Monday, July 24, 2017

Knowing accounting rules is not the same as knowing they are being followed

By Rodney F. Tonkovic, J.D.

A securities fraud action alleging that Kohl's Corporation misrepresented its accounting for lease agreements has been dismissed by a federal court. The complaint alleged that the retailer made a number of misrepresentations and nondisclosures concerning its improper lease accounting practices and the impact of those practices. The court found that the complaint failed to show that Kohl's and the officer defendants either knew information that contradicted their public statements or that they were motivated to keep stock prices artificially high while they sold their own shares (Pension Trust Fund for Operating Engineers v. Kohl's Corporation, July 20, 2017, Stadtmueller, J.P.).

Procedural history. This action was filed nearly four years ago. Kohl's first motion to dismiss was denied without prejudice in 2014, and a second motion was filed in mid-2015. In May 2017, the case was reassigned following the retirement of the judge to whom it was originally assigned. At the time, the second motion to dismiss had been pending unresolved for nearly two years, a situation the court described as "inexplicable and unacceptable." The court then requested supplemental briefing on any relevant case law from the previous two years.

Accounting for leases. Approximately 65 percent of Kohl's 1127 stores are leased. In February 2005, Kohl's disclosed that its lease accounting practices did not conform with GAAP, requiring a restatement of its financial results from 1998 through the first three quarters of 2004. In early 2009, Kohl's filed its Form 10-K representing that its financial statements were in conformity with GAAP and fairly presented the company's financial condition.

In November 2010, Kohl's announced that it had reviewed its historical accounting for leased properties and noted various corrections. These corrections were not material to its previous financial statements, Kohl's said, and were recorded in that quarter through adjustments to depreciation, interest, and rent expense totaling up to $25 million. Similar statements were made in subsequent filings. In August 2011, Kohl's indicated that investors should no longer rely on the financial statements included in its 2010 Form 10-K and 2011 first-quarter Form 10-Q as a result of errors related to its accounting for leases.

In September 2011, Kohl's issued restatements covering 2006 through 2010, plus the first two quarters of 2011. The restated figures showed that Kohl’s had significantly understated its total assets while overstating net income and capitalization. Kohl’s also disclosed material weaknesses in its disclosure and internal controls.

According to the complaint, however, the improper lease accounting caused Kohl's reported liabilities and debt to be materially understated and its reported equity to be materially overstated. Kohl's should have known that its representations that the corrections were not material were false because the company had made a detailed review of its accounting several years earlier, the complaint said. The complaint alleged further that Kohl's disregarded its improper lease accounting practices in order to facilitate insider sales. Finally, the allegedly false and misleading statements and omissions caused investors to purchase Kohl's common stock at artificially inflated prices.

No scienter. The court dismissed the action with prejudice after finding that the complaint failed to meet the pleading standards for fraud cases. The complaint first asserted that Kohl's had access to information demonstrating the falsity of the financial statements it distributed publicly and therefore must have provided the false information either intentionally or recklessly. Kohl's knew and understood the applicable accounting rules, the complaint explained, as a result of its 2005 restatement.

The court concluded that the complaint failed to allege with the required particularity that the officer defendants knew that Kohl's accounting personnel and auditor were committing any errors or that the officers' failure to recognize these errors was an extreme departure from the standards of ordinary care. Knowing an accounting rule and knowing that it is not being followed are two different things, the court remarked. There were no allegations, the court said, tying any individual defendant to information or knowledge that would contradict their statements. At best, Kohl's CEO and CFO were negligent.

Next, the complaint alleged that Kohl's CEO, CFO, and other executives were motivated to provide false information that would keep the price of Kohl’s stock artificially high at the time they sold a significant amount of their own shares. The complaint set forth dates, numbers, and value of the shares sold for nine executives, but gave the court no context to consider the import of the trades, such as the percentage of the officers' total holdings. There was also insufficient information to determine whether the sales represented any kind of pattern, let alone an unusual one.

In short, the complaint failed to plead with particularity facts giving rise to a strong inference of scienter. In dismissing the case with prejudice, the court noted that the originally-assigned judge had put the plaintiffs on notice of weaknesses in the complaint, but they chose to stand on the amended complaint as filed, despite several opportunities.

The case is No. 13-cv-1159.

Friday, July 21, 2017

Piwowar engages in Q&A session on capital formation initiatives

By Jacquelyn Lumb

Commissioner Michael Piwowar participated in a question-and-answer session hosted by the Heritage Foundation titled “SEC, Entrepreneurship and Economic Growth.” David Burton, a senior fellow in economic policy, asked Piwowar about a range of topics including Regulation A, crowdfunding, the SEC’s regulatory agenda and potential reforms. Burton opened by asking Piwowar about the Commission under new Chairman Jay Clayton.

New focus on capital formation. Piwowar said that working under the new chairman was “awesome,” because unlike the former chair who put enforcement first and “the death march of Dodd-Frank” second, the broad theme under the current chairman is capital formation. Some of the agenda does not require legislation, he noted, such as the recent expansion by the Division of Corporation Finance of confidential reviews of all draft registration statements, not just those of emerging growth companies. He reported that the staff is already seeing action under this initiative.

Regulation D. In response to Burton’s inquiry about potential improvements to Regulation D, Piwowar announced that the SEC does not plan to move forward with the additional amendments that were proposed in 2013. Those proposals have given people pause with respect to Reg D offerings, he said, and the SEC should issue a public statement about its intention not to move forward with the amendments. The proposal could be withdrawn, but that would require Commission action.

Burton noted that the SEC has never provided guidance about the level of sophistication necessary to be considered an accredited investor in private offerings under Regulation D. Piwowar has questioned the premise of having an accredited investor definition. It appears to be intended to somehow protect investors, he said, but high risk equals high returns and “mom and pop” investors are not sharing these returns. In his view, such investments could be part of an already diversified portfolio and could lead to higher returns.

Piwowar advised that he has been on a capital formation listening tour to see how to increase the geographic diversity of venture capital financing, which mostly occurs in Silicon Valley, New York and Boston. He added that Corporation Finance Director Bill Hinman wants to make the Division of Corporation Finance more efficient, transparent, and collaborative. In Piwowar’s view, the relationship between regulators and the regulated has become more confrontational over the past eight years and a change in the tone at the top was needed.

Burton asked about possible improvements to the SEC’s disclosure regime. Piwowar said that there are some rulemakings in progress that would clean up some of the redundancies, but added that some on the far left are fighting any reductions in disclosure.

Crowdfunding. Crowdfunding under the JOBS Act has been a disappointment, in Burton’s view, and he asked Piwowar how it could be improved. Piwowar agreed that it was a disappointment but added that it was not a surprise. He dissented to the passage of the rules, but added that a lot of it was statutory. The original House bill was reasonable, in his opinion, but the Senate added highly prescriptive language which did not leave the SEC with much flexibility. He said the SEC should revisit the rules, but the CHOICE Act also has some revisions that he supports.

Finders. Burton asked whether the SEC plans to revisit its position on finders—those that help small businesses identify potential investors. Piwowar said the Advisory Committee on Small and Emerging Companies brings the issue to the SEC’s attention every year. He believes the SEC should move forward, perhaps with a safe harbor to permit finders to do their jobs without registering as broker-dealers.

Mandatory arbitration clauses. In response to a question from the audience at the end, Piwowar said with respect to shareholder lawsuits, companies can ask for relief to put mandatory arbitration clauses in their charters. He noted that a company under the prior Administration thought about doing that but pulled it when the staff would not give the company comfort that it would accelerate the IPO filing. Piwowar encouraged companies to come and talk to the staff about that issue.

