Friday, October 21, 2016

Dow board won’t face suit over $1B price-fixing judgment

By Anne Sherry, J.D.

A district court dismissed a shareholder derivative suit alleging that the board of Dow Chemical breached fiduciary duties in connection with alleged urethane price-fixing. By first making demand on the board, the plaintiff conceded the board’s overall independence. The shareholder therefore had to show the board’s refusal to take on the suit was wrongful, which the Eastern District of Michigan held he failed to do (Levine v. Liveris, October 19, 2016, Ludington, T.).

Dow spent about ten years defending allegations of price-fixing in the urethane market; in 2013, judgment was entered against the company in an amount exceeding $1 billion. Following an unsuccessful appeal, Dow settled the class action for $835 million and settled with plaintiffs who had opted out for an additional $450 million. Other defendants in the action settled long before Dow did and for significantly less, the court’s order states. According to the plaintiff, the Dow directors abdicated their business judgment and gave unfettered authority to trial counsel; rejected settlement proposals; and wrongly covered up the potential liability. The shareholder also alleged that the defendants breached their duties in other ways, such as by covering up the misuse of corporate assets.

The board refused the shareholder’s demands to bring suit. By making those demands, the plaintiff conceded that at least a majority of the board was independent and capable of considering the demands. Therefore, the business judgment rule applied to the board’s refusal. Although the investigation committee convened by the board resembled the board as a whole, neither this nor the fact that the committee unanimously rejected the demands constituted a particularized fact creating a reasonable doubt that the refusal was wrongful. The shareholder also did not create a reasonable doubt that the board used sufficient care in selecting an attorney to investigate the demand.

The court also could not take judicial notice of the allegations made or conclusions reached within the urethane price-fixing litigation. The mere fact that Dow was sued for antitrust law violations and found liable was insufficient to establish that the board acted in bad faith. Additionally, the board explained in its demand rejection letter that suing the officers, directors, and employees allegedly engaged in wrongdoing would be counterproductive even if the suit was viable. Suing would undermine Dow’s then-pending appeal, incur substantial legal fees, and cause reputational harm, the board reasoned. A board may refuse a shareholder demand in good faith even if the lawsuit demanded would likely be successful.

The case is No. 16-cv-11255.

Thursday, October 20, 2016

New C&DIs explain pay ratio disclosure and benefit plans, restricted securities

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation Finance issued five new Compliance and Disclosure Interpretations in an effort to explain how companies may comply with the pay ratio disclosure requirements. The C&DIs involve the Dodd-Frank-mandated regime the Commission adopted just over a year ago and for which compliance is set for the first fiscal year beginning on or after January 1, 2017. A separate set of updated C&DIs deals with Securities Act rules for compensatory benefit plans and restricted securities.

Pay ratio disclosure. The final pay ratio rule mandates disclosure of the ratio between the median of the annual total compensation of all employees and the principal executive officer’s annual total compensation. The Commission’s pay ratio rule is set out in Item 402(u) of Regulation S-K. But the rule text also raises a few perplexing issues that get addressed in the new C&DIs contained in Section 128C of the Division’s Regulation S-K guidance, including the selection of the consistently applied compensation measure (CACM), pay rates, time periods, furloughed workers and independent contractors.

For example, the final rule refers to Item 402(c)(2)(x) (the SEC provided the text as an adjunct to the new C&DIs) for the calculation of annual total compensation and elsewhere to other CACMs, including information derived from a registrant’s tax and/or payroll records. Question 128C.01 confirms that any measure that reasonably reflects employees’ annual compensation can work, if the measure is appropriate given the company’s particular facts and circumstances. But the C&DI suggests a few limits: total cash compensation is okay unless a certain scenario exists, while Social Security taxes withheld is an unlikely choice absent certain facts.

According to Question 128C.02, rates of pay alone could not be used as a CACM, even though pay rates may be a component of determining an employee’s overall compensation. Question 128C.03 clarifies the time period stated in the final rule. Under Question 128C.04, a company must consider its unique circumstances regarding furloughed workers, consistent with Instruction 5 of Item 402(u). Question 128C.05 states that a company should include in its calculations workers for whom the company or its consolidated subsidiary determines compensation. But a company would not be determining compensation if it only specified that workers employed by an unaffiliated third party receive a minimum level of compensation.

Compensatory benefit plans; restricted securities. Shortly after adding the Regulation S-K pay ratio C&DIs, the Division issued another set of revised and new C&DIs covering several topics under the Securities Act rules. For one, the staff updated Question 271.04, which is one of the Securities Act rules C&DIs for general situations, to re-phrase the question and to expand upon the prior answer.

That question involved a non-Exchange Act reporting company that issued options in reliance on Securities Act Rule 701 that is later acquired by an Exchange Act reporting company such that the private company’s options become exercisable for shares of the acquirer. Previously, the question was whether the acquirer could rely on Rule 701(b)(2) to exempt the exercise of the options; the staff said “No.” The revised question asks if the acquirer must register the offer and sale of shares issuable upon the exercise of the options; the answer is “No,” but the explanation now clarifies the scope of reliance on Rule 701 and states that the acquirer’s Exchange Act reports would satisfy any related disclosure requirements.

New Question 271.24 clarifies when an issuer must provide additional information to investors about restricted stock units under Securities Act Rule 701 upon exceeding the $5 million limit that triggers this informational duty. Citing Rule 701(e), the staff explained that this information must be delivered to investors within a reasonable time before the sale. A revision to Question 532.06, one of the Securities Act rules C&DIs for particular situations involving Rule 144(d), references a different question in the SEC release cited in the prior C&DI.

Wednesday, October 19, 2016

Allegations of unsuitable sales of reverse convertibles precluded by SLUSA

By Rodney F. Tonkovic, J.D.

State law claims alleged in a complaint against a seller of convertible notes were precluded by SLUSA and must be dismissed, a district court has found. The court found that the majority of the claims sounded in fraud, and the alleged misrepresentations and omissions were made "in connection with the purchase or sale of a covered security" (Luis v. RBC Capital Markets, LLC, October 13, 2016, Nelson, S.).

Risky notes. The complaint alleges that RBC Capital Markets, LLC improperly marketed and sold proprietary reverse convertible notes to the seven investor plaintiffs. The notes at issue were a form of bond, consisting of a high-yield, short-term note of the issuer linked to the performance of an unrelated reference asset. The notes were riskier than a traditional bond, however, and an investor could lose all of the principal investment and be left with only a depreciated asset. When the notes declined precipitously in value, the investors brought this suit on behalf of a putative class of "several thousand," alleging fraud under state and common law.

