Friday, 31 January 2020

Kirkland & Ellis partner examines courts’ recent treatment of Corwin cleansing cases

By Matthew Solum, Kirkland & Ellis LLP

The Supreme Court of Delaware held in Corwin v. KKR Financial Holdings that litigation challenges to mergers are subject to the deferential “business judgment” standard of review when the transaction was approved by the “fully informed, uncoerced majority of disinterested stockholders.” The decision set a benchmark for merger litigation, according to Matthew Solum of Kirkland & Ellis, as transaction parties have sought thereafter to ensure that their stockholder votes qualified for so-called “Corwin cleansing”—the assurance that any later challenge would be subject to the business judgment rule. He examines post-Corwin cases, which have focused on the question of what it means for the disinterested stockholders to be “fully informed” and “uncoerced,” and whether decisions have gone in favor of, or against, defendants.

To read the entire article, click here.

Wednesday, 29 January 2020

NASAA to FINRA: “limit registered persons becoming their customers’ beneficiaries”

By Jay Fishman, J.D.

Christopher Gerold, the current President of the North American Securities Administrators’ (NASAA) and New Jersey’s Securities Bureau Chief, in a January 24, 2020 comment letter to the Financial Industry Regulation Authority (FINRA), applauded FINRA’s proposed rule to limit broker-dealer member firms’ registered persons from being named their respective customers’ beneficiaries. The proposed rule would allow a registered person to be named a beneficiary or hold a position of trust for a customer when the customer is an immediate family member or when the registered person’s member firm provides written approval. But Gerold, representing NASAA, asked FINRA to further restrict the rule’s application to better avoid conflicts of interest and elder abuse.

Prohibit registered person-beneficiary designations except to immediate family members. NASAA first suggested that FINRA amend the rule to prohibit a registered person from being named a beneficiary or holding a position of trust for a customer unless the registered person is an immediate family member. Additionally, said NASAA, the registered person should be required to obtain prior written approval from the member firm, and the firm should implement a heightened supervision over those customers’ accounts. NASAA declared that these suggested proposed rule revisions would provide the investor protections needed to address the conflicts of interest issue that FINRA identified in its request for comments on the proposed rule.

Further suggested revisions. NASAA also suggested that if the rule does, in fact, permit a customer to designate a registered person as a beneficiary or the holder of a position of trust, then FINRA should require the registered person to seek the member firm’s prior written approval, whether or not the registered person is an immediate family member. And moreover, proclaimed NASAA, the rule should guide the member firm on the type of information it should review before approving a request, e.g., the length of time the registered person has known the customer; the nature of the relationship between the registered person and customer; and the circumstances that precipitated the customer designating the registered person as beneficiary.

Heightened scrutiny of approved accounts. NASAA’s final pertinent remark about the proposed rule as written concerned the rule’s requiring member firms to only “reasonably supervise” a registered person’s compliance with conditions or limitations placed on the account rather than mandating a heightened scrutiny over immediate family member and non-family member accounts. NASAA pointed out the inherent conflicts of interest in the proposal even when the customer is an immediate family member of the registered person. NASAA suggested that the rule require heightened supervision for these immediate family member relationships by, for example, placing additional review on trades and transactions in, and withdrawals from, the account to ensure the registered person is making suitable recommendations to the customer and not taking advantage of the position of trust.

But aside from the proposed rule’s not going far enough to avoid conflicts of interest, NASAA emphasized that without the suggested revisions the proposed rule would not protect older customers from elder abuse, particularly older customers who belong to the registered person’s immediate family. NASAA cited a National Council on Aging report that in almost 60 percent of elder abuse and neglect incidents, the perpetrator is a family member, and two-thirds of the perpetrators are adult children or spouses. In light of this statistic, NASAA suggested that FINRA narrow the definition of “immediate family member” to require that any person “who the registered person financially supports” must reside in the same household as the registered person.

Tuesday, 28 January 2020

SEC issues credit rating reports on NRSRO activities, examination results

By Amanda Maine, J.D.

The SEC’s Office of Credit Ratings (OCR) has published a pair of reports on Nationally Recognized Statistical Rating Organizations (NRSROs) outlining trends in the industry and findings from the staff’s examinations. According to a press release, the examination report shows that NRSROs have made some improvements in response to the staff's examinations. The congressionally-mandated annual report on NRSROs discusses several aspects of the industry, including the state of competition and barriers to entry.

Report to Congress. The staff’s 2019 report to Congress on NRSROs includes information about registered credit rating agencies and an overview of certain SEC and staff activities relating to NRSROs. During the report period, there were nine registered NRSROs, including three “larger NRSROs” (Fitch, Moody’s, and S&P) and six “smaller NRSROs” (A.M. Best, DBRS (which added Morningstar as a credit rating affiliate in 2019), Egan-Jones, HR Ratings, Japan Credit Rating Agency, and Kroll Bond Rating Agency).

The latest statistics indicate that while Moody’s, S&P, and Fitch continue to account for the highest percentages of outstanding ratings, smaller NRSROs have gained market share in certain asset classes, according to the report. S&P accounted for 49.5 percent of outstanding credit ratings during the report period, followed by Moody’s at 32.3 percent and Fitch’s at 13.5 percent. The report points out that while the larger NRSROs account for over 95 percent of all the ratings outstanding as of December 31, 2018, the share of outstanding credit ratings that were issued by the larger NRSROs decreased in each category, most significantly in the asset-backed securities category.The report noted in particular that A.M. Best dominated the insurance category. A large proportion of the aggregate credit ratings were in the government securities category, the report states.

The report also describes NRSRO staffing levels and revenue. One of the report’s findings is that while smaller NRSROs in the aggregate employ only approximately 15.4 percent of all credit analysts employed by NRSROs, this percentage has increased steadily in recent years. Total revenue NRSRO revenue for fiscal year 2018 was approximately $7 billion. Moody’s and S&P both experienced a decline in revenue, while Morningstar experienced a sharp increase.

According to the report, some of the smaller NRSROs have gained market share in the asset-backed securities rating category, especially those backed by discrete asset types. These include “newer or esoteric asset types” such as securities backed by unsecured consumer loans and securitizations backed by aircraft-lease receivables.

The report also finds that barriers to entry continue to exist in the rating agency industry. For example, some fixed income mutual fund managers, pension plan sponsors, and endowment fund managers have historically relied on the larger rating agencies by name, the report explains. Cost is also a barrier to entry, including costs associated with complying with the statutory provisions of the Rating Agency Act and the Dodd-Frank Act.

Examinations findings. The report on NRSRO examinations, generally encompassing the period between January 1 through December 31, 2018 (the review period), includes a list of the staff’s “essential findings,” which were included with one or more recommendations in an examination summary letter sent to an NRSRO but did not necessarily constitute a “material regulatory deficiency.” The staff found that in certain instances, some smaller NRSROs did not adhere to their policies and procedures relating to information disclosed with credit ratings, including the failure to publicly disclose the methodological approach in assigning a credit rating or the modification of press releases based on issuer comments.

The staff also found instances in which both larger and smaller NRSROs did not publish Rule 17g-7(a) information disclosure forms when taking rating actions. For example, one larger NRSRO did not publish an information disclosure form when converting a preliminary rating to a final rating as required by Rule 17g-7(a) and the NRSRO’s own policies and procedures. Other Rule 17g-7(a) findings related to information disclosure forms, including the failure to include the assigned rating in the information disclosure form and the failure to sign the attestation form. One NRSRO did not comply with format requirements when it issued a single information disclosure form that applied to multiple ratings and was hundreds of pages long, the report described.

Other essential findings identified in the report included the failure of NRSROs to address a finding and recommendation from the previous year, failure to adhere to policies and procedures related to rating file documentation, and the failure to consistently apply security patches to IT systems under a defined schedule. In some cases, NRSROs did not provide complete, current, or accurate records to SEC staff upon request. In addition, some NRSROs did not conduct sufficient reviews and remediation of analysts’ non-adherence to their own internal policies and procedures or to SEC rules.

The report also outlines the staff’s findings related to conflicts of interest. These included the failure to disclose or appropriately manage a conflict of interest or adhere to policies and procedures related to certain prohibited conflicts of interest. The staff also found that analytical personnel participated in sales or marketing or were influenced by sales or marketing considerations.

Regarding essential findings pertaining to internal supervisory controls, the staff found that some internal controls were unclear or inconsistent, as well as weak internal supervisory controls related to disclosing or documenting errors in determining credit ratings or related to material, non-public information. The staff also identified certain NRSROs that did not adhere to existing methodologies in determining credit ratings or developing and implementing new or revised procedures and methodologies.

Monday, 27 January 2020

Uber CEO’s ‘law breaker’ reputation not enough to show directors ignored due diligence on acquisition

By Mark S. Nelson, J.D.