Thursday, July 20, 2017

Hester Peirce again gets nod for SEC post

By Mark S. Nelson, J.D.

President Trump has nominated Hester Peirce to be an SEC commissioner. This will be the second time Peirce has received a presidential nod to join the Commission, the first having been under the Obama administration. Trump formally sent Peirce’s nomination to the Senate today, along with numerous others, including additional judicial nominees. Trump had previously announced his plans to nominate Peirce.

This past April, Peirce, now director of the Financial Markets Working Group within the Mercatus Center at George Mason University, testified before the House Financial Services Committee that the Dodd-Frank Act should be subjected to a second look, especially regarding the SEC’s rulemaking process, appropriations for financial regulators, the too-big-to fail problem, and capital markets.

Peirce’s testimony concerned what was then a discussion draft of the Financial CHOICE Act of 2017 (H.R. 10), which would repeal key parts of Dodd-Frank and limit SEC rulemaking. The Congressional Budget Office initially said the CHOICE Act could save $24.1 billion while costing $1.8 billion to implement, but a revised report analyzing the manager’s amendments to the bill concluded savings may total $33.6 billion and cost $11.6 billion to implement. The CHOICE Act passed the House in June.

Wednesday, July 19, 2017

House panel mulls reforms to fixed income market structure

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

The House Subcommittee on Capital Markets, Securities, and Investment held a hearing on July 14 to review the state of the U.S. fixed income markets and the need for reform of the current market structure. Aimed at providing lawmakers with the background to examine the optimal design of the fixed income market based on today’s conditions, the hearing explored the importance of liquidity and data transparency for various fixed income asset classes and the increasing use of technology and electronic trading platforms, among other topics.

Unique characteristics. Chairman Bill Huizenga (R-Mich) began by making a point emphasized by several witnesses, namely, that fixed income markets are different than equity markets. As such, the fixed income market should have a regulatory structure that appropriately reflects its unique characteristics. Accordingly, Huizenga applauded SEC Chair Jay Clayton’s recent call for the creation of a Fixed Income Market Structure Advisory Committee that would be asked to give advice to the Commission on the regulatory issues impacting fixed income markets.

Ranking Member Carolyn B. Maloney (D-NY) echoed Huizenga’s comments about the unique characteristics of the fixed income market, noting the fragmentation and lack of standardization in the corporate bond market. For example, Maloney observed that General Electric currently has 900 bond issues outstanding. Maloney suggested that even with reforms the corporate bond market will still remain relatively illiquid, and we should not fool ourselves into thinking that corporate bonds will ever approach the liquidity of stocks or even Treasury bonds.

While the market for U.S. Treasury securities has become increasingly more standardized and electronic over the past decade, Maloney observed that most dealers still trade with their customers over the telephone. Maloney cautioned that lawmakers need to be careful when making changes to the Treasury market, which remains the largest and most liquid bond market in the world, because taxpayers will end up footing the bill in the form of higher interest rates if Congress gets it wrong.

Municipal bond market reforms. Matthew Andresen, CEO of Headlands Technologies LLC, focused his remarks on suggested improvements to the municipal bond market. Andresen noted that the secondary market for municipal bonds has historically been a dealer market. Despite advances made by the MSRB in making available post-trade data information, retail investors are often dependent on dealers for pricing information the abundance and diversity of municipal bonds and the infrequency of trading of certain issues.

Andresen highlighted several anticompetitive practices that he believes limit the advantages of the existing market structure and exert detrimental effects on retail investors. For example, “filtering” occurs when a broker-dealer handling its own retail customer’s order requests a quote or starts an auction on an alternative trading system (ATS), but uses automated tools on the ATS to filter out responses from specified dealers. Although these restrictions may harm investors’ execution quality, the practices benefit the retail broker-dealers whom these investors depend on for pricing information. Accordingly, a focus on whether the continued use of filters constitutes a “legitimate purpose” under MSRB Rule G-18 may be in order, Andresen stated.

Another practice questioned by Andresen is the "trade through," in which a retail broker-dealer obtains prices for a customer via a bid wanted auction, but then internalizes the order by purchasing the bond from its customer for its own account at a lower price than the winning bid in the auction. This practice of internalizing orders and allowing for a trade through is harmful to customers because it results in bonds selling at inferior prices to those that were available at the time of the trade, Andresen stated. Andresen also believes that municipal bond investors would benefit from enforcement against the use of the "last-look" practice, in which a dealer observes the prices submitted to a completed auction and decides to purchase the bond from the customer at a price slightly better than the winning bid. Dealers continue to use this practice even though it appears to be prohibited by MSRB Rule G-43, Andresen said.

Transparency and standardization of regulatory standards. John Shay, Global Head of Fixed Income and Commodities at Nasdaq, also applauded SEC Chair Clayton’s request for the creation of a Fixed Income Market Structure Advisory Committee. With regard to the Treasury market, Nasdaq believes that transparency benefits all market participants because widespread availability of the best available prices ensures that market participants make informed investment decisions and receive high quality, low cost service. Shay said that TRACE reporting to FINRA was a positive step, but further evolution towards a comprehensive, centralized reporting mechanism is critical.

Nasdaq also advocates the standardization of regulatory standards and surveillance practices across all U.S. Treasury venues, whether electronic multiparty trading platforms or bi-lateral dealer-to-customer arrangements. Shay noted that rules similar to the SEC's Regulation SCI would ensure that participants in the U.S. Treasury markets develop systems with sufficient capacity, resiliency, availability, and security to minimize the occurrence of disruptive systems issues.

Non-linear evolution. Alex Sedgwick, Head of Fixed Income Market Structure & Electronic Trading for T. Rowe Price, stressed that fixed income products can, and historically have, traded in a variety of ways, and that the evolution of market structure has never been linear. The fixed income market represents a collection of several diverse markets, which differ in terms of the drivers of returns, liquidity characteristics, and the amount of electronic trading that takes place.

With respect to the Treasury market, Sedgwick said that his firm generally supports the recommendations of the Joint Staff Report on the Treasury flash rally of October 15, 2014, particularly the utility of enhanced regulatory reporting to help the Treasury Department and other stakeholders better ensure an efficient and competitive market for all participants. With regard to the fixed income market as a whole, T. Rowe Price believes that removing obstacles to further electronification will improve price discovery, facilitate best execution, and enhance capital formation.

Impact of post-crisis regulation. SIFMA Executive Vice President Randy Snook said that while SIFMA supports many of the post-crisis regulatory reform efforts in the area of capital and liquidity, now is the time to review how these rules work together. This review should include the Volcker Rule, liquidity requirements, leverage requirements, and other rules and regulations that have impaired market efficiency and capital formation. In SIFMA’s view, regulators must move very cautiously when considering new requirements and restrictions on activities and participants in the fixed income markets.

Tuesday, July 18, 2017

Comments sought on proposed rule designating IEX listings covered securities

By Rebecca Kahn, J.D.

The SEC issued a proposed amendment to Securities Act Rule 146 to designate certain securities on Investors Exchange LLC (IEX) as covered securities. The designation would mean that IEX-listed securities would not be subject to state securities law registration and qualification requirements. Comments are due within 30 days of publication in the Federal Register (Release No. 33-10390, July 14, 2017).

Background. Securities Act Section 18 was amended in 1996 to exempt from state registration requirements securities listed, or authorized for listing, on named markets (NYSE, NYSE American, or Nasdaq/NGM) or any national securities exchange designated by the Commission to have listing standards that are “substantially similar” to those of the Named Markets.