In essence, the complaint alleged that RBC sold inherently risky notes to retirees who did not understand the nature of the investments and who had told RBC that they were risk-adverse. Because reverse convertible notes are so risky, the investors maintained, RBC had a duty to market them only to those who fully understood and accepted the risks. Instead, RBC hid the risk and pushed the notes on investors who were unwilling to engage in risky options trading. The investors alleged that they relied on RBC's misrepresentations and omissions in purchasing the notes, and brought seven claims under state law, including common law fraud, fraudulent concealment, and violation of two provisions of the Minnesota Securities Act.

SLUSA. RBC contended that the complaint must be dismissed because each claim was barred by SLUSA, and the court agreed. There was no dispute that, under the SLUSA, the action was a "covered class action" based on state law. The court then found that the complaint generally alleged misrepresentations and omissions of material fact by RBC. While the investors pleaded claims for common law negligence, breach of fiduciary duty, and breach of contract, there was no avoiding the fact that the majority of the claims sounded in fraud, and explicitly required allegations of material misrepresentations and omissions, the court said.

The court then concluded that RBC’s alleged misrepresentations and omissions were made "in connection with the purchase or sale of a covered security." First examining whether the notes were covered securities, the court looked at Securities Act Section 18(b)(1)(C), which declares a security to be "covered" if it is "a security of the same issuer that is equal in seniority or that is a senior security to a security described in subparagraph (A) or (B)." This section, the court noted, has never been addressed by a federal court. The court determined that the notes met every element of subsection (C): the notes were "securities" issued by Royal Bank of Canada, the “same issuer” of a security described in subparagraph (A), and were of at least equal seniority to Royal Bank of Canada's common stock. Ultimately, the court declined to narrow the plain language of the statute, and concluded that this interpretation was in keeping with the purpose and scope of SLUSA.

Finally, the court found that RBC's alleged misconduct was "in connection with" the purchase of covered securities. The investor's own allegations, the court said, repeatedly states that RBC’s misrepresentations and omissions directly induced their purchase of the notes. The court accordingly found that the claims were indeed precluded by SLUSA and dismissed the complaint without prejudice.

The case is No. 16-cv-00175.

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Tuesday, October 18, 2016

Former commissioners Pitt and Gallagher critical of current securities enforcement, regulatory landscape

By Amanda Maine, J.D.

Former SEC Chair Harvey Pitt and former Commissioner Daniel Gallagher engaged in a spirited conversation over recent securities enforcement efforts. The conversation took place in front of the Securities Docket’s annual Securities Enforcement Forum in Washington, D.C.

Pitt, who served as SEC chair from 2001 to 2003, said that the SEC has been in a regulatory “holding pattern,” given that there are only three present commissioners as President Obama’s two nominees for the commission’s empty seats still await confirmation. But in the area of enforcement, the staff has been active and aggressive, he said. While SEC activity has moved in a positive direction, with the upcoming election, everyone is awaiting what comes next. Pitt also jokingly referred to “de facto chair Elizabeth Warren,” the Democratic senator from Massachusetts who has been critical of SEC chair Mary Jo White’s tenure and has called for her demotion.

Gallagher, who touted his position of being on the losing side of the most 3-2 votes during his time at the SEC from 2011 to 2015, said that the SEC is less respected today, citing the Madoff Ponzi scheme and the SEC’s failure to detect it as an example. He also renewed his longtime criticism of the Dodd-Frank Act, which he said was written from the perspective of those who want to micromanage the SEC.

Gallagher also took aim at criticism from politicians regarding news reports of misconduct at financial institutions, citing in particular the recent revelation that employees had set up unauthorized accounts that customers had not requested in order to meet sales quotas. Wells Fargo executives have come under fire regarding the incident from a number of different lawmakers, including Sen. Warren, as well as Sens. Jeff Merkley (D-Ore), Bob Menendez (D-NJ), Sherrod Brown (D-Ohio), and Jack Reed (D-RI), who have been especially critical about the executives’ incentive compensation. According to Pitt, there should be concern not just about the number of customers hurt, but also about the company’s culture. What should also be examined is how to fix the environment that created the issues, he said.

Gallagher did not reserve his scorn for politicians, but also singled out the Department of Justice. He noted that the clamor in Washington post -Dodd-Frank was why there aren’t more people in jail. This has resulted in “insanity” from the DOJ, particularly in the large criminal fines imposed in cases involving residential mortgage-backed securities. Gallagher fears the SEC may get “sucked into the vortex created by the Department of Justice” and doesn’t know if the “genie can be put back in the bottle” at this point.

Pitt agreed that there is a degree of “media bloodlust” around certain cases involving large financial entities. Regarding the Justice Department penalties, he advised that the SEC does explain how they determine penalties, while the DOJ does not disclose the basis for their numbers.

Pitt took aim at the adoption of the Volcker rule, which he said was “designed to restrain banks.” When banks tried to develop alternative mechanisms to raise capital, the regulatory response was “that’s shadow banking, and that’s evil, too,” in his view. Wall Street, he said, used to be a place where risks were taken, and while systemic risk is something to be concerned about, the new rules have nothing to do with the 2007-2008 meltdown, Pitt advised. The Volcker Rule was flawed from the get-go, rushed to be implemented, and has prevented small- and mid-cap companies from getting capital, Pitt said.

In response to a question about the SEC’s regulatory functions and its enforcement functions, Pitt proclaimed that the SEC used to be a regulatory agency with enforcement power, and today it is an enforcement agency with regulatory power. People are now afraid of a possible enforcement action if they come to the SEC with questions, according to Pitt. The agency needs “smarter” regulation, he said, and it should review every one of its rules.

Gallagher agreed with Pitt’s review suggestion, observing that the securities laws and regulations have been developed over 70 years, plus the rules required under Dodd-Frank. There has not been a comprehensive review of these rules, despite the addition of so many rules being added to the SEC’s powers. Pitt, sardonically observing that “no crisis should be wasted,” singled out the conflict mineral rules and the pay ratio rules under Dodd-Frank, and criticized Congress for passing the legislation before a final report on the law was available.

An audience member raised the question about the size of penalties under Dodd-Frank and the SEC’s attempts to go after individuals, and whether individuals would want certain jobs, particularly that of chief compliance officer. Gallagher noted that during his time at the SEC, the staff began “ferreting out ‘gatekeepers,’” which he described as “anyone with a pulse.” CCOs, he said, have every right to be horrified at the possibility of SEC enforcement. As far as policy goes, it is wrong because you want to incentivize compliance, he said, not traumatize them with interviews and Wells notices, Gallagher warned.

Monday, October 17, 2016

‘Turnaround Queen’ reverses course, withdraws latest suit against SEC

By John M. Jascob, J.D., LL.M. and Amanda Maine, J.D.

Lynn Tilton and her Patriarch Partners entities have abandoned their latest constitutional challenge to the SEC's administrative enforcement regime. In a notice filed with the federal district court in Manhattan, Tilton's counsel said that the plaintiffs have decided not to pursue injunctive relief against the Commission, but instead will voluntarily dismiss their action without prejudice. Tilton and her companies must now defend against an SEC administrative proceeding that commences on October 24 (Tilton v. SEC, October 14, 2016).