The Delaware Supreme Court affirmed a finding by the Chancery Court that demand was not excused where a majority of Uber Technologies, Inc’s board of directors was independent of CEO/director Travis Kalanick at the time the plaintiff shareholder filed a lawsuit challenging a troubled acquisition undertaken by Uber. That meant the plaintiff was obliged to make a demand on the board, something the plaintiff failed to do. The Chancery Court had dismissed the case with prejudice (McElrath v. Kalanick, January 13, 2020, Seitz, C.).

Troubled deal. The case arose from Uber’s "flawed" acquisition of Ottomotto LLC. Uber, worried that it was trailing Google in autonomous vehicle technologies, sought to acquire Ottomotto primarily to gain the expertise of Ottomotto’s founder, Anthony Levandowski, a former Google employee who created Ottomotto while still working for Google. The transaction was fraught with risks about misappropriation of Google technology and the deal terms reflected this concern: there were "atypical" indemnity provisions and Uber paid only $100,000 for what consisted of the combined human capital of Levandowski and his team rather than a full-fledged company. Further evidence of the deal’s troubled character includes Uber’s eventual payment of Uber stock worth $245 million to Google to resolve claims regarding misuse of Google’s intellectual property. Uber also would go on to fire Levandowski for misuse of proprietary Google data.

The plaintiff, a former Uber employee and shareholder, alleged that Uber’s board breached its fiduciary duties by blindly approving the Uber-Ottomotto acquisition. Specifically, the plaintiff said the unusual indemnity provisions built into the deal, coupled with Kalanick’s "law breaker" reputation regarding his handling of competitors’ intellectual property, required the board to more closely scrutinize the Ottomotto acquisition.

The "usual way" to become a director. In a recitation suitable for a corporate law treatise, the court explained that it reviews demand excusal cases on a de novo basis and that the inquiry consists of determining whether there were any interested directors (substantial likelihood of personal liability) and, then, whether any other directors were beholden to any of the interested directors (inability to be impartial). If a majority of the board members are disinterested and independent, the plaintiff shareholder must ask the board to pursue the proposed litigation. Still, as in the Uber case, where the company has an exculpatory charter provision regarding allegations of due care violations, the plaintiff may invoke an escape valve by alleging the board’s bad faith. But the court further explained that bad faith is a "high hurdle" and requires allegations that the board knew of wrongdoing (gross negligence, for example, would be insufficient).

The court first noted that the Uber-Ottomotto indemnity provisions were odd but also explained that the provisions would offer some benefit to Uber. With respect to the hiring of Levandowski, the court rejected the plaintiff’s analogy to the Disney case where a board ignored the on boarding of a significant hire, an old friend of the company executive to whom the board had delegated the hiring process. In the Uber case, the company had hired an outside firm to review the use of Google proprietary information and the board did consider the Ottomotto acquisition. The court observed that even if the Uber board could have done more to scrutinize the Ottomotto acquisition, its actions did not rise to bad faith.

Next, the court addressed the question of director independence. The Chancery Court had found that Kalanick was an interested director and the Delaware Supreme Court agreed. In its analysis, the justices asked if a majority (six members) of the then-11-member Uber board were independent of Kalanick. The plaintiff did not challenge the independence of five of the needed six independent directors.

The plaintiff and the court, however, did focus on director John Thain, whom Kalanick had appointed at the height of a power struggle that would result in Kalanick’s ouster as CEO and Kalanick’s being subjected to an investor’s fraud suit. But even being appointed director in this manner might not run afoul of directors’ duties. Said the court: "Importantly, being nominated or elected by a director who controls the outcome is insufficient by itself to reasonably doubt a director’s independence because ‘[t]hat is the usual way a person becomes a corporate director’" (citation omitted). The court concluded that while Thain might have felt a need to be loyal to Kalanick under the circumstances of his appointment, there were no additional allegations that the Kalanick-Thain relationship resulted in Thain being biased.

The case is No. 181, 2019.

Friday, 24 January 2020

Supreme Court urged to address "reasonable grounds" exception to administrative exhaustion

By Rodney F. Tonkovic, J.D.

A new petition for certiorari asks the Supreme Court to address exceptions to the requirement that administrative remedies be exhausted. The Tenth Circuit found "no reasonable" grounds to excuse the petitioner's failure to raise an Appointments Clause objection before the SEC. The Tenth Circuit's reasoning conflicts with other circuits' more lenient standards, the petition says, urging the court to reconcile these disparate outcomes (Malouf v. SEC, January 17, 2020).

Commissions scheme. Petitioner Dennis Malouf is the former CEO and majority owner of an investment adviser, UASNM, Inc. Before 2008, he also owned the branch office of a broker-dealer, but sold the branch in order to eliminate conflicts of interest. The sale was financed by installment payments based on the branch's collection of securities-related fees. Malouf then directed execution of trades for UASNM clients to that branch, in order that the purchaser could collect enough in commissions to pay Malouf.

In 2014, the SEC initiated enforcement proceedings against Malouf, asserting that he violated the securities laws by failing to disclose conflicts of interest arising from the (also undisclosed) payment agreement. Later, an administrative law judge found that Malouf's actions had violated the antifraud provisions of the federal securities laws and that he had aided and abetted UASNM's violations. In addition to a cease-and-desist order, the ALJ imposed associational and officer/director bars and the payment of a civil penalty. On appeal, the SEC agreed, but added a lifetime industry bar and ordered disgorgement plus prejudgment interest.

Appeal. On appeal to the Tenth Circuit, Malouf argued, among other positions, that the appointment of his administrative law judge violated the Constitution's Appointments Clause. Malouf explained that he did not argue an Appointments Clause objection before the SEC because doing so would be futile: at the time, he said, the Commission's public position was that ALJs were not "inferior officers" and did not have to be appointed under the Appointments Clause. The court rejected the futility argument, stating that, at that time (September 2015, immediately before Lucia), the Commission would not necessarily have rejected an Appointments Clause challenge. And, while the Tenth Circuit and U.S. Supreme Court later held that SEC administrative law judges are inferior officers subject to the Appointments Clause, the court said that neither case changed the law but instead merely applied the reasoning behind the Supreme Court's 1991 opinion in Freytag to SEC ALJs.

"Reasonable grounds." The petition notes that many statutes require administrative exhaustion in order to preserve and issue for review by a federal court. The Exchange Act and Investment Advisers Act, for example, require exhaustion, but contain an exception if there are "reasonable grounds" for failing to urge the objection before the Commission. There is no uniformity among the lower courts, however, as to what constitutes "reasonable grounds" and other similar exceptions, leading to a "thicket of inconsistent case law" resulting in "an irreconcilable disparity of outcomes."

The petition urges the Court to apply reasoning from the D.C. and Sixth Circuits to Malouf's case. In a 2013 decision, the D.C. Circuit held that an exception for "extraordinary circumstances" in the National Labor Relations Act excused the failure to raise an objection to a recess appointment because that objection went to the NLRB's power to act and implicated "fundamental separation of powers concerns." In short, "the seriousness of the objection, or a constitutional infirmity of the tribunal, in and of themselves, are 'extraordinary circumstances' irrespective of whether the objection could have been asserted before the agency,” the petition maintains. A 2018 case from the Sixth Circuit found "extraordinary circumstances" in the absence of directly applicable case law. A different outcome would have been reached in these circuits, the petition says, and the Court should provide guidance to unify the lower courts' reasoning.

The petition goes on to argue that there were indeed "reasonable grounds" in Malouf's case based on the Commission's litigation conduct from 2014-2018. The Commission's vigorous opposition to Appointments Clause challenges to its ALJs was a matter of public record before it filed its proceeding against Malouf, and there was no judicial support for an objection. The Commission did not change its position until 2018, long after Malouf had appealed to the Tenth Circuit. The agency would certainly have denied any objection in 2015, the petition contends.

Claims processing. The petition argues further that the exhaustion requirement in the Securities Act (which has no express exceptions) is a "claims-processing" rule, as opposed to a jurisdictional condition. If a condition is jurisdictional, the court has no authority to hear the matter, but enforcement of a claims-processing rule is dependent on a party's litigation conduct. Malouf argues that the Securities Act's exhaustion requirement is a claims-processing rule since there is no clear statement that the provision is jurisdictional and due to the fact that there are express exceptions in all the other securities laws. The Tenth Circuit, the petition says, effectively treated the provision as a jurisdictional condition. No court has directly addressed this issue.

Finally, there is disagreement among the lower courts as to whether claims-processing rules are subject to equitable exceptions. The Supreme Court has noted this fact, the petition observes, but has not itself reached the issue. The Court should grant this petition to answer whether the exhaustion requirement in the securities laws is subject to equitable exceptions; such as, futility, changes in law, and miscarriage of justice, the petition says.

The petition is No. 19-909.

Thursday, 23 January 2020

Chicagoland software developer close to settling aiding and abetting charges in connection with spoofing scheme

By Brad Rosen, J.D.