In response to petitions by various exchanges, in 1998 the Commission adopted Rule 146(b) pursuant to Securities Act Section 18(b)(1)(B), finding the specific listing standards of those exchanges substantially similar to those of the Named Markets. Thus, securities listed pursuant to those standards were deemed to be “covered securities” exempt from state securities registration and qualification requirements.

IEX petition. In June 2016, the Commission granted IEX’s application to become a registered national securities exchange. IEX later petitioned to amend Rule 146(b) and determine that the listing standards for IEX-listed securities are substantially similar to those of the Named Markets, making them covered securities under Securities Act Section 18(b).

After reviewing the IEX’s qualitative and quantitative listing standards, the Commission “preliminarily believes” them to be substantially similar to those of Named Markets under Section 18(b)(1)(B) of the Securities Act.

The proposed amendment includes an extensive analysis of the proposed rule’s potential economic impact (including costs of state filing and corresponding legal fees, costs for broker-dealers, and compliance costs), the competitive landscape, and potential impact on the trading services market. The Commission invited commenters to suggest how the “costs, benefits, and the potential impacts” of the proposed amendment on SEC’s mission can be quantified.

The release is No. 33-10390.

Monday, July 17, 2017

Stock-distribution plan not ERISA-protected, fraud claims not waived by release

By Amy Leisinger, J.D.

A Second Circuit panel vacated a judgment to the extent that the district court denied leave to amend to add securities fraud claims. According to the panel, the purported release of liability relied on in denying amendment was unenforceable under Exchange Act Section 29(a), but the related Racketeer Influenced and Corrupt Organizations Act claims were properly dismissed as waived. The panel also upheld the dismissal of the plaintiffs’ Employee Retirement Income Security Act claims, noting that the plan through which the stock was distributed is not an employee pension benefit plan within the meaning of the statute (Pasternack v. Shrader, July 13, 2017, Jacobs, D.).

Compensation claims. Booz Allen Hamilton is a corporation that operates like a partnership, wholly owned by its officers. The company allocates its stock via a Stock Rights Plan (SRP), under which an officer receives allocations of common stock and Class B stock; in each successive year, the officer pays to exchange some of the Class B stock for common stock. The SRP allows participants to realize substantial profits when they sell their common stock at book value (i.e., Booz Allen’s net assets divided by the number of outstanding shares of common stock), typically following retirement.

The plaintiffs, retired Booz Allen officers, brought actions alleging that they were improperly denied compensation when, after their retirement, Booz Allen sold one of its divisions to another organization at $763 per share of common stock, an amount far in excess of book value. The Southern District of New York dismissed the plaintiffs’ ERISA claims on the ground that Booz Allen’s stock-distribution program was not a pension plan under ERISA, and the RICO claims were dismissed as barred by the Private Securities Litigation Reform Act. One plaintiff’s request to amend his complaint to add securities fraud claims was denied on the grounds of futility and undue delay in connection with a release of liability.

ERISA claims. The panel affirmed the district court’s dismissal of the ERISA claims, finding that the distribution plan is not an “employee pension benefit plan” under ERISA. An ERISA-protected plain is one that “results in a deferral of income” or “provides retirement income,” the panel noted. The SRP is not connected with retirement, according to the panel; it is a means by which to ensure that Booz Allen is entirely owned by the officers, and the SRP returns capital by buying out the ownership stake accumulated by a separating partner. Income is not deferred under the SRP, the panel found, as the benefit a participant receives in exchange for capital is an ownership stake and managerial authority, which accrues during tenure at Booz Allen, not retirement. Further, the phrase “provides retirement income” does not cover every instance in which a person cashes out an investment at retirement, even though this may be a result, particularly in this case where the purpose of the SRP is to gather working capital and maintain internal control, according to the panel.

Fraud claims. The panel did vacate the judgment to the extent that it denied the motion to amend to add securities-fraud claims. The individual retiree still had shares when the transaction closed, and, in order to receive a payout, he had to sign a letter surrendering the shares, which contained a release clause. Exchange Act Section 29(a) voids provisions binding a person to waive compliance with an Exchange Act provision, and, according to the panel, shareholders may not be forced to forego their rights due to a contract provision. The letter was essentially a contract for the sale of the officer’s securities, and the release clause purported to waive all claims in contravention of Section 29(a), the panel found.

A waiver in the context of settling litigation can be, and often is, acceptable and appropriate, as it does not “waive compliance” but instead results in a remedy for an alleged violation that satisfies “compliance,” the panel stated. The release clause in the letter had nothing to do with satisfying of a pre-existing claim, the court stated, and the denial of leave to amend based on delay and litigation expense was an abuse of discretion.

RICO claims. Although the release clause does not bar the securities-fraud claims, the panel found, it does prevent the plaintiff from asserting his common law and RICO claims. The RICO statute states that a plaintiff may not rely upon conduct actionable as fraud to establish RICO liability, and the release clause effected a waiver of all claims other than securities fraud. These claims were properly dismissed, the panel concluded.

The case is No. 16-217.

Friday, July 14, 2017

Anti-Fraud Collaboration reviews accounting policies and internal controls

By Jacquelyn Lumb

The Anti-Fraud Collaboration hosted a webcast on effective accounting policies and internal controls as a means of preventing fraud and reducing the number of financial restatements. The panelists were experts in financial reporting and included moderator Cynthia Fornelli, the executive director of the Center for Audit Quality; Brian Croteau, formerly a deputy chief accountant at the SEC and now a partner at PricewaterhouseCoopers; Suzanne Hopgood, the president and CEO of consulting firm Hopgood Group; Karl Erhardt, executive vice president and chief auditor at MetLife; and Linda Zukaukas, executive vice president and corporate controller at American Express.

Accounting policies. Zukaukas noted that a lot of accounting guidance is emerging as a result of the new FASB standards with differing implementation dates. She said companies’ accounting policies should be aligned with the technical guidance but tailored to the specific business. Companies’ accounting policies should be understandable to non-accountants; aligned with business processes; reviewed periodically based on risk; tested in the field prior to implementation; integrated with internal control over financial reporting to monitor compliance; and clearly communicated to the auditors.

Croteau emphasized the importance of communication between management and the auditors. Auditors should be involved early for better planning and to avoid surprises when implementing the new standards. He cited statements by the SEC and the PCAOB in 2005 about accountants’ ability to assist in improving internal controls and determining the appropriate accounting.

Erhardt, who noted that MetLife is currently implementing about two dozen accounting policies under GAAP and international financial reporting standards, emphasized the importance of documenting policy decisions.

Hopgood described it as a learning process with input from both internal and external auditors and the chief financial officer. Audit committees must understand how the financial statements were developed, what the changes are, and if the policies are being followed. They must be willing to ask questions if it appears the policies are not being followed, she advised.

Reviewing accounting policies. Fornelli asked whether it is common practice to revisit existing accounting policies periodically. Zukaukas said that Amex views its critical accounting matters annually and has a refresh cycle based on the importance and materiality of an issue. Croteau said it is important to refresh accounting policies even when there are no new standards to take into account.

New accounting standards. Among the best practices for the new accounting standards are policies that are granular, include examples, are tested, have clear lines of responsibility and communication, and take into consideration industry guidance. It is also important to communicate with colleagues, specialists and advisers, early and often, according to the panelists.

With respect to the implementation of the new revenue recognition standard, Croteau said if it is not done well it will be a step backward and may result in more restatements. Companies should assess their systems and internal controls; revisit business models and contract terms, consider compensation plans early to avoid unintended consequences, and review debt agreements for any needs to modify covenants to avoid unintended constraints or violations.

Internal control over financial reporting. With respect to internal control over financial reporting, Croteau said the tone at the top is important. He recommended a risk-based approach and the development of controls for unusual or non-routine transactions. It is also important to be knowledgeable about the culture of company subsidiaries and to communicate regularly. He recommend that companies line up levels of evidence of control with financial reporting risk and tap external resources when needed.