Forward and back again. The SEC had instituted administrative proceedings against Tilton and Patriarch Partners in March 2015, alleging that they engaged in a deceptive scheme regarding their management of three collateralized loan obligation funds. Tilton initially brought suit against the SEC in the Southern District of New York, challenging the constitutionality of the Commission’s administrative law judges under the Appointments Clause. The Second Circuit ultimately rejected her claims, however, affirming the lower court’s ruling that district courts lack subject matter jurisdiction over the SEC’s administrative proceedings.

In the present action filed on September 9, Tilton took another constitutional tack before the district court, arguing that the SEC’s ALJ regime violated her constitutional rights on equal protection and due process grounds. Among other things, Tilton alleged that the SEC has engaged in a “pattern and practice” of violating respondents’ due process rights, including delaying formal charges while the Commission’s Enforcement staff conducts investigations. In turn, the government argued that the court still lacked subject matter jurisdiction under the Second Circuit’s decision in Tilton I, while rejecting the notion that "pointing to persons who have raised loosely related claims" regarding the SEC’s proceedings demonstrated a "pattern and practice" of due process violations.

Instead of ruling on the issue of subject matter jurisdiction based solely on the five-page summary letters by the parties, the court directed them to "meet and confer" regarding resolution of the jurisdiction question and to submit a joint letter containing their recommendation by October 13. After counsel for the SEC insisted that either no further briefing was necessary or that the Commission would move to dismiss the complaint, however, Tilton and Patriarch Partners decided to abandon their request for an injunction and dismiss their complaint.

The case is No. 16-cv-7048.

Friday, October 14, 2016

CFTC extends date for swap dealer registration de minimis threshold

By Kevin Kulling, J.D.

The CFTC announced that it has approved an order establishing December 31, 2018, as the swap dealer registration de minimis threshold phase-in termination date. With the approval, the de minimis threshold will remain at $8 billion.

Regulatory background. As explained in the order, the Dodd-Frank Wall Street Reform and Consumer Protection Act directed the CFTC and the SEC to jointly further define the term “swap dealer” and to include a de minimis exception. The de minimis exception provides that a person shall not be deemed to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold of $3 billion subject to a phase-in period during which the gross notional amount threshold is set at $8 billion.

Without further action by the CFTC, the phase-in period was scheduled to terminate on December 31, 2017, at which time the de minimis threshold would decrease to $3 billion. Firms would also be required under that scenario to start tracking their swap activity beginning on January 1, 2017, to determine whether their dealing activity over the course of the year would require them to register as swap dealers.

After review, the CFTC determined that it was prudent to extend the phase-in period by one year, which may provide additional time for more information to become available to reassess the de minimis exception.

The CFTC notes that prior to the termination of the phase-in period, the Commission may take further action regarding the de minimis threshold by rule amendment, order, or other appropriate action.

Commissioner statements. In a statement accompanying the order, CFTC Chairman Timothy Massad said that the swap registration requirement is a pillar of the framework for swap regulation mandated by Dodd-Frank. Congress required this framework because excessive risk related to over-the-counter derivatives contributed to the intensity of the worst financial crisis since the Great Depression, according to Massad. At the same time, Massad said, Congress recognized that derivatives play an important role in enabling businesses to hedge risk. Therefore, getting this framework right is very important.

Commissioner Sharon Bowen issued a concurring statement regarding the order. Bowen said that the CFTC has published its final staff report on the de minimis threshold and the nine month period of considering whether to change the threshold has formally begun. It is clear from the report, Bowen said, that the staff does not have sufficient data to make a fully informed decision. “I support this initiative to get additional data on this subject, and I do not support changing the threshold at this time,” the statement said.

Thursday, October 13, 2016

Paxton pretrial habeas petition refused

By Mark S. Nelson, J.D.

Texas Attorney General Ken Paxton may have won a reprieve last week in the SEC’s federal securities fraud case against him, but he appears to have run out of luck in his effort to get the Texas Court of Criminal Appeals to hear his pretrial habeas claims about the state case against him. State prosecutors charged Paxton a year ago with three felony counts, including one count of rendering services without registering as an investment adviser and two counts of securities fraud. The Court of Criminal Appeals has now refused Paxton’s recent petition for discretionary review of a lower court opinion regarding pretrial habeas (Ex Parte Warren Kenneth Paxton, Jr., October 12, 2016).

Paxton argued that part of the state’s case was preempted by federal law and that he had been charged with a non-existent crime. Paxton also disputed the lower court’s interpretation of the mental state required under Texas Securities Act Section 29I (felony law regarding unregistered investment advisers or investment adviser representatives). Moreover, Paxton faulted the lower court’s partial application of the Supreme Court’s Central Hudson commercial speech opinion regarding Section 29I. Paxton’s petition also addressed whether factual disputes exist over one entity’s dual SEC-state registration and he questioned the lack of randomness in the “volunteer” grand jury.

The state’s reply countered each of Paxton’s assertions primarily by explaining how Paxton’s petition misconstrued legal precedents. In June, the en banc Texas Court of Appeals (Fifth) concluded that the trial judge properly denied Paxton’s pretrial habeas request.

Last week Paxton won the “conditional” dismissal of the SEC’s case alleging he committed federal securities fraud. That opinion focused on whether Paxton had a duty to disclose certain financial relationships. Despite the court’s finding that Paxton did not have such a duty, the court indicated that it might allow the SEC to present additional facts before issuing a final order dismissing the case.

The case is Nos. PD-0891, PD-0892, and PD-0893.

Wednesday, October 12, 2016

Demand futility must be pleaded even for a part-direct claim

By Anne Sherry, J.D.

Even if a shareholder’s claim that a REIT overpaid for assets was both direct and derivative, the shareholder was required to show why presuit demand was excused, the Delaware Court of Chancery held. The allegations created a reasonable doubt as to three directors’ disinterestedness in the transactions because they were fiduciaries both of the REIT and the REIT’s controller, but the complaint did not adequately plead facts showing that the controller’s interest was material (Chester County Employees’ Retirement Fund v. New Residential Investment Corp., October 7, 2016, Montgomery-Reeves, T.).

The New Residential Corp. stockholder alleged that the board, along with other entities, caused the REIT to overpay for the assets of Home Loan Servicing Solutions, Ltd., in order to advantage commonly owned real estate assets and maximize fees. The plaintiff also sought a declaratory judgment that certain limitations on fiduciary duties and liability in the New Residential management agreement were not valid defenses. This issue was not ripe for adjudication, the court determined, because the fiduciary duty claims had to be dismissed (with leave to replead).