In an agreed motion to stay discovery deadlines, the CFTC and defendants Jitesh Thakkar and his firm Edge Financial Technologies, Inc. have requested that Judge Andrea Wood stay and suspend all discovery deadlines for a three-month period while the parties look to finalize the settlement of this administrative action. Specifically, the parties have asked the court to freeze the deadlines in connection with the close of fact discovery, disclosure of expert witnesses, submission of expert reports, supplementing initial disclosures, as well as providing rebuttal expert disclosures. Likewise, the parties have also requested a three-month stay in connection with the deadline for dispositive motion (CFTC v. Thakkar, January 21, 2020).

Settlement is imminent. In the motion, the parties informed the court that they are close to resolving the case and have agreed on proposed settlement terms. However, it was noted that the CFTC’s Division of Enforcement attorneys cannot bind the agency to a negotiated consent order that resolves the case without first obtaining approval from the five CFTC commissioners. Consequently, the parties advised the court that time is needed to (1) prepare a mutually-acceptable proposed consent order containing findings of fact and conclusions of law that resolves the CFTC’s claims against the defendants; and (2) recommend the consent order to the full CFTC for its approval.

Moreover, the parties noted that suspending the applicable deadlines for the requested three-month period would provide ample time to finalize the case resolution and minimize the likelihood that the parties will need to return to court and request an extension of the stay. The parties also asserted that resolving the case through a consent order would result in no additional judicial resources being consumed as another reason for granting the requested stay.

Case background and the upcoming sentencing of Navinder Sarao. Previously, Jitesh Thakkar was charged and tried criminally for aiding and abetting the spoofing activities of convicted felon, Navinder Sarao, the purported perpetrator of the infamous 2010 flash crash. In April 2019, a jury voted 10-2 to acquit Thakkar in connection with software consulting services he provided to Sarao. Rather than retry Thakkar, the DOJ dismissed the outstanding charges against him.

As for Sarao, he is finally scheduled to be sentenced in federal court in the Northern District of Illinois on January 28, 2020. In recognition of Sarao’s extraordinary cooperation with law enforcement authorities, the DOJ recommended that any jail sentence be limited to time served. Sarao had previously been in prison for four months in the U.K. prior to being extradited to the United States to face charges. Under the DOJ’s advisory guidelines, a suggested sentence ran from 78 to 97 months.

The CFTC vigorously resumes its administrative action. Despite the DOJ’s unsuccessful prosecution and its dismissal of criminal charges, in September 2019, the CFTC resumed its enforcement action against Thakkar with gusto. The civil action had been stayed during the pendency of the criminal matter. Once the stay was removed, the parties engaged in contentious motion practice, while the CFTC sought extensive discovery even though the agency had access to a massive trove of documents from the criminal matter.

The industry continues to watch closely. The futures and derivatives community, as well as the financial technology industry, will continue to monitor developments in this high-profile case closely. The CFTC’s aggressive pursuit of Thakkar and seeming disconnect with the DOJ in the matter have resulted persistent criticism from members of public and business community. Over 2500 individuals have signed on to a petition titled Justice for Jitesh, which has asserted the CFTC’s continued pursuit of this matter has resulted in an injustice and has been detrimental to the futures industry.

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

Wednesday, 22 January 2020

Claim that CBS misled investors about impact of #MeToo movement may proceed

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

The federal district court in Manhattan has allowed a securities class action to go forward against CBS Corporation and former CEO Leslie Moonves for alleged misstatements to the media concerning the company’s efforts to address workplace sexual misconduct. Judge Valerie Caproni ruled that the complaint adequately alleged that Moonves’s statements regarding the company’s response to the #MeToo movement at a Variety magazine event were materially misleading in light of his own alleged wrongdoing. She dismissed other securities fraud claims against CBS, Moonves, and certain officers and directors, however, holding that the statements underpinning those claims were either immaterial or not adequately alleged to be false or misleading (Construction Laborers Pension Trust for Southern California v. CBS Corp., January 15, 2020, Caproni, V.).

The complaint alleges that Moonves—who was heralded as the architect of CBS’s success while overseeing a dramatic rise in share price during his more than 20-year tenure at the firm—concealed a dark history of sexual misconduct and fostered a hostile workplace culture that posed material business risks to the company. According to the plaintiffs, the defendants allegedly failed to disclose the risk that journalists would uncover and expose Moonves’s misconduct and force Moonves out, all the while paying lip service to the company’s purported anti-harassment ethical standards. CBS ultimately terminated Moonves for cause in December 2018 after the New York Times published the details of a draft report from an independent investigation by CBS that described previously unreported acts of sexual misconduct by Moonves.

Risk of #MeToo revelations. The court observed that a single theory of securities fraud underpinned the complaint, namely that the advent of the #MeToo movement’s revelations of sexual assault carried out by media and entertainment power brokers increased the risk that CBS would lose Moonves to sexual scandal. Despite this, the theory posits, the defendants failed to disclose that risk even as they touted CBS’s ethical culture and Moonves’s importance to the company’s financial performance.

The court first rejected claims that statements from CBS's business conduct statement that were incorporated into its proxies from 2016 to 2018 were false or misleading. The court observed that language in the business conduct statement stating that CBS “believes in an environment that is free from workplace bullying” and “CBS has a ‘zero tolerance’ policy for sexual harassment” were far too general and aspirational to invite reasonable reliance by investors. These statements were not made to reassure investors that no CBS executive was susceptible to being the target of accusations of sexual harassment, the court opined, nor did they describe concrete steps taken by CBS to ensure compliance with internal policy or the law. Accordingly, most statements in the business conduct statements were mere puffery, the court found.

The court also rejected claims that various risk disclosures by CBS in its Forms 10-K and 10-Q regarding Moonves’s importance to the company were false and misleading. Although the plaintiffs argued that the risk disclosures were misleading because CBS failed to disclose the risk that Moonves would be ousted due to accusations of sexual misconduct, the court disagreed. The disclosures stated simply that Moonves was important to CBS, the court observed. They did not state or suggest that Moonves had always behaved appropriately, nor did they purport to assess the likelihood that he would leave the company.

The court next turned to claims that CBS and certain individual defendants misstated material facts to various news outlets when commenting on the #MeToo movement and on CBS’s efforts to address workplace sexual misconduct in the wake of correspondent Charlie Rose’s firing by CBS News in late 2017. The court first found that statements by CBS News President David Rhodes that CBS had “worked to strengthen existing systems to ensure a safe environment where everyone can do their best work” and “we take swift action when we learn of unacceptable behavior” were generic puffery. They did not state or imply that Moonves, or any other CBS executive, had not engaged in misconduct or would not be swept up in the #MeToo movement.

The court did find, however, that the complaint adequately alleged that remarks by Moonves at the Innovate Summit hosted by Variety magazine in November 2017 constituted a misleading statement of material fact. At that event, Moonves had said: "[#MeToo] is a watershed moment. It’s important that a company’s culture will not allow for this. And that’s the thing that’s far-reaching. There’s a lot we’re learning. There’s a lot we didn’t know." Although it was a close call, the court held that it was barely plausible that a reasonable investor would construe Moonves’s statement as implicitly representing that he was just learning of problems with workplace sexual harassment at CBS. The statement implied that he had not known of these problems previously, even though, in truth, he was at that time actively seeking to conceal his own past sexual misconduct from CBS and the public.

The misleading aspect of Moonves’s statement was also adequately alleged to be material, the court held. The court reasoned that a reasonable investor could have understood Moonves’s statement to mean that he did not have exposure to sexual misconduct allegations, thus providing reassurance that Moonves, the one executive that the company and analysts viewed as crucial to CBS’s continued success, would not be compromised by the #MeToo Movement. Thus, a reasonable investor could rely upon his statement as reflecting Moonves’s own—and thus CBS’s—lack of high-level exposure to the #MeToo movement.

Finally, the complaint adequately pleaded scienter against CBS and Moonves. Although it was again a close call, the plaintiffs sufficiently alleged that Moonves was consciously reckless when he made his statement to the Variety audience. The complaint included extensive and specific allegations that Moonves had sexually harassed and assaulted employees and non-employees—precisely the sort of behavior that #MeToo reporting was ferreting out and precisely the conduct that his Variety statement impliedly distanced himself from, the court reasoned. The plaintiffs’ allegations gave rise to a strong inference that Moonves knew at the time he made his statement that his remarks and their implications were not truthful or that, at a minimum, he was highly unreasonable in failing to appreciate that possibility.

The plaintiffs also adequately pleaded corporate scienter because the complaint alleged facts supporting a conclusion that, when he spoke at the Variety event, Moonves was acting as CBS’s agent under its control and within the scope of his authority. Moonves allegedly spoke on behalf of CBS as its CEO and chairman to articulate the company’s stance on the #MeToo movement. Because that was not a fraud against CBS, Moonves’s scienter could be imputed to CBS, the court held.

The case is No. 18-CV-7796 (VEC).

Tuesday, 21 January 2020

Airbnb statement contemplates diverse group of stakeholders

By Mark S. Nelson, J.D.