Management override. The panelists also addressed the threat of management override which Hopgood called the Achilles heel of fraud prevention. Zukaukas said that among the mitigants were tone at the top, requiring all employees to take training and monitoring their training for compliance, centralizing control functions, and automating as many transactions as possible.

Among the warning signs of potential management override are an inappropriate tone at the top, unreasonable earnings pressure, an ineffective audit committee, bias in accounting estimates, and compensation structures that are heavily based on obtaining performance targets.

Audit committees. Erhardt described the qualities to look for in audit committee members, which include individuals who are independent minded, willing to challenge management when something doesn’t seem right, have critical thinking and communication skills, the ability to work with staff at different levels, business and industry knowledge, and the ability to navigate technological changes.

Thursday, July 13, 2017

Clayton lays out guiding principles for SEC in first public speech as Chair

By John Filar Atwood

SEC Chair Jay Clayton said that under his leadership the Commission will be guided by eight core principles, and gave initial indications of how the agency will proceed on issues such as enforcement, capital formation, and equity market structure. In his first public remarks since taking over as Chair, Clayton emphasized that that he will not pursue wholesale changes to the Commission’s fundamental regulatory approach.

In a speech to the Economic Club of New York, Clayton said the SEC plans to adhere closely to its mission of protecting investors, maintaining fair and efficient markets, and facilitating capital formation. In addition, all agency actions will be analyzed through the lens of how they impact the long-term interests of the average investor.

As a third principle, Clayton said that he believes the SEC’s historic approach to regulation, which is based on disclosure and materiality, is sound and he does not intend to seek major changes to the agency’s approach. In his view, the Commission should strive to ensure that investors have access to a well-crafted package of information that facilitates informed decision-making.

Effect of regulatory changes. Clayton said that under his leadership the Commission will be mindful that even incremental regulatory changes can have dramatic and lasting effects on the market. He believes that the disclosure-based regime has worked so well that the SEC, lawmakers and other regulators have slowly but significantly expanded the scope of required disclosures beyond the core concept of materiality.

Each change has been justified by specific benefits afforded to certain shareholders and constituencies, he noted, but he believes the SEC and other regulators must evaluate the cumulative effect of the changes. In particular, he noted the 50 percent decline in the number of U.S.-listed public companies over the past 20 years, and said that it worth considering whether increased disclosure and other burdens have rendered alternatives for raising capital, such as the private markets, increasingly attractive.

Another principle under which the SEC will operate is that the agency must evolve with the markets, Clayton said. The Commission will use technology to improve and make more efficient its regulation and oversight of the public markets. On this point, he cautioned that the agency should not take lightly the fact that regulatory changes often impose significant implementation costs on companies and shareholders.

Periodic review of rules. Clayton said that going forward the SEC will operate under the principle that effective rulemaking does not end with rule adoption. The Commission should review its rules retrospectively, he said, and seek feedback on whether its rules are, or are not, functioning as intended.

While he is Chair, the Commission will be mindful that the cost of a new rule often includes the cost of demonstrating compliance, he said. The requirement that a CEO certify that a new requirement has been met, for example, may involve auditors, outside counsel or other third parties, he noted. This is the appropriate regulatory approach in some areas, Clayton said, but the SEC needs to be sure that it understands how a new rule will be implemented and how the staff will examine for compliance with it.

The final principle articulated by Clayton is that the Commission will seek to coordinate its efforts with federal and state regulators, the Department of Justice, self-regulatory organizations, and standard-setting entities, among others. He cited over-the-counter derivatives and cybersecurity as areas where effective coordination will be critical.

Principles in action. Having stated the eight principles, Clayton turned to some specific areas where he plans to apply them. With respect to enforcement, he stated that he intends to continue deploying significant resources to rooting out fraudulent market practices. He urged market professionals, who are essential to the proper operation of the markets, not to take advantage of their special place in the economy.

On the enforcement of cybersecurity rules, he emphasized companies’ obligation to disclose material information about cyber risks. However, he believes that Commission should be cautious about punishing responsible companies who nevertheless are victims of cyber attacks. In his opinion, the SEC needs to take a broad view and bring proportionality to this area.

Capital formation. With regard to capital formation, Clayton said that the agency needs to work to improve the attractiveness of the public markets, an effort that began with the recent extension of the JOBS Act confidential filing privilege to all companies. He hopes this approach will encourage companies to sell shares in the public markets and to enter them at an earlier stage in the companies’ development.

Clayton also said that he understands that in some cases the SEC’s reporting rules may require publicly traded companies to make disclosures that are burdensome to generate, but may not be material to the total mix of information available to investors. He urged companies to make use of Rule 3-13 of Regulation S-X, which allows issuers to request modifications to their financial reporting requirements in these situations. The staff is placing a high priority on responding with timely guidance to these requests, he said.

Market structure. Regarding equity market structure, Clayton noted that a lot of thought has been devoted to the topic at the Commission, in Congress, and in the private sector. It is time to take action, he said, adding that the SEC may launch a pilot program to test how adjustments to the access fee cap under Exchange Act Rule 610 would affect equities trading. He expects the Commission to consider a proposal on the pilot program in the coming months.

Clayton said that he hopes the tenure of the SEC’s Equity Market Structure Advisory Committee will be extended into 2018. In addition, he has asked the staff to develop a plan for creating a Fixed Income Market Structure Advisory Committee that would be asked to give advice to the Commission on the regulatory issues impacting fixed income markets.

Fiduciary rule. Clayton briefly touched on the fiduciary rule, noting that with the Department of Labor’s rule now partially in effect, it is important that the SEC make all reasonable efforts to bring clarity and consistency to this area. The SEC issued a statement seeking public input on standards of conduct for investment advisers and broker-dealers in June, and he urged interested parties to provide feedback to help shape the Commission’s actions in this area.

Wednesday, July 12, 2017

Nevada D&Os won’t face liability for ignoring Delaware practice

By Anne Sherry, J.D.

Directors and officers of Nevada corporations will soon have assurance that they need not abide by other states’ laws or practices. SB 203, which takes effect October 1, also clarifies the factors that a director or officer may consider when resisting a change in control and tightens the burden of proof required for an officer or director to be individually liable.

Laws of other jurisdictions. The text of the bill expresses the legislature’s finding that Nevada’s laws, including the fiduciary duties and liabilities of officers and directors of domestic corporations, “must not be supplanted or modified by laws or judicial decisions from any other jurisdiction.” Accordingly, the law establishes that while directors and officers “may be informed by” other jurisdictions’ laws, judicial decisions, and best practices, the failure or refusal to take those other sources into account is not a breach of fiduciary duty.

Burden of proof. Nevada law already established a presumption that directors and officers act in good faith, on an informed basis, and with a view to the interest of the corporation. The bill clarifies that individual liability arises only upon (1) rebuttal of this presumption and (2) proof of a breach of fiduciary duty involving intentional misconduct, fraud, or a knowing violation of law.

Resisting a change-in-control. The amended law also makes clear that when resisting a change of control (or exercising other powers), directors and officers may consider the long- or short-term interests of the corporation or its stockholders, including the possibility that these interests may be best served by the corporation’s continued independence. A director may resist a change in control if the board determines it is opposed to or not in the best interest of the corporation, upon considering the relevant factors, including the nature of the indebtedness and other obligations that would result. Directors and officers may consider or assign weight to the interests of a particular person or group, but they are not required to consider, as a dominant factor, the effect of a corporate action on any particular group or constituency.