The decision turned on the nature of the plaintiff’s claim as direct or derivative under a Tooley (Del. 2004) analysis. Additionally, under Gentile v. Rossette (Del. 2006), a claim of corporate overpayment may be both direct and derivative when a stockholder that effectively controls a corporation causes it to issue “excessive” shares of stock in exchange for a lesser value of the controller’s assets. For the claim to be dual-natured, the exchange must also cause an increase in the percentage of outstanding shares owned by the controlling shareholder, corresponding to a decrease in the share percentage owned by minority shareholders.

In El Paso Pipeline (Del. Ch. 2015), however, the chancery court explained that different considerations apply on a motion to dismiss for failure to make presuit demand on the board. In the court’s view, Delaware law “can and should” treat a claim as derivative for purposes of the demand requirement, but as direct for purposes of determining whether sell-side investors can continue to pursue a claim post-merger. Assuming that the REIT shareholder claims are dual-natured, the court found that conducting a demand analysis for claims of overpayment “best harmonizes the case law.”

Undertaking that analysis, the court held that the plaintiff did not sufficiently plead demand futility. The plaintiff did plead that at least half of the New Residential directors were beholden to the REIT’s controller, Fortress. However, the complaint did not go far enough to establish that Fortress had a material interest in the challenged transactions. Although affiliated entities received options and fees in the transaction, the complaint did not allege materiality to Fortress, such as by alleging the percentage of Fortress’s ownership of the recipients or the ratio of the alleged benefits to a Fortress financial metric. The complaint also failed to adequately allege how the New Residential directors were incentivized to overpay for the assets. The court dismissed these claims but recognized their potential viability and allowed leave to replead.

The case is No. 11058-VCMR.

Tuesday, October 11, 2016

Commenters discuss SEC/FASB overlap and tax disclosure

By Jacquelyn Lumb

The SEC extended the comment period on its proposal to amend certain disclosure requirements that may be redundant, duplicative, overlapping or outdated. The comment period was originally intended to end on October 3, 2016 but was extended to November 2 to give interested parties more time to analyze the issues and submit their comments. Among the recent commenters are Deloitte & Touche, the Center for Audit Quality (CAQ), Citizens for Tax Justice (CTJ), and the Financial Accountability and Corporate Transparency Coalition (FACT).

SEC/GAAP overlap. Deloitte submitted its input on a number of amendments, deletions, and potential referrals to FASB in addition to overlapping GAAP and SEC disclosure requirements. The firm said it supports the SEC’s efforts to work with FASB to determine whether certain incremental requirements in the SEC’s rules should be incorporated into GAAP. If the SEC chooses to retain disclosure requirements that are similar, but not identical, to the GAAP requirements, Deloitte said the disclosure objective should be clearly distinguished. The firm also urged the SEC and FASB to avoid duplicative and overlapping disclosure as new standards are developed and the SEC’s disclosure regime is modernized.

Deloitte supports the SEC’s proposal to eliminate many of the bright line disclosure requirements, which it said is consistent with FASB’s proposed elimination of “at a minimum” disclosures in GAAP. With respect to the disclosure about legal proceedings, Deloitte said a referral to GAAP may not be appropriate. The SEC should reconsider the disclosure objective of Item 103, in Deloitte’s view, to determine whether it should make substantive changes or eliminate the incremental disclosure requirements.

CAQ said that codifying the disclosure requirements related to financial statements in one place would be beneficial for all stakeholders, but agreed with Deloitte that if the SEC retains its requirements, it should include the disclosure objective beyond those addressed in FASB’s standard setting process. CAQ does not support combining the SEC’s Item 303 legal proceedings with FASB’s ASC 450, but also agreed with Deloitte that it should evaluate the Item 303 disclosure requirements and better articulate its objective. Both Deloitte and CAQ noted that if the SEC integrates Item 103 and ASC 450, the American Bar Association’s statement regarding lawyers’ responses to auditors’ requests for information and the PCAOB’s auditing standards may have to be revised.

Tax disclosure. CTJ wrote that there is clearly a need for additional income tax disclosure. Current disclosure does not provide the definitive information needed to have a robust debate over the current corporate tax code, CTJ explained, with international tax and income the most lacking.

One of the central features of the corporate income tax code is that it allows corporations to defer paying taxes on foreign income until it is repatriated back to the U.S. Many countries have single digit or zero tax rates which create an enormous incentive for U.S. companies to avoid taxes by claiming that as much income as possible is earned in these tax haven countries, according to CTJ, with estimates as high as $2.4 trillion in earnings offshore, or a loss of over $100 billion in U.S. tax revenue every year.

CTJ said that requiring companies to disclose in their Forms 10-K more information about their operations and tax provisions on a country-by-country basis would help inform the policy debate. In addition, investors need to know how exposed the companies they invest in are to increases in taxes on their international profits. CTJ said the offshore operations of companies are too critical to the U.S. economy to remain in the shadows.

FACT noted that, contrary to concerns about information overload, most commenters have called for increased disclosure to better assess emerging risks. FACT also referred to the detailed comments it submitted in response to the SEC’s earlier concept release on the disclosure requirements regarding the need for additional disclosure about the tax strategies of multinational corporations. In those comments, FACT highlighted the increase in offshore profits, Apple’s $14.5 billion miscalculation based on the tax benefits provided by Ireland, and Dell’s $28 billion discrepancy in valuation based on differing estimates of how to appraise the value of a company’s offshore profits given the potential tax liabilities.

Aggregated foreign tax disclosures are of little use to investors who want to assess the risk associated with aggressive tax strategies, according to FACT. The IRS recently finalized a rule to require country-by-country reporting of revenues, profits, and taxes paid and of certain operations by larger multinational corporations. The EU also has established new country-by-country reporting requirements for larger firms. FACT said the SEC should take steps to require the disclosure of this critically important information as well.

Monday, October 10, 2016

CFTC signs cooperation agreement with U.K. FCA on supervision of cross-border firms

By Lene Powell, J.D.

The heads of the CFTC and U.K. Financial Conduct Authority (FCA) signed a Memorandum of Understanding (MOU) regarding information sharing and cooperation in the supervision of certain cross-border regulated firms. The MOU addresses issues of common regulatory concern, including initial application for registration and ongoing supervision of covered firms.

Signed by CFTC Chairman Timothy Massad and FCA Chief Executive Andrew Bailey on October 6, 2016, the MOU complements existing cooperation agreements and notes the particular importance of close cooperation in crises threatening systemically important firms.

Covered firms. In the U.S., covered firms include CFTC-registered swap dealers (SDs) and major swap participants (MSPs), as well as applicants for registration. U.K. covered firms include entities authorized and supervised by the FCA in accordance with European single market directives in Article 2(8) of EU Regulation No. 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR).

Cooperation. According to the MOU, cooperation will be most useful in issues of common regulatory concern, including initial application for registration as SD or MSP, ongoing supervision and oversight of covered firms, and regulatory or supervision actions by the CFTC or FCA that may affect the entity's operation in the jurisdiction of the other authority.

