Friday, September 23, 2016

Governance pros testify on shareholder proposals, disclosure

By Anne Sherry, J.D.

A House Financial Services subcommittee hearing with the broad title of “Corporate Governance: Fostering a System that Promotes Capital Formation and Maximizes Shareholder Value” ended up focusing somewhat narrowly on a few discrete topics. Leaders at CalPERS, the Business Roundtable, the Society of Corporate Governance Professionals, and the Manhattan Institute gave their views on shareholder proposal thresholds, proxy advisors, and the SEC disclosure regime. Several subcommittee members also used the opportunity to posit whether clawbacks may have prevented the cross-selling fraud at Wells Fargo.

Shareholder proposals. The SEC’s shareholder proposal process under Rule 14a-8 dominated the hearing before the Subcommittee on Capital Markets and Government Sponsored Enterprises. The ownership and resubmission thresholds in particular garnered the most discussion. The ownership threshold requires a shareholder to hold $2,000 in stock or 1 percent, whichever is less, for a year before submitting a proposal. Several of the witnesses believed the $2,000 threshold to be far too low, often amounting to a tiny fraction of a percentage point of a company’s market cap.

The resubmission threshold permits a company to exclude a resubmitted proposal if it received less than 3, 6, and 10 percent of the vote, respectively, if proposed once, twice, or thrice in the preceding 5 years. Darla C. Stuckey, President and CEO of the Society of Corporate Governance Professionals, likened the resubmission threshold to a sieve. The “tyranny of the 10 percent” allows many proposals to be resubmitted indefinitely. Stuckey cited the example of a Consolidated Edison shareholder proposal that went to a vote for 16 years in a row. The proposal received between 10 and 17 percent of votes cast ever year, but never qualified for exclusion under the resubmission thresholds. Today, she said, 96 percent of proposals pass the 3-percent threshold in the first year.

Proxy advisory firms. James R. Copland, Senior Fellow and Director of Legal Policy at the think tank Manhattan Institute, connected the resubmission issue to proxy advisory firms like Institutional Shareholder Services. A large percentage of institutional shareholders vote based on proxy advisory firms’ advice, he said, making ISS a gatekeeper: “If ISS supports a proposal, it can remain indefinitely on the ballot.” In the last 10 years, 31 percent of shareholder proposals were resubmissions, Copland said. As for the ownership threshold, Copland agreed that the dollar amount was low but seemed to argue that the one-year holding requirement could be lower. He cited the example of a hedge fund that buys a big stake in a company it wants to try to turn around. Requiring the hedge fund to wait a year to submit a shareholder proposal doesn’t make sense, he said.

French Hill (R-Ark) asked the witnesses about conflicts of interest at proxy advisory firms. John Engler, the former Michigan governor who now serves as president of Business Roundtable, said that firms sit on both sides of a transaction when they make recommendations about good governance while offering to sell companies strategies to solve the problems the firms identify. Copland also said conflicts are a significant consideration, but highlighted the disconnect between what proxy advisory firms do and what the median shareholder wants. Mutual funds, he said, excepting the largest companies like Vanguard, have to do everything they can to reduce their administrative costs. That means relying on the advice of ISS or Glass Lewis. Because of this, retail investors who own mutual funds are effectively voting along proxy advisory firms’ recommendations, even though ISS is eight times more likely to support a shareholder proposal than the median investor.

Anne Simpson, who is Investment Director, Sustainability at CalPERS, said that the institutional investor ultimately is aligned with management: both want companies to do well. But she said, a small investor has a daunting task of looking at complicated corporate disclosure, comparing the differences over time, comparing the company with other companies, and relating executive compensation to financial performance. Simpson said that CalPERS strongly supports the SEC’s Dodd-Frank rulemaking efforts on executive compensation, including the pay ratio disclosure, say-on-pay, and clawbacks.

Clawbacks. After Stuckey observed that companies spend $90 million every year on the direct costs of responding to shareholder proposals, Brad Sherman (D-Cal) related this figure to the recent Wells Fargo scandal. If the SEC had promptly entered a clawback rule, he posited, Wells Fargo executives may not have had the incentive to push for cross-selling. Sherman suggested that “crony capitalism” costs shareholders more than $90 million per year. On that remark, Simpson said that CalPERS has $1 billion invested in Wells Fargo and lost more than $90 million “just on that one company, just from that series of decisions not in the public interest.” Governor Engler pushed back against the “aspersions that there are boards running amok breaching their fiduciary duties.” He pointed out that CalPERS earned a 0.6 percent return last year, well below the assumed rate of 7.5 percent. “Maybe it’s crony capitalism, maybe it’s bad investment,” he said.

Diverse boards. Ranking Member Carolyn Maloney (D-NY) asked about board diversity. Her bill requiring companies to report directors’ gender is based on two studies cited in a GAO report finding that greater gender diversity increased profits by about 5 percent. CalPERS has done extensive research and found that diversity is important in two key ways, Simpson said. First, it promotes good risk management by challenging groupthink. Second, diversity relates to talent recruitment. If you confine yourself to a small pool of candidates like former Fortune 500 CEOs, “you are fishing in a very small pool,” she said.