Tuesday, July 11, 2017

Wyoming adopts new investment adviser, crowdfunding, Reg. A + rules

By Jay Fishman, J.D.

Wyoming, the only state to have never regulated investment advisers, now adopts investment adviser rules by emergency, effective June 30 to October 28, 2017. The rules align with Wyoming’s new Securities Act that took effect on July 1, 2017. The new Act is modeled after the Uniform Securities Act of 2002.

The emergency rules additionally include two crowdfunding exemptions and a Regulation A + notice filing, along with broker-dealer, agent, issuer-agent, exemption and securities registration, and small company offering registration amendments to pre-new Act rules.

Investment advisers--Initial registration. To initially register, investment adviser applicants must electronically file with the IARD a complete Form ADV, Uniform Application for Investment Adviser Registration. The application must be accompanied by: (1) proof of meeting written exam requirements; (2) financial statements including a copy of last fiscal year’s balance sheet (but an unaudited balance sheet is required instead if the last fiscal year’s balance sheet is older than 45 days from the application filing date); (3) a copy of a surety bond (if applicable); (4) a $250 fee; and (5) any other Wyoming secretary of state-required information. The secretary will accept a copy of Form ADV, Part 2 filed electronically with the IARD or a paper copy filed directly with the secretary.

Annual renewal. To annually renew their registrations, investment advisers must electronically file with the IARD a $250 renewal fee and a copy of a surety bond (if applicable).

Amendments. Investment advisers must electronically file with the IARD any amendments to Form ADV. An amendment filed within 30 days of the event necessitating the amendment is considered “promptly filed.” Investment advisers must also electronically file with the IARD an annual update to Form ADV, within 90 days of their fiscal year-end.

Completion of filing. An initial or renewal investment adviser application is not considered “filed” until the secretary has received the required documents and fees.

Withdrawal. Investment advisers may withdraw from registration by electronically filing with the IARD a Form ADV-W, Notice of Withdrawal from Registration as Investment Adviser.

Other IA topics. The rules additionally cover the following topics:
  • Investment adviser representative registration;
  • Federal covered investment adviser notice filing;
  • Exemption for private fund advisers; 
  • Written exam requirement;
  • Minimum financial requirement (net worth);
  • Financial reporting;
  • Recordkeeping;
  • Business continuity and succession planning;
  • Bonding;
  • Custody;
  • Disclosures (Brochure Rule); 
  • Prohibited conduct; and
  • Investment advisory contract.
Intrastate crowdfunding exemption. Issuers claiming the intrastate crowdfunding exemption under the Wyoming Uniform Securities Act must file a notice with the secretary on the Wyoming Invests Now (WIN) Form. The notice must be filed at least 10 days before an offer is made under the exemption. The issuer must notify the secretary by email or in writing of the date the first offer is made. Any subsequent change to the offering information must be submitted to the secretary on the WIN Form within 15 days of the change. Purchaser residency validation, quarterly reports, and records are also required.

Federal crowdfunding. Issuers intending to make a crowdfunding offering under federal Securities Act, Sections 4(a)(6) and 18(b)(4)(C) must, for the initial offering in Wyoming, have their principal place of business in Wyoming or sell at least 50 percent of the aggregate amount of the offering to Wyoming residents. The issuers must file with the secretary of state: (1) a complete Uniform Notice of Federal Crowdfunding Form (or copies of all SEC-filed documents); (2) a Form U-2, Uniform Consent to Service of Process, if the consent is not filed on the federal crowdfunding form; and (3) a $200 fee. Renewal and amendment filing requirements are also provided in the rule.

Regulation A, Tier 2 offering. Issuers intending to make a Tier 2 offering under federal Regulation A must submit the following at least 21 calendar days before the initial sale in Wyoming:
  • A complete Regulation A – Tier 2 Notice Filing Form (or copies of SEC-filed documents);
  • A Form U-2, Uniform Consent to Service of Process if the Form U-2 is not filed on the Regulation A – Tier 2 form; and
  • A $200 renewal fee. 
Renewal and amendment filing requirements are also provided in the rule.

Monday, July 10, 2017

Merely working for a public company is insufficient to trigger Dodd-Frank whistleblower protection

By Joanne Cursinella, J.D.

A CPA who was terminated from Grant Thornton, LLP, allegedly for reporting fraudulent activity, could not sustain her whistleblower protection claim because working for a public company, without more, is insufficient to trigger Dodd-Frank whistleblower protections (Reyher v. Grant Thornton, LLP, July 6, 2017, Brody, A.).

Recruited. According to the court, Ann Marie Reyher is an experienced CPA who was recruited in 2016 to work for defendant Grant Thornton, LLP as a managing director in its Philadelphia office. Despite “numerous assurances that her responsibilities at Grant Thornton would be limited to her area of expertise,” individuals and trusts, she was assigned a client list that only included corporate clients. In any case, Reyher began work for her assigned clients. Reyher said expressed her distress about this to two of Grant Thornton partners, to no avail.

Accounting irregularities. Reyher claimed that she found “accounting irregularities,” during her work and alleged that Grant Thornton employees knowingly included inaccurate information in client tax documents. She complained to firm administrators about this activity, which she said “amounted to bank fraud, mail fraud, wire fraud, and/or fraud against shareholders.” Her complaint, in fact, cited specific violations as to four clients, none of which were alleged to be public companies, and in fact, the court noted, from the descriptions, the opposite was probably true.

Terminated. Reyher was terminated seven weeks after beginning employment with Grant Thornton. According to the court, she was told at her termination meeting that she was being let go for being “disruptive” and “not a good fit for our culture.” Reyher, however, alleges that she was terminated in retaliation for her complaints about accounting irregularities and her refusal to engage in illegal activity, and claimed whistleblower protection was suitable under Dodd-Frank.

No Dodd-Frank protection. Reyher argued that her termination violated Section 922 of the Dodd-Frank Act. That section prohibits an employer from discharging an employee in retaliation for that employee having engaged in certain types of protected whistleblowing activity, the court said. Reyher claimed that her internal complaints regarding her clients were disclosures that are protected under Sarbanes-Oxley Act of 2002 and by extension under Dodd-Frank, which incorporated existing SOX whistleblower protections and added incentives to bolster existing protections for whistleblowers. She argued that Grant Thornton’s work for publicly traded companies was sufficient to bring her case within the scope of SOX and, therefore, by incorporation, Dodd-Frank protection.

The court noted that Reyher did not allege that there was any connection between Grant Thornton’s work for publicly traded companies and her internal complaints regarding her clients. There were no allegations that she performed any work on behalf of publicly traded companies. Further, there were no allegations that any of the practices she complained of implicated publicly traded companies or that the clients themselves were public companies or consisted of public companies. She argued instead that Grant Thornton’s unrelated work for publicly traded companies was in itself sufficient to bring her case within the scope of whistleblower protection.

The court disagreed, however, saying that a purported whistleblower employed by a private company cannot invoke the whistleblower protections of SOX and Dodd-Frank merely because her employer happens to contract with public companies on matters unrelated to the alleged whistleblowing. The connection between Grant Thornton and its public company clients is little more than a coincidence as far as Reyher’s clients were concerned, the court said, and she did not adequately plead that she engaged in conduct that is protected under SOX (or Dodd-Frank).

The case is No. 16-cv-1757.

Friday, July 07, 2017

SIFMA and ABA urge SEC not to expand Guide 3 disclosure requirements

By Jacquelyn Lumb

The Securities Industry and Financial Markets Association and The Clearing House Association L.L.C. have submitted their views to the SEC regarding potential revisions to Industry Guide 3, Statistical Disclosure by Bank Holding Companies, in which they noted that the guide mostly overlaps or duplicates existing disclosure requirements. They recommend that the SEC significantly streamline the guide so that it serves as a “gap filler” for U.S. bank holding companies and that it require only information that is not included in SEC filings and that would be useful and material to investors. The associations added that for foreign banking entities that file on Form 20-F, the SEC should defer to home country practices and eliminate the guide’s applicability to these registrants.