Airbnb, Inc. announced it will pursue a renewed focus on a wider group of stakeholders in its business and measure its progress in working with those stakeholders though a set of principles and metrics. "We believe that building an enduringly successful business goes hand-in-hand with making a positive contribution to society," said Airbnb via press release. The announcement comes as many companies begin to grapple with Business Roundtable’s statement last year on the guiding principles it views as necessary for companies to keep pace with an evolving corporate governance landscape.

The Airbnb statement also comes as markets anticipate the 2020 crop of IPOs and whether Airbnb might be one of them. That decision may depend not only Airbnb’s finances and general economic factors, but also on the attractiveness of a traditional IPO or the availability of an alternative type of listing, the impact of WeWork’s failed IPO, and potentially the outcome of a Delaware Supreme Court case that will examine the use of forum selection clauses that purport to require Securities Act claims to be heard in federal courts (oral argument in Salzberg v. Sciabacucchi was held January 8, 2020). Airbnb’s stakeholder statement also places a heavy emphasis on safety, a topic that has received media attention because of issues at Airbnb "party houses," which the company banned last year.

Focus on stakeholder outreach. Airbnb’s broader vision of its stakeholders has been in progress for several years and pre-dates Business Roundtable’s 2019 statement urging companies to take a wider and longer view of their stakeholders. In 2018, Brian Chesky, an Airbnb Co-Founder and its CEO and Head of Community, told Airbnb’s community: "It’s clear that our responsibility isn’t just to our employees, our shareholders, or even to our community—it’s also to the next generation. Companies have a responsibility to improve society, and the problems Airbnb can have a role in solving are so vast that we need to operate on a longer time horizon."

Chesky explained at the time that many businesses continue to adhere to a 20th century business model that too often focuses on short-term gains. As a result, Chesky's vision for Airbnb would emphasize an infinite time horizon for the business and service to all of Airbnb's stakeholders. Part of that vision requires the company to achieve "harmony" among three main groups of stakeholders: (1) Airbnb's employees and shareholders; (2) Airbnb's community of hosts and guests; and (3) "the world outside of Airbnb."

The latest statement from Airbnb attempts to add substance and measurability to these goals. As a result, Airbnb has identified a set of five stakeholders in its business and aligned these stakeholders with principles and metrics (listed below from left to right: stakeholder—principle—metrics) that the company believes will measure its progress in promoting stakeholder interests:
  • Guests—safety—safety and property damage reports.
  • Hosts—partnerships—seek new hosts, support longer tenures, and facilitate earnings.
  • Communities—diversity and sustainable travel—manage local/global carbon footprint.
  • Shareholders—maintain value of business for the long term—use GAAP and other financial measures.
  • Employees—gender, racial and ethnic diversity—focus on data and transparency.
With respect to the last group, employees, Airbnb said that, as of 2018, its workforce was just under 50 percent female and that underrepresented minorities accounted for just over 12 percent of its employees.

Airbnb also said it will revise its corporate governance structure to better serve its stakeholders. For example, the company will create a board committee on stakeholders along with a similarly focused management team. The company statement on employee pay is somewhat vague but appears to emphasize achievement of stakeholder and guest safety goals. Moreover, the company plans to host a "Stakeholder Day" to announce progress on its stakeholder goals and it will promote the communities it serves though a grant program.

BRT, Leo Strine push firms on governance. The Airbnb statement would appear to be broadly consistent with BRT’s "all" stakeholder approach and with the risk approach taken by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Business Roundtable’s 2019 statement urged companies to promote the interests of "all" stakeholders. To this end, BRT said companies should focus on customers, employees, suppliers, and local communities while pursuing shareholder value over the long term.

COSO, whose governance framework is widely used by public companies, has stated principles for environmental, social and governance (ESG) issues. The COSO principles are couched in terms of risk and urge companies to identify ESG issues, review and remediate them, and to report on their progress. For COSO, citing multiple sources, the "E" in ESG means "environmental," which to a large extent focuses on reducing companies’ carbon footprints. The "S" means "social" and includes human capital (an issue noted by SEC Chairman Jay Clayton and an SEC rulemaking petition), compliance with labor and supply chain laws, and integration with local communities. The "G" stands for "governance" and can impact stakeholders: "A well-defined corporate governance system can be used to balance or align interests between stakeholders and can work as a tool to support a company’s long-term strategy."

Moreover, retired Delaware Supreme Court Chief Justice Leo E. Strine, Jr. has pushed firms to do more on a number of governance fronts. Several of Strine’s recent extra-judicial writings focused on the influence (or sometimes lack of influence) of the big four fund complexes on corporate governance and how those funds’ decisions impact ordinary investors. Some of Strine’s ideas also can be found in aspects of proposed federal legislation, for example, the Accountable Capitalism Act (H.R. 7294; S. 3348), originally sponsored in the last Congress by Sen. Elizabeth Warren (D-Mass), and the Shareholders United Act (H.R. 936), sponsored by Rep. Jamie Raskin (D-Md), which was included in the For The People Act (H.R. 1), which passed the House in March 2019 by a vote of 234-193.

Congress also has begun to address ESG disclosure issues. For example, the House Financial Services Committee reported the ESG Disclosure Simplification Act (H.R. 4329), sponsored by Rep. Juan Vargas (D-Calif), by a vote of 31-22 in September of 2019. The bill would emphasize sustainability, disclosure, and the use by public companies of SEC-defined ESG metrics.

Monday, 20 January 2020

Keeping the dream alive

[In commemoration of Martin Luther King, Jr. Day, we republish a post by the late Jim Hamilton from August 28, 2010, celebrating the anniversary of Dr. King's "I Have a Dream" speech.]

By Jim Hamilton, J.D., LL.M.

I once heard Alabama federal district judge (later named to the 11th Circuit Court of Appeals) Frank Johnson Jr. caution people not to think that federal judges decide momentous civil rights cases every day. Most of the work of federal judges, he said, consists of interpreting arcane federal regulations and U.S. code provisions. Frank Johnson Jr. was the federal judge in the Rosa Parks case, which changed the history of the South and the entire U.S. So, every once in a while, I have to leave the arcane world of securities regulation to mention something more momentous.

Today is the anniversary of Dr. Martin Luther King Jr.’s "I have a dream" speech. It envisions a world and a South where, in Dr. King’s words, "one day on the red hills of Georgia the sons of former slaves and the sons of former slave owners will be able to sit down together at the table of brotherhood.’’

There is a New South today, and there are many to thank for it: President Jimmy Carter, Senator Claude Pepper of Florida - and dare I mention Governor and later Senator Terry Sanford of North Carolina? Yes, I do dare because he was a great man also.

But if the New South has a father, it has to be Dr. King. When I drive past the new gleaming auto plants and Siemens plants in South Carolina and Georgia and see the sign announcing a new $1 billion VW plant in Tennessee, I think how Dr. King made it all possible. Yes, he did. Because no global company, not Nissan, not BMW not Seimens, would ever have come and built large new plants in a segregated South. That would never have happened, and that is the God’s truth.

So, on the anniversary of "I have a dream," let us pause to honor Dr. King. Tomorrow, we return to the arcane world of securities regulation.

Friday, 17 January 2020

Court forces merger between Boston Scientific and Channel Medsystems

By Anne Sherry, J.D.

The Delaware Court of Chancery ordered specific performance of a merger between Boston Scientific and Channel Medsystems. Boston Scientific had terminated the agreement based on the intervening discovery of a Channel officer’s fraud, but the court found that the fraud did not constitute a material adverse effect given the FDA’s acceptance of Channel’s remediation plan. Furthermore, Boston Scientific’s termination constituted a breach of its contractual obligation to use commercially reasonable efforts to consummate the merger (Channel Medsystems, Inc. v. Boston Scientific Corporation, December 18, 2019, Bouchard, A.).

In December 2017, about two months after Boston Scientific and Channel entered into the merger agreement, Channel discovered that its vice president of quality had engaged in a scheme to defraud the company. The officer used shell companies and falsified invoices to steal $2.6 million over about five years. He also falsified other documents, some of which were contained in Channel’s submissions to the FDA seeking approval of its sole product, a gynecological device called Cerene. The FDA accepted Channel’s remediation plan in April 2018, a strong indicator that the fraud would not impede FDA approval. However, Boston Scientific terminated the merger agreement in May 2018. The FDA approved Cerene in March 2019, and Channel sued for specific performance of the merger.

The court concluded that although the officer’s fraud caused a number of representations in the agreement to be inaccurate, Boston Scientific failed to prove that those inaccuracies would reasonably be expected to have a material adverse effect. As is typically the case, the agreement did not define what is "material" for purposes of a material adverse effect, so the court turned to Delaware cases holding that the effect should "substantially threaten the overall earnings potential of the target in a durationally significant manner" (Akorn, Inc. v. Fresenius Kabi AG (Del. Ch. 2018)). Furthermore, it held that the relevant date for assessing whether there was a reasonable expectation of a future material adverse effect is the date on which Boston Scientific provided its notice of termination, and the relevant date on which that material adverse effect would be expected to occur is the date the parties expected to close.