The MOU provides for:
  • Event-triggered notifications for certain events, including regulatory changes, material events that could affect a firm's financial operational stability, and enforcement actions and significant regulatory actions against a covered firm;
  • Request-based sharing of information relating to a firm's regulatory filings and financial and operational condition, as well as regulatory reports on firms such as examination reports;
  • Procedures for on-site visits and requests for information;
  • Periodic meetings.
Treatment of non-public information. Although the CFTC and FCA do not intend the MOU specifically as a means to gather information for law enforcement purposes, non-public information provided under the MOU may be used in investigations and enforcement actions in accordance with use and confidentiality provisions in previous MOUs. The regulators must keep non-public information confidential, and there are restrictions on onward sharing. The agreement provides for procedures for notification and consent for further sharing.

Friday, October 07, 2016

‘Tandy’ text recedes from filing review process

By Mark S. Nelson, J.D.

The SEC’s Division of Corporation finance announced that companies responding to staff comment letters as part of the agency’s filing review process will no longer need to include the so-called “Tandy” language in their replies. Perhaps the inclusion in recent years of similar language in SEC-generated letters that often signal the end of a review dialog presaged the decision to let companies drop the representation from their replies. The Tandy update is effective now and even applies to companies that have yet to provide Tandy representations.

The Division announced it would publish filing review dialogs on EDGAR back in 2004, and in May 2005 it officially began to publicly release them. For much of this period, the staff requested that companies responding to comment letters provide the Tandy text. Some companies’ Tandy representations specifically mentioned the context of the review. A typical exchange looked like this:

SEC letter to company:
In connection with responding to our comments, please provide, in writing, a statement from the company acknowledging that
  • the company is responsible for the adequacy and accuracy of the disclosure in the filings;
  • staff comments or changes to disclosure in response to staff comments in the filings reviewed by the staff do not foreclose the Commission from taking any action with respect to the filing; and
  • the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.
Company reply to SEC:
The adequacy and accuracy of the disclosure in the filing is the responsibility of the Company. The Company acknowledges that the staff comments or changes to the disclosure in the Schedule TO-I made in response to the staff comments do not foreclose the Commission from taking any action with respect to the Schedule TO-I. The Company acknowledges that it may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States.
But more recent SEC-generated review-ending letters began to include Tandy-like language to remind companies of their obligation to comply with federal securities laws. A typical SEC letter stated:
We have completed our review of your filing. We remind you that our comments or changes to disclosure in response to our comments do not foreclose the Commission from taking any action with respect to the company or the filing and the company may not assert staff comments as a defense in any proceeding initiated by the Commission or any person under the federal securities laws of the United States. We urge all persons who are responsible for the accuracy and adequacy of the disclosure in the filing to be certain that the filing includes the information the Securities Exchange Act of 1934 and all applicable rules require.
Previously, these letters would have simply stated that SEC staff had finished reviewing a company’s filings without saying more.

According to the Division’s latest announcement, SEC-generated letters to companies now will include a brief admonition:
We remind you that the company and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff.

Thursday, October 06, 2016

Advisory committee considers disclosure, diversity, capital issues affecting small companies

By Amy Leisinger, J.D.

The SEC’s Advisory Committee on Small and Emerging Companies met to discuss the impact of Regulation S‑K disclosure requirements and issues concerning corporate board diversity on smaller companies and to begin formulating potential recommendations for the Commission. The committee also heard from the Division of Trading and Markets on the tick-size pilot and treatment of capital “finders” and the Division of Corporation Finance regarding ongoing outreach efforts for smaller companies about raising capital generally.

Disclosure. Several committee members noted that disclosure rules, particularly Regulation S-K, cover a large amount of information but suggested that, while transparency is important, regulators need to consider what levels of disclosure will actually allow, or even encourage, small companies to succeed. The primary focus must be on determining what information is material and ensuring that the material information is disclosed. For example, in most cases, comprehensive disclosure about business structure is not as crucial for small companies, one member noted. The question ultimately comes down to which individual or entity will be the end consumer of the information provided and, as such, a more principles-based approach to disclosure may be appropriate for small and emerging entities. The starting point should be asking whether the disclosure provides data to assist in informed investment decision-making, one member said.

The committee also considered whether the SEC should require companies to disclose costs associated with compliance efforts. This information may be more useful to the agency than anecdotal industry comments in evaluating the true burdens of regulation and would bring to light potential disproportionate burdens imposed on small companies. However, one member noted, fixing regulations may not fix cost issues; some businesses have an incentive to spend time interpreting and assessing application of disclosure requirements.

Diversity. National Association of Corporate Directors board member Cari Dominguez offered a primer on diversity issues in public company boards and suggested that boards cannot fulfill their responsibilities without reflecting the composition of stakeholders and customers. While most agree that increasing board diversity is an important goal, she explained, progress in the U.S. has been slow in comparison with other countries. Other nations have called on boards to establish and measure diversity and set specific targets, and many foreign companies have implemented voluntary measures to increase diversity and limit director tenure. Leaders of large U.S. companies are more likely to discuss these issues; more than half of the small-cap companies polled stated that their boards did not discuss gender, racial, ethnic, or age diversity in the past year, Dominguez said. She urged all boards to get diversity on their discussion agendas and figure out ways to expand their pools of potential board candidates.

Some committee members cited a lack of knowledge concerning where to find qualified director candidates who would provide diversity and noted that the most competent individuals are often already overburdened with board services at other companies. Further, they cautioned that mandating diversity or enforcing quotas could have a negative impact on optimal board composition and highlighted the fact that the market will eventually address disparities in board diversity.

Others agreed that proscribed standards are not the answer but suggested that disclosure of director characteristics may be the best way to address the matter, particularly with regard to any unconscious biases that may be looming within a company. Market forces will eventually balance out boards, but that could take years, they noted. To speed up the process, it is necessary to show that diversification adds value, members concluded.

Capital formation. The committee closed its meeting with a discussion of outreach initiatives for smaller companies regarding capital-raising activities. Entrepreneurs need to know about the various approaches to capital formation and their requirements and limitations, members said, and the Division of Corporation Finance has made great strides in conducting local seminars for small business owners. However, the committee found, more can and should be done, both in terms of additional locations and enhanced information for investors and lawyers who assist small business owners. The committee acknowledged the limits on SEC staff in terms of actually providing advice on the propriety of any approach in a specific case but did suggest that efforts be made to better organize the educational information that is available and ensure access for all entrepreneurs.

Wednesday, October 05, 2016

SEC says Microsoft’s proxy access bylaw does not substantially implement shareholder proposal

By Jacquelyn Lumb

Microsoft Corporation may not omit from its proxy materials a proxy access shareholder proposal based on the staff’s conclusion that the company’s bylaw does not compare favorably with the guidelines in the proposal. Microsoft’s bylaw has a 20-shareholder limit for forming a nominating group while the proposal has no limits on the size of the group. Shareholders want proxy access bylaws that can actually be implemented, the proponent explained. Their goal is not to obtain a watered down version of proxy access.