Expansion of available information. The associations pointed to the dramatic expansion of information that is required in SEC filings since the guide was last revised in 1986 and said they see no need for additions to the guide. The existing disclosure requirements already provide adequate regulation, according to the associations. They also oppose the codification of the guide into Regulations S-X or S-K and said it should remain as guidance that provides bank holding companies with the flexibility they need in their approaches to disclosure.

Bank holding companies provide information in Pillar 3 reports which are publicly available, the associations noted. In their view, this information should not be required in SEC filings because it would increase duplicative disclosures while not adding material information. This information is provided for different purposes, they added, and quantitative information that is incorporated by reference from regulatory reports cannot be accompanied by qualitative, contextualizing disclosures.

Opposition to interim disclosures. The associations also wrote that the SEC should not require disclosures in interim periods since it could lead to a lot of duplication, but should conform annual reporting periods to the Regulation S-X requirements as historical data is readily accessible.

Periodic reviews. Guide 3 should continue to apply to bank holding companies and other registrants with material lending and deposit activities since this information is useful to investors, according to the associations. The guide should be reviewed and updated periodically, including the period after the new FASB standards on financial instruments and credit losses are fully implemented. The associations added that the disclosure requirements for the new FASB and IASB standards on financial instruments and credit losses are comprehensive and should not be revised or supplemented at this time.

Opposition to structured data disclosures. Finally, the associations said the Guide 3 disclosures should not be required in structured data format, such as XBRL, since the information is spread throughout SEC filings and does not readily lend itself to the structured data format. The cost of doing so would also be significant, in their view.

ABA’s views. The American Bankers Association also cited the dramatic increase in the availability of financial data, including that in MD&A which has served investors well. The information requirements in Guide 3 often overlap with the information required by U.S. GAAP or MD&A, and given the guide’s prescriptive requirements, some of the key information may lack relevance or confuse investors. ABA said the reduction and elimination of redundancy of prescriptive disclosure requirements should be a priority and any further expansion of the Guide 3 disclosure is unnecessary.

Among ABA’s recommendations are to align the number of years of data presented in Guide 3 with GAAP; align the size thresholds with the current definitions of a smaller reporting company; apply the requirements to non-bank holdings registrants that have significant operations in which credit is provided; not to apply the requirements to interim financial filings; and not to require the information in XBRL format.

Thursday, July 06, 2017

California adopts finder exemption

By Jay Fishman, J.D.

The California Department of Business Oversight has adopted a broker-dealer registration exemption for finders, namely those individuals who introduce investors to securities issuers. To qualify for the exemption, an individual must meet the “finder” definition and other requirements in the California Securities Law of 1968 and not be subject to either California or federal Regulation D Rule 506(d) “bad boy” disqualification provisions.

Form filing (initial/renewal). Eligible individuals must file with the Department a Statement of Information for Finder Pursuant to Section 25206.1 of the California Corporations Code, accompanied by a $300 fee and any additional information the commissioner requests. The form includes language that a finder can voluntarily, but is not required to, provide his social security number. Finders must submit amendments to the Statement within 10 business days of the occurrence of a change. Finders may renew the exemption by annually filing the Statement accompanied by a $275 fee and any additional information the Commissioner requests.

Withdrawal. Finders must file the Statement within 15 calendar days of withdrawing from engaging in business under the exemption.

Recordkeeping. Finders must maintain and preserve the written agreement and other records for a statutory-prescribed time-period at a Statement-designated location. The records are subject to commissioner inspection at any time.

Prohibitions against fraud. California Securities Act prohibitions against fraud and misleading acts apply to finders.

Wednesday, July 05, 2017

SEC extends confidential review of IPO filings to all companies

By John Filar Atwood

The right to file IPO draft registration statements for review by the SEC before they are made public, formerly only available to emerging growth companies (EGCs), will now be extended to all companies. The SEC’s Division of Corporation Finance announced that beginning July 10, all filers will be allowed to have their draft IPO registration statements reviewed on a confidential basis.

According to a Commission news release, the widely-used JOBS Act provision also will extend to most offerings made with one year after a company enters the public reporting system. The SEC believes that the non-public review process after the IPO will reduce the potential for lengthy exposure to market fluctuations that can adversely affect the offering process and harm existing public shareholders.

Director of the Division of Corporation Finance Bill Hinman explained that the move is intended to foster capital formation and provide investment opportunities while protecting investors. The new process should make it easier for more companies to participate in the SEC’s disclosure-based system, he noted.

Cover letter. In the announcement, the staff said that it will review a draft initial Securities Act registration statement and related revisions on a nonpublic basis provided that the issuer confirms in a cover letter that it will publicly file its registration statement and nonpublic draft submissions at least 15 days prior to any road show. In the absence of a road show, the registration statement must be publicly filed at least 15 days prior to the requested effective date.

The staff noted that by requiring a public filing period prior to the launch of marketing, the process incorporates a feature of the EGC review process that provides an opportunity for the public to evaluate the offerings. For initial registrations under Exchange Act Section 12(b), the company must publicly file at least 15 days prior to the anticipated effective date of the registration statement for its listing on a national securities exchange.

The staff will accept draft registration statements submitted prior to the end of the twelfth month following the effective date of an issuer’s initial Securities Act or Exchange Act registration statement for confidential review. In these circumstances, a company must confirm in a cover letter that it will publicly file its registration statement and nonpublic draft submission such that it is publicly available on the EDGAR system at least 48 hours prior to any requested effective time and date.

According to the staff, confidential review in these cases will apply only to the initial submission. The staff advised that an issuer responding to staff comments on a draft registration statement should do so with a public filing, not with a revised draft registration statement.

The staff will conduct any further review of a filing using its normal procedures, and will act upon requests for acceleration in accordance with Securities Act Rule 461. Similar to the initial registration procedures an issuer should file the draft registration statement it had previously submitted for nonpublic review at the time it publicly files its registration statement, the staff said.

Content of the filing. The staff encouraged issues to take steps to ensure that a draft registration statement is substantially complete when submitted, but advised that it will not delay processing a filing if an issuer reasonably believes omitted financial information will not be required at the time the registration statement is publicly filed. In addition, the staff will consider an issuer’s specific facts and circumstances in connection with any request made under Rule 3-13 of Regulation S-X.

The staff is willing to consider reasonable requests for expedited processing of draft and filed registration statements. It encouraged issuers and their advisers to review the transaction timing with the staff assigned to the review their specific filing.

EGCs. The staff noted that the expanded nonpublic review process will not limit the process by which EGCs submit draft registration statements for confidential review. The staff will continue to process those submissions and filed registration statements in the normal course of business.

Monday, July 03, 2017

Dodd-Frank showdown in the Windy City

By Brad Rosen, J.D.

The opponents of Title VII of the Dodd-Frank legislation, those reforms that brought sweeping changes to the derivatives and swaps industry, came out with guns a-blazing at the recent John Lothian News/FOW conference in downtown Chicago. Over 200 participants representing CTAs, hedge funds, proprietary trading firms, and other trading industry players attended the event, exploring a wide range of regulatory and technology issues facing the trading community during the course of the day.

