware of MNPI need not know specifically how MNPI was obtained or communicated, or whether any personal benefit was paid or promised, provided that the person who traded while aware of the MNPI (or who communicated the MNPI) was aware, consciously avoided being aware, or recklessly disregarded that the MNPI was wrongfully obtained or communicated, or improperly used.

The bill would provide for derivative liability but it also provides for the non-liability for any controlling person or employer who did not participate in or induce acts that would violate the ban on insider trading. Moreover, the insider trading ban proposed in the bill would not apply to a person who acts at the specific direction, and solely for the account of, another person whose securities trading or communication of MNPI would be lawful under the bill. Moreover, the SEC would have authority to grant exemptions from the new insider trading ban.

However, the bill would provide an affirmative defense for persons who enter into Exchange Act Rule 10b5-1 trading plans. A separate provision in the bill would require the SEC to review and make conforming amendments to Rule 10b5-1 within six months after enactment of the Insider Trading Prohibition Act.

In January, the House passed by a vote of 413-3 the Promoting Transparent Standards for Corporate Insiders Act (H.R. 624), sponsored by Rep. Waters, which would direct the SEC to reconsider and revise Rule 10b5-1. Senator Chris Van Hollen (D-Md) has introduced a companion bill (S. 573). Although the Waters and Van Hollen bills are more prescriptive in stating precisely what items the SEC should consider in studying Rule 10b5-1 than is the Insider Trading Prohibition Act, all three bills direct the SEC to make amendments to Rule 10b5-1. However, it is at least arguable that the Insider Trading Prohibition Act’s authority in this regard may be somewhat narrower ("necessary or appropriate because of the amendment to the Securities Exchange Act of 1934 made by this Act"—emphasis added) than the authority contained in the Waters and Van Hollen bills ("consistent with the results of such study").

Lastly, the Rules Committee Print of the Insider Trading Prohibition Act included a rule of construction providing that Exchange Act Sections 10(b) and 14(e), and any judicial precedents established under these sections, would continue to apply to insider trading cases if they are not in conflict with the new insider trading ban. The McHenry amendment eliminated this provision from the House bill.

Need for clarity. Representative Himes was one of several lawmakers in the 114th Congress to introduce similar legislation (H.R. 1625) shortly after the Second Circuit's 2104 Newman decision appeared to make it more difficult for the government to bring insider trading cases. Senator Jack Reed (D-RI) and Rep. Stephen Lynch (D-Mass) (S. 702 and H.R. 1173, respectively) also had introduced insider trading legislation. In the years since Newman, the Second Circuit has perhaps raised as many questions as it has answered through its application of insider trading principles in its amended Martoma opinion (See original Martoma opinion). The Supreme Court also has reaffirmed key principles announced in its Dirks opinion, which still undergirds much of the Supreme Court’s conception of insider trading, including the personal benefit requirement.

Prior to the House Financial Services Committee’s May 2019 vote to approve the bill, Rep. Himes told members the bill would do two things: (1) make sure that elected officials instead of unelected judges make insider trading law; and (2) end the series of reversals in insider trading cases within the Second Circuit brought about by the Newman decision. Representative Himes noted that the bill was largely uncontroversial, although some commenters objected to its treatment of automated stock sales plans. Still, Rep. Himes said he had spoken to SEC Chairman Jay Clayton about some technical issues and that remaining differences could be settled as the bill moved to the House floor.

Ranking Member McHenry said at that time the bill was imperfect but that there was a commitment from Chairwoman Waters and Rep. Himes to work out some details before a vote by the full House. Representative McHenry had indicated that the remaining issues involved the bill's personal benefit provision and its treatment of downstream tippees.

Other noteworthy proposed amendments. It is briefly worth mentioning two proposed amendments that were ultimately withdrawn. The first one, submitted by Rep. Robin Kelly (D-Ill) and supported by Rep. Bill Foster (D-Ill), chairman of the House FSC’s Task Force on Artificial Intelligence, would have required the SEC to report to Congress on the SEC’s use of artificial intelligence and machine learning tools to detect insider trading. The SEC could have omitted from the report any information that would undermine its ability to enforce insider trading laws.

Under another proposed amendment, submitted by Rep. Anthony Brown (D-Md), the SEC would have been required to study and report to Congress on how online platforms impact markets and on the application of insider trading rules to such platforms. "Online platform" would have been defined to mean "any public-facing website, web application, or digital application (including a social network, ad network, or search engine)." In one respect, the provision would have addressed issues that several Congressional committees and other potential legislation might address regarding the economic power of major technology and social media firms. It is also possible that the definition could have brought token exchanges into the study. The SEC previously issued statements on the operation of online platforms and on the trading of digital asset securities.