Boston Scientific’s evidence of a material adverse effect fell short from both a qualitative and quantitative standpoint. The company’s main qualitative argument was that even if Cerene received FDA approval, Boston Scientific would need to remediate and retest Cerene before putting it on the market. This argument was not credible given the circumstances surrounding the decision to terminate the agreement in reliance solely on a consultant’s report without speaking with the consultant or Channel, retaining an outside consultant, quantifying the costs of remediation, or looking into Channel’s remediation efforts to date. The executive who made that decision also did not confer with a number of executives whose perspectives would have been relevant. Boston Scientific kept no written record of the meeting at which the decision was made to terminate, or any documentation at all assessing the impact of the fraud at Channel after it received the consultant’s report, and its quality expert could not identify any instance where any company, including Boston Scientific, voluntarily rebuilt a quality system and retested a device after receiving FDA approval. Furthermore, Boston Scientific’s concerns about potential products liability litigation, competitive harm, and future regulatory action were based on unsubstantiated speculation.

Boston Scientific also failed to make the quantitative case for the existence of a material adverse effect. The court did not credit its expert’s analysis because it was premised on an assumption that Boston Scientific would shelve Cerene for two to four years while it rebuilt and retested the device, a position that the court explained was not objectively reasonable. The expert also analyzed a putative change in Channel’s value that incorporated merger synergies. The chancery court consistently holds that a target should be valued as a standalone entity when determining whether a material adverse event has occurred.

Having determined that Boston Scientific’s termination of the agreement was not justified by the existence of a material adverse effect, the court held that the company breached its obligation to use commercially reasonable efforts to consummate the merger. As for the remedy, the parties expressly agreed that a failure to perform would warrant specific performance, and the equities weighed in Channel’s favor so as to make that remedy appropriate.

The case is No. 2018-0673-AGB.

Thursday, 16 January 2020

Federal prosecutors argue against former Theranos head's motion to dismiss indictment

By Rodney F. Tonkovic, J.D.

Federal prosecutors have filed motions in opposition to former Theranos CEO Elizabeth Holmes's motion to dismiss several counts of the indictment against her and the company's COO. Holmes argued that parts of the indictment failed to allege falsity and a duty disclose and also moved to dismiss portions of the indictment relating to defrauding patients who used Theranos's blood tests. The government asks the court to deny the motion in its entirety (U.S. v. Holmes, January 13, 2020).

The action was brought against Theranos founder Elizabeth Holmes and the company's president and COO, Ramesh "Sunny" Balwani. The indictment alleges that Theranos, a blood-testing company, misled the public regarding the capabilities of its technology. Holmes and Balwani represented that the technology yielded accurate results while knowing that the tests were unreliable. Holmes and Balwani were charged with two counts of conspiracy to commit wire fraud and nine counts of wire fraud stemming from two schemes: a multi-million dollar scheme to defraud investors and another scheme to defraud patients and doctors.

Falsity and duty to disclose. Holmes and Balwani ("Theranos") have asked the court to dismiss certain clauses from the superseding indictment, asserting that it fails to allege falsity and a duty to disclose. The government's motion in opposition argues that Theranos articulated the wrong standards. First, Theranos asserts that specific falsehoods are required to allege wire fraud. But, the government says, Ninth Circuit precedent says that all that must be pleaded is a fraudulent scheme or artifice, and any deceptive statements or half-truths are considered material evidence of the fraud. The court can deny the motion to dismiss based on this standard, the government argues, and does not need to consider whether the challenged clauses allege actual falsity. The government says that it only needs to properly allege wire fraud and has done so.

Even if the court considers the allegations, the government continues, they clearly allege falsity. Theranos made misrepresentations in furtherance of the scheme, including lies to doctors and patients concerning the consistency of the company's test devices when the devices' unreliability was known. Further, the statements at issue were also fraudulent as "half-truths" due to critical omissions meant to deceive, the government contends.

The superseding indictment also alleges a duty to disclose. In the Ninth Circuit, a duty to disclose arises from affirmatively telling a half-truth about a material fact, whether or not there is a relationship of trust. Even so, the government asserts that a duty of trust existed because Theranos induced investors to relax their ordinary care and vigilance through deceptive demonstrations designed to show that the technology worked.

Doctors and patients. Not only did investors lose hundreds of millions when the misrepresentations came to light, but thousands of patients received unreliable blood tests which, in many cases, caused actual harm. In their motion, the defendants asked the court to limit the case to fraud targeting investors.

The government says that this motion should be denied for three reasons. First, the indictment meets constitutional standards for pleading fraud against doctors and patients. A charging document alleging every detail that will be presented at trial is not required. Next, the alleged fraud goes to the core of the bargain between Theranos and its customers – the decision to market unreliable tests is the definition of intent to defraud, the government says. Finally, the indictment alleges that Theranos intended to deprive its victims of the money paid for testing services, and the fact that not every victim paid Theranos directly does not affect this charge's viability.

The case is No. 18-CR-00258.

Wednesday, 15 January 2020

Inaugural Asset Management Advisory Committee meeting focuses on industry transformation

By Amy Leisinger, J.D.

In the first meeting of the Asset Management Advisory Committee, panelists discussed recent developments in fund investing and the evolution of the asset management industry. Separately, panelists emphasized the importance of investor choice, particularly regarding private equity and other investments. According to Committee Chairman Edward Bernard of T. Rowe Price, informed debate leads to better ideas and solutions; even with varying perspectives, the ultimate goals of market success and proper investor protection remain the same, he explained.

"I believe the AMAC will help ensure that our regulatory approach to asset management meets the needs of retail investors and market participants at a time when the asset management industry and our markets more generally are rapidly evolving," SEC Chairman Jay Clayton said.

Industry changes. Michael Goldstein of Empirical Research Partners highlighted several aspects of transformation in asset management. The U.S. money management industry is approximately $45 trillion in size and has a substantial retail component, he said. New capital raised by private equity and venture capital has increased though some inertia remains among holdings in general. Interest rates and pricing have a lot to do with investor behaviors, Goldstein noted, but a growing preference for machines over people has changed the industry landscape, as has the trend of companies staying private for longer periods. In addition, mutual funds are getting more involved in the venture capital space, and financial professionals are moving toward describing themselves as "wealth managers" and "financial planners," as opposed to the more common "brokers." This could indicate a shift in the roles in which these professionals see themselves, he opined.

In addition, Goldstein noted that the dominance of "baby boomers" as asset holders has created some inertia and limited disruptions to a certain extent. However, at the same time, the nature of investment advice has shifted toward indexing, he said. According to Goldstein, the more the industry automates, the more decisions and returns are standardized. Technology is increasingly defining outcomes, and automated advice is becoming the norm. Ultimately, this is a reflection of what is happening in the economy and in terms of globalization, he explained.

Deloitte Consulting Principal Ben Phillips agreed that automation and data accumulation are increasing in popularity but also noted a shift from products to services; changing needs are changing consumer demand, he explained. Investors are becoming more outcome-oriented and focused on low fees, and shifts in supply and demand, particularly in connection with the decline in listed companies, are reshaping the U.S. asset management industry, according to Phillips. In addition, there is an enhanced focus on performance fees over asset-under-management fees and mass customization in efforts to align with what customers seek. Asset managers will need to increasingly rely on private markets to achieve client goals, he opined.

Private investments. In a separate panel, Stephanie Drescher of Apollo Global Management noted that credit markets are shifting private, as alternative credit and equity continue to outperform traditional asset classes. This has resulted in a substantial flow to alternative managers, with pensions even seeing increased allocations to private investments, she noted. Blackstone Group’s John Finley opined that volatility is lower in private markets and that adjustments can be made as necessary to ensure growth. We should look at democratizing access to private markets, he said.

Colby Penzone of Fidelity Investments agreed, suggesting that broadening access to private markets beyond qualified institutional buyers and accredited investors could be beneficial. Many investors already have indirect exposure to private investments through funds and other proprietary vehicles or third parties. While investor and intermediary education will be critical in the event of allowing access to private markets, the ultimate benefits could outweigh the costs.

"The SEC is in the protection business and the choice business," Finley noted. The primary focus should be on how to do both with respect to private markets, he concluded.

Tuesday, 14 January 2020

2019 year in review: Blog Tracker hot topics

By Lene Powell, J.D.

In Securities hot topics in 2019: A whirlwind expert review, we look back at blog posts by securities practitioners and other experts for insights on trends and developments in 2019, including:
  • continued dramatic growth of securities litigation and calls for reform;
  • the SEC’s adoption of Regulation Best Interest and related Form CRS and interpretations regarding the duties broker-dealers and advisers owe to customers;
  • corporate governance hot spots, including controversial proposed SEC rules on proxy advice and shareholder proposals, as well as continued debate on the role of ESG (environmental-social-governance) in corporate social responsibility; and
  • an emerging legal framework for digital assets and cryptocurrencies.