Craig Pirrong, a free market oriented economist and University of Houston professor of finance, led off the event with a keynote address where he unabashedly called for the repeal of Title VII. His remarks were then followed by an Oxford-style debate where the question posed was: “Should Title VII and the Volcker Rule be repealed in full?” Gary DeWaal, a longtime leader at the Futures Industry Association and special counsel at Katten Muchin Rosenman LLP, argued in favor. Leslie Sutphen, president of Financial Markets Consulting LLC and the co-founder and current president of Women in Listed Derivatives, argued in favor of the Dodd-Frank reforms.

Pirrong referred to the Dodd-Frank legislation as “Franken-Dodd,” and took the metaphor a bit further describing it as having escaped the control of its creators and wreaking havoc on the countryside. He sees four central problems with the Dodd-Franks reforms:

  • Unintended consequences. Dodd-Frank sought to address too big-too-fail problems and concentration among market participants. Pirrong noted the biggest losers in the aftermath of Dodd–Frank have been smaller- and medium-sized players who cannot afford the compliance costs associated with the regulations. “The big guys are doing fine,” he observed.
  • Mischaracterization of sources of risk. According to Pirrong, the underlying narrative of the Dodd-Frank reforms has been that derivative instruments are inherently risky and caused the financial crisis. As a result, Dodd-Frank mandated clearing for everything that could be cleared and margining for everything that couldn’t. Pirrong argues this did not eliminate risk but rather transformed credit risk into liquidity risk. Pirrong is deeply concerned that the next crisis will be marked by a liquidity vacuum. 
  • Imposition of solutions where no problems exist. Pirrong is highly critical of the CFTC’s position limit rule, which he notes has been hanging around for the past seven year. In his view, a position limit rule has no theoretical justification, no supporting evidence, and will solve no existing problem. However, he expects such a rule will impose substantial compliance costs without providing any corresponding benefits. 
  • Forcing a one-size-fits-all model. Another problem with Dodd-Frank, according to the Dr. Pirrong, is that it takes a futures model framework, where contract terms and practice are standardized, and forces it on a swaps market where customization predominates.
Professor Pirrong apparently convinced the crowd. After his talk, 58 percent of the attendees polled favored the repeal of Title VII of Dodd-Frank. Then came the great debate. Gary DeWaal echoed many of the themes from the keynote, and focused further on how the Dodd-Frank reforms have led to greater concentration among industry players, and hence increased systematic risk. DeWaal observed there are only 21approved CCPs, and that ten firms hold 96 percent of the cash value of all swaps. In DeWaal’s view, when the next major crisis arises, we will see greater liquidity risk, credit risk, interconnection risk, and moral hazard risk.

Not surprisingly, Leslie Sutphen, in arguing against the repeal of Title VII, took issue with most of DeWaal and Pirrong’s assertions. “Prior to Dodd-Frank, there was a lack a lack of regulation, poor risk management, and a lack of supervision,” Sutphen observed. She also believes that the margin and liquidity issues are being conflated. Furthermore, Sutphen did not see CCP concentration as being a concern. Margin money is collected on the front end and is available as needed.

In Sutphen’s view, reliance on a futures model for the swaps market is a good thing, noting that the futures markets worked effectively during the financial crisis. “Risk is dispersed in a pay as you go clearing model,” she noted, adding “Dodd-Frank has introduced greater transparency and has been a great service to the swap markets.” Sutphen did, however, acknowledge that Dodd-Frank has more than its share of problems, and modification in some respect is warranted.

At the conclusion of the debate, the attendees were polled again. This time only 37 percent favored the repeal of Title VII. This is not entirely surprising. Even though there is currently much talk of significant overhaul to the regulatory landscape, Title VII remains somewhat sacrosanct. CFTC Acting Chairman Giancarlo has reiterated his support for the basic Title VII framework on a number of occasions recently. Most industry leaders also back the majority of these reforms. Notwithstanding, change is in the air and it remains to be seen where many of these reforms will eventually land.

Friday, June 30, 2017

WLF amicus brief urges high court to reverse Leidos on Item 303

By Rodney F. Tonkovic, J.D.

The Washington Legal Foundation has filed an amicus brief with the U.S. Supreme Court supporting the petitioner in Leidos, Inc. v. Indiana Public Retirement System. In Leidos, a Second Circuit panel held that the failure to make a required disclosure under Item 303 of Regulation S-K is an omission that can serve as the basis for a securities fraud claim under Section 10(b). The brief argues that the Second Circuit's ruling would dramatically expand securities fraud liability.

Item 303. In the Second Circuit, the failure to make a required Item 303 disclosure is an omission that can serve as the basis for a securities fraud claim under Section 10(b). In Leidos, the court held specifically that the plain language of Item 303 requires actual knowledge of the relevant trend or uncertainty in order to be liable for failing to disclose it.

The Leidos petition argues that the Second Circuit’s holding entrenches a deep circuit split, particularly between the Second and Ninth Circuits, which see more securities cases than the rest combined. According to the Second Circuit, the petition explains, a duty to disclose under Section 10(b) can derive from statutes or regulations obliging a party to speak, including Item 303, even if those omissions do not make any affirmative statements misleading. This holding is in direct conflict with Third and Ninth Circuit decisions holding that Item 303 does not create such an independent duty to disclose. Moreover, the petition argues, the decision is an "unprecedented expansion" of liability under Section 10(b) that, left undisturbed, could expose issuers to massive liability and would lead to an increase in fraud claims.

WLF urges reversal. The WLF argues that the Second Circuit's interpretation is flawed and at odds with the plain meaning of Rule 10b-5(b), the common law of fraud by omission, and Supreme Court precedent. Failing to comply with Item 303 should not be an independent basis for liability under the antifraud provisions and to rule otherwise would greatly expand the implied private right of action well beyond anything contemplated by Congress or the courts, the brief says.

The WLF first argues that the Second Circuit has misapplied Rule 10b-5(b) and the common law principle of half-truth on which the rule is based (i.e., a statement that is literally true but still misleading by omission). Simply put, the brief says an affirmative statement is a misleading half-truth, and thus potentially actionable, or it is not and is thus not actionable. Accordingly, Rule 10b-5 cannot support a finding that the failure to make disclosures of uncertainties and trends under Item 303 creates a duty to disclose where there is no specific, identified statement alleged to be misleading as a result of an omission. The Court has made clear in Matrixx and other cases that there is no affirmative duty to disclose any and all material information.

Even if viewed as a pure omission claim, the brief continues, the Supreme Court has only recognized an actionable fraudulent omission where there is: (1) a fiduciary relationship; and (2) a transaction to which the defendant was a party and in which he participated for personal gain. Neither condition is satisfied by the mere omission of information that is the subject of Item 303. The Second Circuit, the WLF argues, has imposed fraud liability for an issuer's omission in its financial results where there was no transaction with the investors and no actionable fiduciary relationship. This is an unwarranted expansion of the Court's Section 10(b) jurisprudence, the brief maintains.

Concluding by turning to the public policy implications of the Leidos holding, the WLF says adopting the Second Circuit’s holding would undermine the purpose and benefits of Item 303. The brief points out that the SEC discourages unnecessary and duplicative disclosure in favor of information that promotes the understanding of a company's financial condition. The specter of fraud claims for inadequate Item 303 disclosures would "trigger a deluge of disclosures." There is also the potential for a flood of shareholder litigation that will burden the courts and drive up costs for companies.

Thursday, June 29, 2017

FSB explores FinTech financial stability implications, regulatory challenges

By Amy Leisinger, J.D.

The Financial Stability Board has issued a report discussing the potential financial stability implications of, and regulatory issues surrounding, technological innovation and the evolution of FinTech. The report identifies several key areas of focus for regulators, including management of operational and cyber risks and consistent monitoring of possible macro-financial risks. Given the small size of FinTech relative to the financial system as a whole, no substantial financial stability risks currently exist, but issues could quickly arise as the industry develops, the FSB notes.