Industry comment, reaction. The House FSC’s Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a hearing in April at which members considered a group of securities bills, including a discussion draft of the Insider Trading Prohibition Act. John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and one of the bill’s drafters, said the bill would clarify the personal benefit aspect of insider trading law, which has been the focus of much concern ever since the Second Circuit’s decision in Newman.

According to Coffee, however, three changes would further clarify the bill’s scope. First, Coffee urged a rewrite to clarify that there is no personal benefit requirement; the discussion draft, Coffee said, could be read to implicitly retain this requirement. (The McHenry amendment would later clarify that the personal benefit requirement was still part of the bill.) Second, Coffee noted the absence of a good faith defense to derivative liability under the discussion draft of the bill (i.e., controlling person liability) in contrast to Exchange Act Section 20(a), which has a good faith defense. Coffee urged an amendment to add a good faith defense to the bill (as an aside, the "profit from" language in the discussion draft that Coffee also had cited for his concern about the lack of a good faith defense was dropped in the later Rules Committee Print of the bill).

Third, Coffee urged an amendment to the Insider Trading Prohibition Act to grant the SEC rulemaking authority not just to curb liability under the bill but to also expand liability as the market place and modes of committing fraud evolve. This authority, Coffee said, should be included to put the proposed insider trading ban on par with the more expansive SEC authority under Exchange Act Section 14(e), which states: "The Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative." By contrast, the proposed bill limits the SEC’s authority to exempting a person, security, or transaction (or any of these in the plural form) from the proposed insider trading ban on terms or conditions the Commission considers necessary or appropriate in furtherance of the purpose of this title.

Melanie Senter Lubin, Maryland Commissioner of Securities and a board member of the North American Securities Administrators Association, observed that "no statute or SEC rule explicitly prohibits insider trading." Lubin explained that current law relies on Exchange Act Section 10(b)’s and Rule 10b-5’s general antifraud authority to address "deceptive device[s] or contrivance[s]." Lubin characterized the discussion draft of the Insider Trading Prohibition Act as a "major step forward" in codifying a clearer definition of insider trading.

Remington A. Gregg, counsel for civil justice and consumer rights at Public Citizen, said that, on a societal level, unlawful insider trading can magnify income inequality by allowing corporate executives to profit from trading activities that ordinary investors could not engage in. More specifically, Gregg voiced concerns about the personal benefit requirement. "We believe the personal benefit test unjustly limits the boundaries of what should be illegal insider trading," said Gregg.

Tom Quaadman, executive vice president of the Center for Capital Markets Competitiveness at the U.S. Chamber of Commerce, told lawmakers the group has some "concerns" about the bill, although it "strongly opposes any form of insider trading." For example, Quaadman said the bill, as drafted, could become "under-inclusive and over-inclusive" simply from the process of codification of many existing insider trading principles; Rep. Huizenga would later make this point on the House floor. As for the required mental state, Quaadman said the bill could lessen or eliminate the scienter requirement. Quaadman said the Chamber also was concerned that the bill leaves existing Exchange Act Section 10(b) intact such that prosecutors might have a choice between using Section 10(b) or the proposed new insider trading provision (this issue did not materialize during floor debate on the bill in the House). Moreover, Quaadman said the bill could have the unintended consequence of limiting the use of Rule 10b5-1 plans.

Commenting in the Harvard Law School Forum on Corporate Governance and Financial Regulations blog in the months after the introduction of the Insider Trading Prohibition Act, Rahul Mukhi, Shannon Daugherty, and Destiny D. Dike, all of Cleary Gottlieb Steen & Hamilton LLP, opined that the bill could expand insider trading liability by using a "wrongfully obtained" standard and that the bill could result in confusion over whether it imposes a mental requirement based on recklessness or willfullness. (Coffee had addressed this issue in his testimony on the discussion draft of the bill and posited that Exchange Act Section 32(a) would still require a willfulness standard for criminal violations.).

More recently, the Council of Institutional Investors reiterated that it "generally supports" the Insider Trading Prohibition Act while noting that all four of the witnesses at the April House FSC hearing on the bill voiced similar "general support." The CII also said that although the bill could allow for more insider trading prosecutions, it would appropriately clarify that a tippee can be prosecuted even if they did not pay for a tip or they lacked specific knowledge of where a tip came from. The CII also had expressed support for the Insider Trading Prohibition Act in a prior letter published at the time of the House FSC’s May markup of the bill.