Monday, 13 January 2020

FIA and ISDA provide ESMA with their view of position limits under MiFID II

By Brad Rosen, J.D.

The Futures Industry Association (FIA), together with the International Swap Dealer Association (ISDA) responded jointly to the European Securities Markets Authority’s (ESMA) consultation referred to as the MiFID II review report on position limits and position management and draft technical advice on weekly position reports. ESMA issued its call for evidence in May 2019 inviting stakeholders to share their views with regard to the position limit regime. In their response, FIA and ISDA noted that MiFID II position limits had only been in place for approximately two years, were previously unprecedented in the European Union (EU), and were without any equivalent regime in other jurisdictions. The associations indicated that their memberships did not view the position limit regime as having caused significant negative consequences, with the exception of its impact on new and illiquid contracts. Notwithstanding, FIA and ISDA identified several areas for improvement in the position limit regime, and included the following key messages in its response letter to ESMA:
  • Refocus the scope of position limits. The associations recommended refocusing the scope of the position limits regime to include only the most important benchmark contracts with a particular focus on food commodity contracts. FIA and ISDA asserted that this would help solve the problems associated with the application of limits to new and illiquid contracts, where exchanges, dealers, and end-users have raised concerns that the existing limits are a hurdle to the development of markets for new contracts.
  • Limiting the scope of covered contracts. The associations also call for limiting the scope of contracts covered by position limits. FIA and ISDA noted that the definition of financial instruments—and of commodity derivatives—has led to extensive discussions as to whether some securities or some derivatives with no underlying physical commodity should be subject to position limits. They further noted their present inclusion in the regime is a result of their cross references between MiFID and MiFIR which suggest that they are commodity derivatives. Additionally, the associations asserted that their members support the objectives of the legislation, and particularly, the prevention of excessive speculation for underlying commodities such as food. However, they are in support of ESMA’s proposal limiting the position limit regime to a set of important, critical derivatives contracts. Further, FIA and ISDA support ESMA’s suggestion to disapply position limits applicable to securitized commodity contracts.
  • Expanding the scope of the hedging exemption. While the associations recognize that the current position limits regime includes exemptions for market participants pursuing hedging activity, they also noted that the MiFID II definition of "hedging" is clear that only non-financial entities can engage in such activity. As a result, they note that the exemption is unavailable to investment banks or commodity trading houses that are MiFID II-authorized, which both play a vital role in providing smaller commercial players with access to commodity derivatives markets.
  • Retaining carve-outs. FIA and ISDA strongly recommended retaining carve-outs from position limits for physically settled power and gas contracts asserting they are sufficiently regulated under the Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) and otherwise supervised. The associations contend that the linkage between wholesale gas and power markets in the EU remains unique in commodity markets. They noted that REMIT was designed in 2011 based on the advice from the Committee of European Securities Regulators (CESR) before the creation of ESMA and from the European regulators Group for Electricity and Gas to combat insider trading and market manipulation in that sector.
As for next steps, ESMA will consider the feedback it receives to its consultation paper. Thereafter, it is expected to deliver a final report to the European Commission by end of March 2020.

Friday, 10 January 2020

BSA enforcement authority lies with FinCEN, not the SEC, Alpine Securities argues

By Rodney F. Tonkovic, J.D.

A broker-dealer hit with a $12 million civil penalty for filing deficient Suspicious Activity Reports has brought an appeal to the Second Circuit. Alpine Securities Corporation argues that the SEC was enforcing provisions of the Bank Secrecy Act that have been expressly delegated to another agency. The Commission's asserted toehold in doing so lies in the books-and-records provisions of the Exchange Act, but to claim that these provisions incorporated parts of the BSA enacted years later violates the notice and comment requirements of the Administrative Procedure Act, Alpine maintains. Finally, Alpine maintains that the district court abused its discretion through the sheer size of the penalty (SEC v. Alpine Securities Corporation, January 6, 2020).

Suspicious money laundering reporting requirements. The Bank Secrecy Act (BSA) requires broker-dealers to file a Suspicious Activity Report (SAR) with the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) to report certain transactions that the broker-dealer has reason to suspect involve funds from an illegal activity, are designed to evade BSA requirements, have no business or lawful purpose, or involve the use of the broker-dealer to facilitate illegal activity.

Alpine's SARs. Alpine Securities Corporation, a broker-dealer providing clearing services for microcap securities, had been charged by the SEC with violating Exchange Act Rule 17a-8 by filing fatally deficient SARs or by failing to file any SAR when it had a duty to do so. A strict-liability provision, Rule 17a-8 requires compliance with BSA regulations that govern the filing of SARs by broker-dealers. According to the complaint, Alpine routinely failed to identify and report suspicious activity of which it was aware. Among other deficiencies, the SARs lacked required information such as why underlying transactions were suspicious, the relevant criminal or regulatory history of the customers, the involvement of shell companies, and certain red flags for "pump and dump" schemes.

In September 2019, the Southern District of New York imposed a permanent injunction and $12 million civil penalty against Alpine. The court found that the Commission met its burden of showing over 2,700 separate violations and that a request for a penalty of over $22 million was not disproportionate. A lower, first-tier, civil penalty was imposed in light of Alpine's financial condition. The court noted that the scale and duration of the violations undermined Alpine’s assertion that its conduct was merely negligent.

Can the SEC enforce BSA? On appeal, Alpine argues that the SEC does not have the authority to enforce the SAR provisions of the BSA via Rule 17a-8. According to Alpine, Congress expressly delegated the power to administer and enforce the BSA to the Department of the Treasury as delegated to FinCEN. While this case was nominally brought under Rule 17a-8, the claims were predicated solely on violations of the BSA, the brief posits. While the district court found authority in the Exchange Act, Alpine counters that Section 17(a)'s authority over reporting does not even mention the BSA, and finding otherwise would permit the Commission to invade an authority specifically given to another agency in another statute. Courts, including the Second Circuit, have consistently rejected attempts by agencies to expand their own jurisdiction, the brief says.

The brief also takes issue with the district court's acceptance of the Commission's position that Rule 17a-8 evolved over time to incorporate the SAR provisions of the BSA, despite the rule having been adopted a decade earlier. This assertion, Alpine says, amounts to the incorporation of future legislation without notice, publication, or comment, in violation of the Administrative Procedure Act and Federal Register Act. Incorporating future statutes promulgated by a different agency also raises a delegation issue: if the requirements of Rule 17a-8 change every time FinCen amends the BSA regulations, FinCen, not the SEC, is engaging in rulemaking under Exchange Act Section 17(a). Moreover, the rules of the Office of the Federal Register state that formal approval is required to incorporate materials by reference.

Alpine notes here that the district court also failed to consider and apply Kisor v. Wilkie. The Supreme Court issued Kisor while remedies briefing was taking place, but the district court denied Alpine's motion for reconsideration. The court applied Auer deference, but Alpine contends that it committed errors discussed in Kisor, namely, not exhausting the statutory construction analysis and by giving controlling weight to an agency position that did not deserve it.

Other arguments. Next, Alpine argues that the district court adopted "novel" theories that "snippets" culled from industry guidance created automatic requirements for the filing of SARs. This approach, the brief argues, is at odds with FinCEN's approach to BSA enforcement. In short, the court's acceptance of the SEC's emphasis on "red flags" has created a new filing trigger where no such mandatory narrative requirement had been previously imposed. In arriving at this conclusion, the district court erroneously deferred to the SEC's interpretation of FinCEN's guidance, the brief says. And, there were material issues of fact with respect to whether Alpine's SARs were deficient at all; the brief claims that the court disregarded significant evidence from Alpine's fact and expert witnesses on this point.

Finally, the brief argues that the $12 million penalty is "unprecedented" and that the district court relied on impermissible factors while disregarding evidence in imposing it. Here, Alpine asserts that the penalty is "exponentially" greater than the maximum that would be imposed under the comparable BSA provisions (which would amount to $1.36 million in this case). It is not logical to increase a maximum penalty from $500 to $80,000 for the same violation simply because the SEC is the plaintiff, Alpine says. Plus, there was no evidence of illicit gain, fraud, or losses to victims. Alpine pointed out in closing that the penalty is so far in excess of its ability to pay that it would force closure of the firm.

The case is No. 19-3272-cv.

Thursday, 9 January 2020

SEC proposal would require SROs to submit new NMS plan for market data dissemination

By John Filar Atwood

In a three-to-two vote, the SEC agreed to publish for comment a proposal to direct the equities exchanges and FINRA to file with the SEC a new national market system (NMS) equity data plan to increase transparency and address conflicts of interest presented by the existing governance structure of NMS plans. The Commission also will publish for public comment notices of proposed amendments to the existing plans filed by the plan participants that are intended to address conflicts of interest and the protection of confidential information.