Shareholder proposal. The shareholder proposal seeks amendments to Microsoft’s existing proxy access bylaw, which was adopted prior to receiving the proposal. The proposal outlines what the proponent considers essential elements for substantial implementation of a proxy access bylaw, which includes no limitation on the number of shareholders that can aggregate their shares to achieve the three percent of outstanding shares entitled to vote in the election of directors.

Troublesome bylaw. The proponent notes that even if the 20 largest public pension funds were to aggregate their shares, they would not meet the three percent criteria at most of the companies examined in a Council of Institutional Investors study. Microsoft’s bylaw includes provisions that impair shareholders’ ability to use it, in the proponent’s view, which renders it unworkable.

Microsoft’s argument. Microsoft sought the staff’s concurrence that its proxy access bylaw compared favorably and that it substantially implemented the proposal. The bylaw achieved the proposal’s essential purpose, in Microsoft’s view. If the staff did not concur with this view, Microsoft warned that it would result in endless nitpicking and impossible line-drawing over aspects of company bylaws.

With respect to allowing an unlimited number of shareholders to form a nominating group, Microsoft said such an unwieldy group would raise administrative concerns. Microsoft added that the staff has found identical 20-shareholder group provisions to have implemented the essential elements of other proposals which also requested that proxy access be available to an unrestricted number of shareholders forming a group.

Microsoft also cited CII’s findings that at most of the companies it looked at, the holders of the largest 20 pension plans would not be sufficient to meet the three percent ownership threshold, but noted that its 20 largest shareholders in the aggregate hold more than 40 percent of its shares. The 20-shareholder nominating group is a widely embraced standard among companies that have adopted proxy access, according to Microsoft, and it is reasonably designed to ensure the availability of proxy access without creating an overly complex process.

Proponent’s argument. The proponent countered that Rule 14a-8(i)(10) says a proposal can be excluded from the proxy if it has been substantially implemented, not because a company has chosen a popular alternative. While Microsoft’s 20 largest shareholders hold more than 40 percent of its shares, the proponent said most of them have never filed a shareholder proposal and it is unlikely they would do so. Most proxy proposals come from a category known as corporate gadflies, including the proponent, and Microsoft’s top 40 investors do not include any of these shareholders, according to the proponent.

With respect to Microsoft’s argument that allowing a large group of shareholders to aggregate their shares would be difficult, the proponent asked why the company would object, given the difficulty. The proponent added that most of the no-action decisions on proxy access proposals were decided based on arguments by the companies without the benefit of counter arguments by the proponents. In this case, the proponent said Microsoft has not met the burden of proof that limiting shareholder groups to 20 will not impair the implementation of proxy access.

Staff position. The staff advised that, based on the information presented, it was unable to conclude that Microsoft’s proxy access bylaw compares favorably with the guidelines included in the proposal. Accordingly, the proposal may not be omitted from its proxy materials in reliance on Rule 14a-8(i)(10).

Tuesday, October 04, 2016

Mass. regulator says Morgan Stanley cross-selling ‘sales contests’ ran amok, may have hurt clients

By Mark S. Nelson, J.D.

The Massachusetts Securities Division unveiled an administrative complaint against Morgan Stanley Smith Barney LLC in which regulators allege the Massachusetts-registered broker-dealer’s 2014 and 2015 “sales contests” to win clients’ securities-based lending business generated conflicts of interest, violated the firm’s internal policies against such contests, and could have hurt clients. The Division seeks to permanently bar Morgan Stanley from engaging in these banking and securities cross-selling practices, to censure the firm and impose an administrative fine, and to obtain equitable relief for the firm’s clients (In the Matter of Morgan Stanley Smith Barney LLC, October 3, 2016).

According to the complaint, Morgan Stanley created the sales contest to persuade its retail wealth management clients to take out securities-based loans via portfolio loan accounts (PLAs). A PLA would allow a client to obtain a loan by putting up securities in the investment account as collateral. The firm allegedly chose the PLA route to keep pace with its competitors and to supplement its revenues after the Great Recession.

Massachusetts regulators detailed how they say Morgan Stanley knowingly allowed the sales contest to continue for nearly a year after the compliance and risk office at one of its complexes detected the program, albeit only after the program had already been in existence for a year, and despite a firm-wide ban on such contests unless they are operated on a national scale (regulators allege the complex-based contests were local in scope).

Morgan Stanley allegedly encouraged its financial advisers to invoke “triggers,” such as tax liabilities, mortgage needs, weddings, and graduations, as reasons clients should take out loans. Depending on the number of loans made, advisers could earn extra pay of between $1,000 to $5,000. The complaint describes a high pressure culture bent on competition that even used employee tracking metrics to pit advisers against each other, but without disclosing the available sales incentives to the firm’s clients.

Morgan Stanley is alleged to have violated Massachusetts General Law Sections 204(a)(2)(G) and (J), which penalize unethical or dishonest conduct or practices in the securities business, and the failure reasonably to supervise agents, investment adviser representatives or other employees. The complaint said the Division’s enforcement section learned of the Morgan Stanley sales contest when an ex-Morgan Stanley adviser replied to a Division inquiry asking why he had left the firm. The former adviser said he was uncomfortable recommending the credit line option to all clients and worried about whether asking clients to accumulate potentially “bad debt” was consistent with his fiduciary role.

The complaint is Docket No. E-2016-0055.

Monday, October 03, 2016

House science committee seeks answers in SEC’s Exxon investigation

By Joanne Cursinella, J.D.

Texas Republican Lamar Smith, chairman of the House Committee on Science, Space, and Technology, has sent a letter to SEC Chair Mary Jo White requesting relevant information concerning the SEC’s investigation into Exxon Mobile Corporation. The committee is “troubled” by press accounts that the investigation is “couched” in terms relating to the science of climate change. Smith is therefore requesting documentation from the SEC to evaluate the purpose, scope, and origin of the investigation.

Multiple investigations. According to the letter, the Commission’s Exxon investigation, dating from at least August of 2016, has been directly linked by the media to the Commission’s “far-reaching” inquiry into New York Attorney General Eric Schneiderman’s own investigation into Exxon under state securities fraud law. The committee itself is currently investigating the New York attorney general’s Exxon probe in order to assess the adverse effects his investigation might pose to the scientific research and development enterprise.

The House committee, which has jurisdiction over energy and environmental research, has an obligation to see that such research advances the American scientific enterprise to the fullest extent possible free from threat of intimidation or prosecution. Smith points out the attorney general’s investigation has so far failed to discover any wrongdoing by Exxon.