In its report, the FSB identified several potential benefits associated with FinTech, including decentralization and increased intermediation by non-financial entities and enhanced efficiency, transparency, and competition. However, the report also notes a number of potential risks, including institution-specific financial and operations risks, such maturity and liquidity mismatches and governance control. Macro-financial risks to the financial system could also result from increased interconnectedness and dependence on third-party service providers, the FSB states. Although there are limitations on the availability of data as FinTech develops, regulators should take these benefits and risks into account when making assessments and setting up regulatory approaches, according to the report.

A majority of jurisdictions have already taken or plan to take action in response to FinTech, but financial stability is not often cited as an objective, the FSB notes. To adequately address stability concerns, international bodies and national regulators should consider whether current frameworks provide appropriate oversight for third-party service providers to financial institutions, including cloud computing firms and data service providers, to ensure IT safety and security, according to the FSB. In addition, the report stresses the need for additional efforts to mitigate cyber risks in the form of contingency plans for cyber-attacks, information-sharing resources, and ongoing monitoring to minimize the possibility of cyber events that could adversely affect financial stability. While, at present, there are no compelling signs of macro-financial risks directly connected with FinTech, experience shows that issues can emerge quickly if left unchecked, the report explains.

According to the FSB, regulators should be sufficiently agile to respond to rapid changes in FinTech and, to accomplish this, they should build staff expertise in the FinTech space and continue to improve communication with the private sector, as well as with one another. Innovations in the execution of cross-border transactions may raise issues regarding cross-jurisdictional regulatory compatibility, the report explains. In addition to monitoring developments in FinTech generally, the FSB stresses that authorities should also consider the potential effect of digital currencies on monetary policy and financial stability. Changes in business models and continuing evolution could have an impact on financial stability in ways that cannot be predicted at this stage, the FSB concludes.

Wednesday, June 28, 2017

House Financial Services Committee examines market data issues, conflicts of interest

By Lene Powell, J.D.

In a hearing of the capital markets subcommittee of the House Financial Services Committee, lawmakers heard from securities exchanges, market makers, and brokerages in a broad exploration of equity market structure issues including data feeds and broker rebates, among other topics.

SIP vs. proprietary feeds. Many lawmakers sought input about market data and incentives—what market information is available, who pays for it, and whether current arrangements disadvantage any market participants. Jeff Brown, a senior vice president at Charles Schwab appearing on behalf of SIFMA, noted that the Securities Information Processor (SIP) feeds are slower than proprietary data feeds and contain only ephemeral top-of-book quotes. Brown pointed out that broker-dealers are required by rule to provide the raw material for the feeds to the exchanges, and then by rule must buy back the finished product—thus generating guaranteed profits for exchanges. That was a nice business to be in, he said.

Also, said Brown, the SIP has failed before and could fail again, but exchanges do not particularly have an incentive to improve it. “The fact is, exchanges and the members of the NMS Plan Governing Committee that oversees the SIP are never going to make the SIP so good that it would cannibalize the proprietary data feeds which they sell. There’s a conflict. Why would you ever do that?”

To ensure that market data is timely, comprehensive, nondiscriminatory, and accessible to all market participants at a reasonable cost, Brown believes the SEC should consider enhancing the SIP feeds with bid and offer quotes beyond the top of book data and provide that as the sole source of consolidated market data to meet regulatory obligations. Brown also urged the SEC to consider replacing the single-consolidator SIP model of market data dissemination with a competitive construct, such as a Competing Market Data Aggregators model.

Brad Katsuyama, CEO of the IEX Group, Inc. and Investors Exchange LLC, agreed that exchanges have conflicts of interest related to selling market data. According to Katsuyama, the proper role of an exchange is act as a neutral referee, providing the most accurate price to both sides of the trade, but exchanges fail in this role by selling a faster view of market data to high speed traders than the exchange itself relies on to price trades on its own market. The national stock exchanges have made a conscious decision to sell high-speed data and technology, instead of allowing third-party vendors to compete at selling these products. This conflicts with exchanges’ regulatory role and gives them monopoly power, said Katsuyama. He said that one broker recently stated their market data costs have increased 700 percent since 2008, which he finds especially striking given that technology costs have dropped in other industries.

Tuesday, June 27, 2017

On final day, high court decides statute of repose issue, will hear whistleblower case

By Rodney F. Tonkovic, J.D.

On the last day of the October Term 2016, the Supreme Court decided one case and granted certiorari in another. The Court held that Securities Act Section 13's three-year time limit is a statute of repose not subject to equitable tolling. Certiorari has been granted for a case asking whether the Dodd-Frank anti-retaliation provision applies to individuals who have not reported to the SEC. Finally, two petitions have been filed asking the court to consider the application of the Securities Litigation Uniform Standards Act to state law contract and breach of fiduciary duty claims.

Calpers v. ANZ. The court held in a 5-4 vote that American Pipe’s equitable tolling rule is unavailable to save an individual suit filed outside the three-year repose period contained in Securities Act Section 13. Due to its structure and language, the court said, Section 13 is a statute of repose. American Pipe emphasized equitable principles to the near exclusion of other interests, the court said, suggesting that it is limited to a court’s equitable powers to toll a statute of limitations, and a repose statute’s purpose supplants a court’s equitable powers (California Public Employees' Retirement System, Petitioner v. ANZ Securities, Inc., Kennedy, A., June 26, 2017).

The court has not yet addressed a petition filed on the same day as ANZ and asking a similar question. SRM Global Master Fund L.P. v. The Bear Sterns Companies LLC concerns the application of American Pipe to the statute of repose under Exchange Act Section 10(b).

Somers. The court also granted certiorari for a petition asking if Dodd-Frank protections apply to whistleblowers who did not report to the SEC. The case below turned on Dodd-Frank Act's definition of a "whistleblower." A divided Ninth Circuit panel held that the anti-retaliation provision applies to all who make internal reports under SOX and other federal laws. In so holding, the panel agreed with the Second Circuit's interpretation of the question, but conflicted with that of the Fifth Circuit (Digital Realty Trust v. Somers, April 25, 2017).

SLUSA petitions. Next, two petitions from the Seventh Circuit ask the court to consider the application of the SLUSA to contract and breach of fiduciary duty claims. The petitioners, who ran afoul of SLUSA preclusion, note that misrepresentations or omissions are not elements of breach of contract or fiduciary duty claims, but misrepresentations or omissions can sometimes be the basis for those claims. The role that the false statement or omission must play in a complaint in order to find SLUSA preclusion has led to a circuit split, the petitions say, and the issue arises frequently in the lower courts. Both cases were decided on the same day, and the petitions each cite the other opinion.

Monday, June 26, 2017

White paper examines disclosure rollbacks, virtual currencies and other securities filings hot topics

The Trump Administration’s desire to deregulate the financial services industry has already resulted in the disapproval of the resource extraction issuers rule and a call for new SEC guidance on conflict minerals disclosure. Wolters Kluwer senior writers Jay Fishman, J.D. and Mark S. Nelson, J.D. have prepared a white paper that examines the moves the Trump Administration and the SEC have already made in 2017 to alter public company disclosure obligations. The white paper also takes a wider view of issues affecting securities filings, including how the SEC is addressing fintech and what it is doing about its aging cybersecurity guidance. States too have taken up cybersecurity, including Colorado, which recently adopted rules that emphasize the security of confidential personal information. The authors look at emerging issues with virtual currencies and discuss the potential impact on capital formation of new Rule 147A and amendments to Regulation A and Rule 147.

To view the full article, please click here.