The proposal seeks to address the gap that has developed between the public consolidated market data feeds provided by three equity data plans and the private, proprietary data feeds sold by the exchanges. Industry stakeholders have expressed concern that the gap adversely affects those who do not access the proprietary data products, or who may not have the processing capacity to trade competitively.

Equity markets and the corporate structure of exchanges have changed dramatically since the adoption of Regulation NMS in 2005. Exchanges have converted to for-profit entities that sell their own market data products. In addition, "exchange groups" (multiple exchanges operating under common ownership) have emerged through which much of the voting power and control of the equity data plans has been consolidated.

The Commission believes that these developments have heightened conflicts of interest between the exchanges’ commercial interests and their regulatory obligations to provide consolidated market data. In particular, the SEC noted that the operation of the equity data plans has not kept pace with the efforts of the exchanges to expand the content of, and to use technology to increase the speed of, certain proprietary data products.

Governance provisions. In addition, in drafting the proposal the SEC noted that the current governance structure of the data dissemination plans perpetuates disincentives to enhance consolidated equity market data feeds, which are often slower the SROs’ proprietary feeds. Accordingly, the proposed order attempts to modernize the governance of securities information processors (SIPs) by mandating governance provisions for the new consolidated data plan. Among other things, the new plan would have an operating committee that provides votes to individuals representing non-SROs, with non-SROs having one-third of the combined voting power.

Commissioner Allison Herren Lee does not believe that adding non-SRO voting members to the governance structure and giving them one-third of the vote will ensure robust and useful SIPs. "These members would have neither the voting power, nor necessarily the market incentives, to affirmatively usher in the larger reforms required for the SIPs to provide adequate market data to investors on a fair and reasonable basis," she said. Lee, who voted against the proposal, worries that the Commission will preserve for years to come an insufficient governance structure just because it has been somewhat improved.

Commissioner Robert Jackson, who also dissented, said that rather than giving investors a say on how public data feeds are run, the proposal invites for-profit exchanges to draft their own rules. He does not blame stock exchanges for seeking to maximize their opportunities. Rather, he thinks lawmakers should change the law to address the incentives that are created by giving exchanges both control over public feeds and the opportunity to profit by selling private ones. "Without changing those incentives, we cannot and should not expect the market to fix the market," he concluded.

No perfect solution. Commissioner Elad Roisman noted that the NMS has been a hot topic for a long time, and that there is no perfect solution to NMS issues. "If there were a silver bullet, we would have thought of it. We need to move forward, and this proposal is an important first step," he said.

Chairman Jay Clayton emphasized that modernization of the markets is necessary, but acknowledged that there are very different opinions on how to go about it. In his view, the proposal "looks past the noise and moves the issue forward in a thoughtful, sensible way."

It is worth evaluating the extent to which the structure of the three existing equity data plans is in need of modernization, Clayton said. "The current structure has redundancies, inefficiencies, and inconsistencies that it may be possible to eliminate for the benefit of all market participants without any meaningful adverse effects," he noted.

Clayton concluded by inviting commenters to suggest additional or alternative measures to those in the proposal. However, he asked that any such suggestions include a comprehensive explanation as to why the alternative would be effective in addressing the significant issues set forth in the proposal.

Wednesday, 8 January 2020

OCIE announces 2020 examination priorities

By Amy Leisinger, J.D.

The SEC’s Office of Compliance Inspections and Examinations has published its annual examination priorities to enhance the transparency of its examination program and provide insight into potential risks to investors and market integrity. According to OCIE, examiners will focus heavily on issues directly affecting retail investor protection, entities providing critical services to capital markets, operations of SEC-regulated entities, and information security and fintech approaches. The office noted that many of these themes involve perennial risks and that examiners must remain vigilant in these significant areas.

"As markets evolve, so do risks and potential harm to investors. OCIE continually works to adjust its examination focus areas to target these risks and publishes its annual priorities to communicate where we see the potential for increased risk and related harm," said OCIE Director Pete Driscoll.

By the numbers. While explaining that numbers do not the complete story of effectiveness, OCIE’s report noted that the office completed 3,089 examinations in FY 2019. Examinations of registered investment advisers covered 15 percent of the population, and examinations of investment companies increased to over 15. OCIE also completed over 350 examinations of broker-dealers, 110 examinations of national securities exchanges, and over 90 examinations of municipal advisors and transfer agents. In addition, the report stated that OCIE verified over 3.1 million investor accounts involving assets totaling over $1.5 trillion.

2020 priorities. OCIE stated that, in 2020, it will continue to focus on the protection of retail investors, particularly regarding various intermediaries interacting with investors and the investment products marketed to them. Specifically, OCIE explained, examinations will include reviews of disclosures relating to fees, discounts, expenses, and conflicts of interest, as well as recommendations and advice given to retail investors. Examinations of registered investment advisers will focus on those that have never been examined, including advisers advising retail investors and private funds. Examiners will also continue to assess whether, as fiduciaries, investment advisers have fulfilled their duties of care and loyalty. After the compliance dates, OCIE also will assess the implementation of Regulation Best Interest requirements by both broker-dealers and investment advisers, as well as the content and delivery of Form CRS.

In addition, OCIE will focus on entities that provide services to the functioning of the capital markets, including clearing agencies, national securities exchanges, alternative trading systems, and transfer agents. As part of its examinations, OCIE will consider registered clearing agencies’ governance, legal, compliance and risk management frameworks by reviewing efforts to escalate identified deficiencies and evaluate the operations of national securities exchanges and how they react to market disruptions. Transfer agents’ core functions also will be a key focus, including the timing of transfers, recordkeeping and record retention, and safeguarding of securities, the report noted.

OCIE also is focused on working with firms to identify and address information security risks, the report explained. Examinations will focus on, among other things, proper storage configuration, access controls, data loss prevention, vendor management and training, and incident response and resiliency. OCIE also will evaluate oversight of service providers and network solutions and any safeguards in place to ensure proper disposal of hardware that may contain vulnerable information. The report also recognized that advancements in financial technologies warrant ongoing attention and stated that OCIE will continue to examine registered entities engaged in the digital asset space, as well as advisers that provide services to clients through automated tools and platforms.

Finally, OCIE explained that it will continue to prioritize examinations for compliance with anti-money laundering obligations and assessments of whether firms have established appropriate customer identification programs, conducted due diligence, and complied with beneficial ownership requirements. The office will also continue its oversight of FINRA and the MSRB to evaluate the operational effectiveness and policies, procedures, and controls, the report concluded.

Tuesday, 7 January 2020

Massachusetts proposes fiduciary duty rule

By Jay Fishman, J.D.

The Massachusetts Securities Division has proposed a fiduciary duty for broker-dealers, agents, investment advisers, and investment adviser representatives when they provide investment advice; recommend an investment strategy; open or transfer assets to any account type; or buy, sell or exchange any security, commodity or insurance product. Specifically, the above-mentioned industry persons are deemed to act unethically and dishonestly when they fail to act as fiduciaries for their customers or clients (as defined in the rule) during any period they:
  • have or exercise discretion over a customer’s or client’s account (unless the discretion relates solely to the time and/or price of the order’s execution);
  • have a contractual fiduciary duty;
  • have a contractual obligation to regularly or periodically monitor a customer’s or client’s account;
  • receive ongoing compensation or charge ongoing fees for advising a customer or client about the value of securities or the value of investing in, buying, or selling securities; or
  • engage in an act, practice or business resulting in a customer or client having a reasonable expectation that the respective broker-dealer, agent, investment adviser, or investment adviser representative will regularly or periodically monitor the customer’s or client’s account(s) or portfolio.
Two fiduciary duties. Broker-dealers, agents, investment advisers, and investment adviser representatives have both a fiduciary duty of care and a fiduciary duty of loyalty, as described in the rule.

Customer and client exclusions. A "customer" or "client" includes current and prospective customers and clients but does not include:
  1. financial institutions such as banks, savings and loans, insurance companies, trust companies, or registered investment companies;
  2. broker-dealers registered with a state securities commission;
  3. investment advisers registered with the SEC or with a state securities commission; or
  4. other institutional buyers.
When not a fiduciary duty. The fiduciary duty does not apply to persons acting as Employment Retirement Income Security Act (ERISA)-defined fiduciaries for an employee benefit plan, its participants, or its beneficiaries. Also, the fiduciary duty does not mandate any capital, custody, margin, financial responsibility, recordkeeping, bonding, financial, or operational reporting for broker-dealers or agents that differ from, or are in addition to, 15 U.S.C. §78o(i) requirements.

Monday, 6 January 2020

Rule 506 disqualifications waived for unregistered—but cooperating—blockchain company

By Jay Fishman, J.D.

The SEC, as part of a settlement agreement with a New York based start-up blockchain company (BC), waived the federal Regulation D, Rule 506(d)(2)(ii) disqualification provisions, thereby allowing BC to sell its digital tokens in the future by either publicly registering them with the Commission or by claiming an applicable registration exemption such as the exemption under Rule 506 (In the Matter of Blockchain of Things, Inc., December 18, 2019, Release No. 10737).