According to the letter, the committee is concerned that the SEC’s actions in “wielding its enforcement authority” against companies like Exxon for its collection and reliance on climate data used to value its assets may have a negative effect on conducting climate change research. Further, to the extent that the SEC's investigation was initiated in reliance on the New York attorney general’s investigation, Smith is concerned that the Commission’s actions may ”serve to illustrate the very effects on free scientific inquiry” that the committee is investigating.

Document request. In order to aid the committee in evaluating the Commission’s investigation into Exxon’s activities, the committee has requested documents dating back to January 2015 in four specific categories be produced by October 13.

Friday, September 30, 2016

Interest rate swap clearing requirement expanded

By R. Jason Howard, J.D.

A unanimous vote by the Commission approved an amendment to CFTC regulation 50.4 that establishes a new clearing requirement determination by expanding on the interest swaps required to be cleared.

Expanded classes. The expanded classes of interest rate swaps denominated in particular currencies in each of the four interest rate swap classes described in regulation 50.4(a), and required to be cleared under section 2(h) of the Commodity Exchange Act, include:
  • Fixed-to-floating interest rate swaps denominated in Australian dollars (AUD), Canadian dollars (CAD), Hong Kong dollars (HKD), Mexican pesos (MXN), Norwegian krone (NOK), Polish zloty (PLN), Singapore dollars (SGD), Swedish krona (SEK), and Swiss francs (CHF);
  • basis swaps denominated in AUD; 
  • forward rate agreements (FRAs) denominated in NOK, PLN, and SEK; and
  • overnight index swaps (OIS) denominated in AUD and CAD, as well as U.S. dollar, euro, and sterling-denominated OIS with termination dates up to three years.
AUD-denominated FRAs were not included in the final rulemaking in spite of being included in the proposal to expand Commission regulation 50.4(a).

There will be a phased-in approach to the final rule “according to an implementation schedule based on when analogous clearing requirements have taken, or will take, effect in non-U. S. jurisdictions.”

CFTC Chairman Timothy Massad said he was pleased that the CFTC is continuing its progress of increasing the use of central clearing for over-the-counter swaps by “expanding the Commission’s swap requirement to include interest rate swaps denominated in nine additional currencies.”

On the topic of risk, Massad said that “requiring clearing for these swaps will further reduce risk within our financial system. Today’s determination also represents another important step toward cross-border harmonization of swaps regulations, which is critically important to creating an effective regulatory framework.”

The CFTC also issued a Q&A on the clearing requirement determination under Section 2(h) of the Commodity Exchange Act for interest rate swaps.

Thursday, September 29, 2016

Court reverses judgment for SEC on disclosure, accounting fraud claims

By Lene Powell, J.D.

A federal district court erred in awarding partial summary judgment for the SEC in an enforcement action against a bank and its CEO for alleged disclosure and accounting fraud, the Eleventh Circuit ruled. The district court wrongly decided as a matter of law that the CEO made false statements and failed to establish an affirmative defense that he relied on an accounting firm’s professional advice, when these issues involved questions of fact that should have been submitted to a jury. The Eleventh Circuit vacated the district court’s judgment and remanded for a new trial (SEC v. BankAtlantic Bancorp, Inc., September 28, 2016, Wilson, C.).

Alleged fraud. In the first half of 2007 during the run-up to the Great Recession, the market for Florida real estate softened, threatening BankAtlantic Bancorp’s portfolio of commercial residential loans. Alan Levan, the bank’s chairman and CEO, acknowledged the risk in a March 14 email to the bank’s Major Loan Committee, saying it was “pretty obvious that the music has stopped” and he believed the bank was in for a “long sustained problem in this sector.” Despite the gloom in this and other internal emails, Levan presented an optimistic front in a July 25, 2007 earnings call with shareholders about credit risk posed by the deteriorating real estate loans. He allowed that there were significant challenges in the builder land bank (BLB) loan category, but said they were not concerned about any other asset class and the portfolio as a whole was performing “extremely well.”

Meanwhile, Levan engaged an investment bank to advise on the possible sale of some loans in the troubled portfolio. The bank’s CFO warned Levan that accepting bids for the sale of the loans would require a change in their accounting classification from “held-for-investment” to “held-for-sale,” which under GAAP valuation standards would lower the value significantly. Upon advice from PwC that classification depended on whether management intended to sell the loans, the bank continued to categorize the loans as held-for-investment, allowing it to report the loan values at the higher original purchase price.

Fraud verdict. The SEC alleged that Levan’s statements during the earnings call were false or misleading in violation of Section 10(b) of the Exchange Act, and that it was improper for BankAtlantic to classify the loans marketed through the investment bank as held-for-investment. The district court agreed with the SEC and granted partial summary judgment that the statements constituted misrepresentations as a matter of law. The district court also determined as a matter of law that Levan and BankAtlantic failed to establish an affirmative defense that they relied on PwC’s advice regarding classification of the loans.

After a six-week trial, a jury found the defendants liable for making material misrepresentations and filing materially false financial statements by improperly classifying the loans. The court ordered civil monetary penalties of $4.5 million and $1.3 million against BankAtlantic and Levan, respectively, and enjoined Levan from serving as a director or officer of a public company for two years. The defendants appealed.

Disclosure claim. Reviewing the grant of partial summary judgment de novo, the circuit court found that testimony of Levan and the CFO and other record evidence contradicting the district court’s findings was sufficient to create a genuine issue of material fact as to whether Levan’s statements were false or misleading under Rule 10b-5.

Although courts will not accept self-serving testimony offered in a wholly conclusory manner, Levan and the CFO provided specificity and supporting facts for their testimony that they believed the earning call statements to be true. Levan testified that the loans the bank was concerned about were spread over multiple portfolios, not confined to any non-BLB asset class, and record evidence demonstrated that non-BLB loans generally were performing. Further, the defendants presented evidence that loan extensions and downgrades did not necessarily mean that the loans were in trouble. Accordingly, the circuit court held that the district court improperly weighed evidence at the summary judgment stage and should have credited information that contradicted its key factual conclusions.

Accounting claim. The district court also improperly decided as a matter of law that the defendants failed to establish a reliance-on-professional-advice affirmative defense. The defendants provided evidence that PwC received all the information necessary to render accounting advice, creating a genuine issue of material fact as to whether the defendants provided all relevant facts to PwC. By brushing aside this evidence in order to reach its conclusion, the district court inappropriately weighed the evidence at the summary judgment stage, the circuit court said.

Other rulings. Because it vacated and remanded the district court’s grant of partial summary judgment, the circuit court did not reach the issue of the two-year officer and director bar. The circuit court affirmed the district court’s rejection of judgment as a matter of law regarding the accounting fraud and pre-trial evidentiary rulings regarding testimony of the SEC’s expert and PwC’s 2012 look back report, finding no abuse of discretion or substantial prejudice in those rulings.

The case is No. 15-14629.

Wednesday, September 28, 2016

NASAA requests clarifications to SEC’s continuity plan proposal

By Amy Leisinger, J.D.

In comments to the SEC, NASAA offered support for the Commission’s proposal to require registered investment advisers to adopt and implement written business continuity and transition plans. According to the organization, proposed Rule 206(4)-4 is substantially similar to NASAA’s model rule on continuity planning. However, NASAA asked the SEC to clarify how the proposed rule relates to existing record-preservation duties and to what extent each plan would need to address an adviser’s specific safeguarding duties under Regulation S-P.

SEC proposal. In June 2016, the SEC issued a proposed rule that would require SEC-registered investment advisers to adopt and implement written business continuity and transition plans designed to address risks related to a significant disruption in the investment adviser’s operations, including, among other things, cyberattacks and technology failures. An adviser’s plan would need to be based upon the particular risks associated with its operations and include policies and procedures addressing: mainte­nance of systems and protection of data; prearranged alternative physical locations; communication plans; review of third-party service providers; and a plan of transition in the event the adviser is winding down or is unable to continue providing advisory services.

NASAA praise, critiques. NASAA noted the importance of a new rule to govern business continuity and transition planning that applies to all SEC-registered advisers, particularly in light the failure of many firms to give sufficient attention to the issue in their compliance programs.

This type of planning is not only a sound business practice, but is also crucial to investor protection, it stated. Moreover, NASAA explained, the proposal is generally consistent with NASAA’s model rule on continuity and transition planning for state-registered investment advisers with only minor differences in the approach to transitions of key personnel.

NASAA recommended, however, that the SEC clarify whether the proposed rule would create any new duties to preserve records and whether a business continuity and transition plan must address an adviser’s obligations under Regulation S-P’s Safeguards Rule. In addition to general obligations to maintain required books and records under Advisers Act rules, the Safeguards Rule requires SEC-registered advisers to adopt written policies and procedures designed to safeguard customer records and information and to properly dispose of consumer report information. Proposed Rule 206(4)-4 states that a plan must provide for protection and backup of client records and for generation of client-specific information necessary to transition an account.

The proposal is not clear as to whether the scope of documents included in a plan is co-extensive with the scope of information required to be preserved under existing rules, and the Commission should take steps to address this ambiguity, NASAA concluded.

Tuesday, September 27, 2016

Circuit split could put equitable tolling back on High Court’s agenda

By Anne Sherry, J.D.

Two new petitions for certiorari ask the Supreme Court to look again at the effect of American Pipe tolling on statutes of repose. The petitioners opted out of class actions against Bear Stearns and the underwriters of Lehman Brothers debt offerings, respectively, for allegedly fraudulent activity during the financial crisis. The Second Circuit dismissed their individual claims as time-barred by the statute of repose, following its IndyMac decision, with which other circuits disagree (SRM Global Master Fund L.P. v. The Bear Sterns Companies LLC and CalPERS v. Moody Investors Service, Inc., September 22, 2016).

The Supreme Court granted cert in the IndyMac case in 2014, but withdrew it as improvidently granted after learning that the district court was reviewing a tentative settlement. According to the petitioners, the need for resolution to the circuit split has only grown since IndyMac last appeared on the Court’s docket. SRM Global Master Fund asks whether the timely filing of a class action tolls the five-year period of repose in 28 U.S.C. §1658(b)(2). CalPERS asks whether a class action satisfies Securities Act Section 13’s three-year limitation. Also, the pension fund, which filed its individual suit before a class was certified, presents the question of whether a class member may file an individual suit prior to class certification, notwithstanding the expiration of the relevant time limitations.

Second Circuit bars tolling. In IndyMac, several putative class members sought to intervene in an action in order to revive dismissed claims, arguing that American Pipe preserved their right to sue. Affirming the district court’s denial of intervention, the Second Circuit noted that courts have repeatedly recognized that Section 13’s three-year limitations period is a statute of repose, an absolute period not subject to equitable tolling. The court reasoned that it did not matter whether American Pipe’s tolling rule was equitable or legal: if equitable, it would not toll a repose period; if legal, the Rules Enabling Act would bar its extension to the Section 13 limitations period. The court recently issued a summary order reiterating its position.

Circuit split should be resolved in favor of tolling. Courts of appeal for the Tenth, Seventh, and Federal Circuits have held that American Pipe applies to statutes of repose, while the Sixth and Eleventh Circuits joined the Second in refusing to apply tolling. IndyMac is wrongly decided, however, according to the petitioners. Congress could not have intended the flood of protective motions that would result if statutes of repose were not tolled during the pendency of a class certification action, the petitioners point out. The Second Circuit’s rule also dramatically increases the cost of litigation by requiring every potential opt-out plaintiff to retain counsel, file an individual complaint, and monitor the entire litigation, while the defendants pay their lawyers to monitor and respond to duplicative and redundant pleadings and briefs. The petitioners also hint that the Second Circuit’s construction of American Pipe is not entirely friendly to defendants, which may have to shoulder the costs of unnecessary litigation if a fee-shifting statute applies.

Tolling does not frustrate purposes of the repose periods. The petitioners add that applying American Pipe tolling to Section 13 comports with the legislative purposes of the Securities Act. Quoting Crown, Cork & Seal (U.S. 1983), they note that the limitations period is intended to put defendants on notice of adverse claims and prevent plaintiffs from sleeping on their rights—ends that are met when a class action is commenced. American Pipe also respects the purpose of statutes of repose that a defendant should be free from liability after the legislatively determined period. “American Pipe is entirely consistent with that purpose because it guarantees that after the limitations period has expired, no liability will be imposed beyond that claimed in lawsuits filed on or before that date.”

No tolling makes opt-out meaningless. The petitioners also argue that the IndyMac rule has grave constitutional implications. Members of a class cannot opt out in part—for example, if a class action states some claims on which the limitations period has run and others that are still viable. A class member cannot opt out of the viable claims while preserving their presence in the class for purposes of the time-barred claims. SRM itself opted out of a settlement that would have extinguished its swap-based claims for no consideration; when the Second Circuit held its individual claims to be time-barred, it “retroactively transform[ed] SRM’s constitutionally protected opt-out into litigation suicide.” A rule permitting class members to opt out, but not to pursue their own individual claims, is as destructive to due process as simply prohibiting plaintiffs from opting out at all, SRM submits.

CalPERS’ pre-certification action meant there was no interruption. CalPERS adds that the Court should decide whether a limitations period can bar an individual action by a class member during the pendency of a timely class action. In both American Pipe and IndyMac, it notes, the class member waited until class certification was denied before pursuing an individual action. But CalPERS filed its own action after the statute of repose had expired but before the district court ruled on class certification. “In such circumstances, tolling is not required because the class member’s action was timely commenced and maintained without interruption.”

The cases are No. 16-372 and No. 16-373.