The Commission agreed to the waiver and to also not sue BC’s directors and officers partly because BC’s misconduct occurred over a relatively short six-month period, after which BC immediately ceased digital coin sales. But the SEC primarily agreed to the waiver because BC submitted a waiver request letter to the SEC imploring the Commission to not apply the disqualifications because doing so would put the start-up out of business, as well as promising to consult with the SEC staff before ever again distributing digital coins. The waiver, while granted, was made contingent on BC’s "request letter promise" to consult with Commission staff before distributing digital assets except in accordance with a qualified registration or exemption.

BC’s violations. From December 2017 to July 2018, BC raised more than $12 million from digital token sales made to U.S. investors and resales made to investors in four Asian countries. BC began its New York operation in 2015 to develop blockchain technology integration solutions and sell digital tokens on its website, but violated Securities Act Sections 5(a) and 5(b) by not registering itself and the tokens with the SEC or, respecting the tokens, alternatively claiming a registration exemption for them. Moreover, declared the Commission, BC’s digital tokens were "securities" under the test in the 1946 U.S. Supreme Court SEC v. W.J. Howey case because a BC digital token purchaser would have a reasonable expectation of obtaining a future profit based on BC’s start-up efforts to spur development of an ecosystem on its platform, including BC’s use of its offering proceeds and steps to control and increase the value of BC’s tokens (In the Matter of Blockchain of Things, December 18, 2019, Release No. 10736).

Regarding the four Asian resellers, they were to serve as the exclusive sellers of BC’s digital tokens in their respective countries but were free to resell the tokens to U.S. investors, which violated federal securities laws. And regarding the information that U.S. investors received prior to the sales, a BC white paper and its website information told them that as purchasers they would be able to convert their tokens into certain credits, allowing them to access and use the credits platform and its services, but neither the white paper nor any other documentation available to the prospective purchasers provided information on the quantity of credit services they could use upon exchanging their token for credit. And other required important information surrounding their token purchases was not disclosed to them.

Settlement stipulations. The Commission’s settlement agreement mandated BC to: (1) cease and desist from violating the above-mentioned Securities Act registration provisions; (2) pay a $250,000 penalty; (3) undertake to return funds to the investors who bought tokens in the initial coin offering (ICO) and request a return of the funds; (4) register its tokens as securities under the Exchange Act; and (5) file required periodic reports with the SEC.

The SEC’s Enforcement Division’s Associate Director, Carolyn Welshhans, proclaimed that BC "did not provide ICO investors with the information they were entitled to receive in connection with a securities offering. We will continue to consider appropriate remedies, such as those in today’s order, to provide investors with compensation and required information and to provide companies who conducted unregistered offerings with an opportunity to move forward in compliance with the federal securities laws."

These Releases are Nos. 10736 and 10737.

Friday, 3 January 2020

CFTC issues no-action relief for transition away from LIBOR

By Mark S. Nelson, J.D.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO), Division of Market Oversight (DMO), and Division of Clearing and Risk (DCR) will refrain from recommending enforcement actions to the Commission if firms with swaps transitioning away from LIBOR fail to comply with a wide swath of Commodity Exchange Act (CEA) provisions and CFTC regulations governing swaps. The relief was provided in response to a request from the Alternative Reference Rates Committee (ARRC) and in response to the U.K. Financial Conduct Authority’s announcement that it will not require LIBOR panel banks to contribute to LIBOR after 2021 (CFTC Letter No. 19-26, December 17, 2019; CFTC Letter No. 19-27, December 17, 2019; CFTC Letter No. 19-28, December 17, 2019).

The three no-action letters address different aspects of the swaps market, but despite this fact, the main text and footnotes explaining the varied requirements under each no-action letter suggest a few similarities. For example, the letters discourage alteration of the economic terms of swaps and other price-forming activity. Similarly, the DSIO and DCR letters caution against extending maximum maturities or increasing total effective notional amounts.

According to the letter issued by the DSIO, the necessary relief will encompass a number of swaps regulations. For example, relief will be extended regarding the swap dealer de minimis registration threshold, uncleared swap margin rules pertaining to legacy swaps, and the basis swaps method. Additional relief applies to the swap dealer conduct requirements, rules applicable to swap documentation and swaps processing (e.g., confirmation, swap trading relationship, and reconciliation), and end users (e.g., margin rules, eligible contract participants, and documentation).

The DMO likewise issued a letter granting ARRC-related no-action relief. Specifically, the DMO said it would not recommend the Commission bring an enforcement action if, until December 31, 2021, any person fails to comply with the trade execution requirement in CEA Section 2(h)(8) regarding an IBOR-linked swap that is amended or created by an IBOR transition mechanism, solely to accommodate replacement of an applicable IBOR with reference risk-free rates (RFR).

The DCR letter addresses uncleared legacy interest rate swaps (IRS), including legacy status (although the relief would not apply to voluntarily cleared swaps), and IBOR rates and permissible fallback amendments. The DCR said the latter item is limited to uncleared legacy IRS referencing USD LIBOR, JPY LIBOR, GBP LIBOR, CHF LIBOR, and SGD SOR. Moreover, with respect to the latter item, the DCR said additional relief is possible. With respect to the amendment process, the DCR noted that fallback amendments are not required and that a swap instead could be cleared or terminated. The DCR said the no-action relief would not apply to the trade execution requirement.

"Next year is going to be crucial for the transition away from LIBOR. Firms that fail to do so will put themselves and the global financial system at risk," said CFTC Chairman Heath Tarbert in a press release. "The CFTC remains committed to working with market participants and our fellow regulators on this critical issue."

The releases are Nos. 19-26, 19-27, and 19-28.

Thursday, 2 January 2020

Audit committee chairs weigh in on audit quality, standards


In an effort to increase transparency and engage with audit committees, the Public Company Accounting Oversight Board had conversations with the audit committee chairs of almost all of the U.S. issuers inspected in 2019 (nearly 400). Engagement with audit committees helps the PCAOB to advance its mission and may assist audit committees in fulfilling their duties, the Board noted. The Board shared the executives’ comments and provided perspectives from them on measures that have been taken to improve audit quality. In response to requests from audit committee chairs, the PCAOB also provided an overview of its inspections process and responded to frequently asked questions.

Audit quality. According to the PCAOB report, most audit committee chairs evaluated audit quality by heavily focusing on their engagement teams and less so on the characteristics of the audit firm. If the engagement teams were performing well, firm-wide metrics regarding audit quality or transparency were less relevant, they explained. Some executives also noted that audit quality centers on the exercise of judgment, which can be a challenge to measure. The PCAOB also found varying levels of familiarity with "audit quality indicators" but explained some audit committee chairs were familiar with metrics such as diversity, experience, issuer knowledge, quality and continuity, professional skepticism and judgment, and responsiveness.

Many of the executives also stated that, with proper oversight and controls, shared service centers were a good way to leverage expertise while providing quality and reduced costs. Most audit committee chairs also were satisfied with their relationships with their auditors and the information they received regarding auditor independence. The executives also generally deemed communications with auditors "very good and thorough," the PCAOB noted.

New standards. In conversations with the PCAOB, the audit committee chairs also addressed new accounting and auditing standards, and some expressed concern regarding the effects that the overlapping implementation of several standards could have on resources. They also indicated that preparations to implement Critical Audit Matters (CAMs) were generally going well and expressed a desire that, going forward, conversations would focus on how CAMs affect the audit process.

What’s working well. According to the audit committee chairs, several approaches have been effective in maintaining audit quality. Among other things, the executives suggested:
  • asking if the audit firm has an annual audit quality or transparency report;
  • discussing how the auditor will address a previous PCAOB inspection report;
  • selecting relevant audit quality indicators to discuss with the engagement team;
  • conducting ongoing assessments of the engagement team;
  • dedicating portions of audit committee meetings to deep dives on topics such as governance and cybersecurity;
  • discussing new accounting and auditing standards directly with the auditor and with consultants as necessary; and
  • discussing how the audit firm uses technology in its work.
Inspections. In the report, the PCAOB staff also provided responses to common questions related to the basics of its inspection process. The staff noted that they use both risk-based and random methods when selecting audits for review and focus on risk factors that include economic trends, industry developments, capitalization changes, and inspection history. During an inspection, the staff explained, inspectors may focus on an auditor’s risk assessment processes, areas affected by economic trends or that present significant risks, and other quality control issues. The fact that the staff includes a deficiency in a report does not necessarily mean that financial statements are materially misstated or that material weaknesses are undisclosed, the report stated. However, the PCAOB does use the information collected during inspections to inform its inspection reports, standard-setting activities, and economic and research analysis work, the staff explained.

The report also noted that PCAOB has resources and training for audit committee members and remains committed to robust economic analysis to understand the effects of its standard-setting and oversight activities.