Thursday, September 22, 2016

Office of the Chief Accountant personnel offer updates at AICPA banking conference

By Jacquelyn Lumb

Staff from the SEC’s Office of the Chief Accountant provided updates at the AICPA’s annual conference on banking and savings institutions, which included the areas of internal control over financial reporting, auditor independence, non-GAAP financial measures, and revenue recognition. Deputy Chief Accountant Wesley Bricker said the staff is involved in the implementation discussions with respect to all of the key priorities that have been completed by FASB and the IASB, including revenue recognition and leases, the impact of which will extend beyond any particular industry group. Bricker warned that aggressive interpretations of the new standards, aimed at a specific outcome, will not be well-received.

Implementing new standards. The transition reporting group has been a critical forum for addressing implementation issues as they arise, according to Bricker. The industry must identify these issues in order for TRG to provide the appropriate resolution. Bricker encouraged companies to set the right tone at the top to ensure the formulation of the sound judgments required by the new standards, and to engage in investor outreach and education to assist in their understanding of the new requirements.

Bricker acknowledged that auditors may be asked to provide feedback on the implementation of the new standards. Auditors may freely discuss the new requirements, he explained, but they must retain their commitment to independence and recognize the boundaries of their involvement, which cannot include decision-making that would lead to auditing their own work. With respect to the new standard for reporting credit losses on financial instruments, Bricker said it reflects a significant enhancement that will provide more decision-useful information. It will not prevent the next financial crisis, he said, but it will provide more timely information about potential losses.

Non-GAAP financial measures. Bricker responded to a question about the publicity surrounding the use of non-GAAP financial measures and noted that, when their use is consistent with the rules, they can provide high quality content to investors. The SEC is not trying to eliminate the use of non-GAAP financial measures, he said, but only in those instances when they are presented more prominently than GAAP measures or are misleading.

Bricker cited a survey by the Wall Street Journal in which roughly half of the Fortune 500 companies admitted that they had challenges with respect to the prominence of the non-GAAP information they had provided. After the staff issued compliance and disclosure interpretations on the use of non-GAAP financial measures, the percentage fell to 20 percent, so Bricker said the strategy is working. The SEC’s work in this area is continuing, he advised, and it is an all-agency approach.

Differing interpretations. Bricker was asked how to respond when there are differences of opinion on loan loss reserves among registrants, auditors, the SEC, and the banking agencies. He said the continuing dialog during the transition will promote a better application of the standard, and it is better to have that discussion before the financial statements are presented to investors. He added that the staff has healthy and constructive discussions with the banking regulators and the standard setters. If a registrant finds that differing points of view seem irreconcilable, it should continue to escalate the issue, he said. The staff has a consultation protocol to assist in these situations.

Internal control concerns. Professional accounting fellow Michal Dusza talked about some of the industry’s concerns that the PCAOB’s inspectors have expectations beyond the requirements of the internal control over financial reporting standard. The SEC staff engaged with industry representatives and with the PCAOB and provided its views at last year’s conference, he noted. Overall, the staff encouraged greater engagement between the auditors and audit committees and timely discussions about risk assessments. If this hasn’t occurred by now with respect to this year’s audit, Dusza encouraged auditors and audit committees to begin the discussions promptly.

Auditor independence. He also spoke about auditor independence as a shared responsibility and highlighted the threat of scope creep in which an otherwise permissible non-audit service becomes impermissible. He cited a no-action letter to Fidelity Management & Research Company in which certain loan provisions within an investment company complex led to non-compliance with the independence standard. The staff granted the no-action relief but on a temporary basis and advised that it may not renew its assurances with respect to enforcement action 18 months after the June 20, 2016 no-action relief was granted.

Wednesday, September 21, 2016

MSRB touts core Dodd-Frank adviser reforms in letter to Congress

By Mark S. Nelson, J.D.

The Municipal Securities Rulemaking Board told members of Congress that it has implemented a suite of core rules dealing with oversight of municipal advisers within the $3.7 trillion municipal securities market. The MSRB’s rules were mandated by Dodd-Frank Act reforms enacted in response to the Great Recession.

Key achievements. According to a press release accompanying the MSRB’s letter to congressional leaders, the MSRB’s municipal adviser rules seek to enhance market transparency while also providing tools to educate market participants and investors. The MSRB said it plays a “unique” role regarding municipal entity protection, but also works with the SEC and the Financial Industry Regulatory Authority, Inc. on examinations of municipal advisers.

MSRB Chair Nathaniel Singer summarized the regulator's achievements: “New rules guard against unfair practices by municipal advisors and work to ensure that the professionals advising our state and local governments are qualified and are appropriately trained, licensed and educated. The MSRB has also advanced new education and outreach initiatives and market transparency tools since the enactment of the Dodd-Frank Act that support the objective to protect municipal entities and complement the new regulatory framework.”

MSRB rules. The MSRB explained to members of Congress that it has made significant inroads on a variety of topics impacting municipal securities markets. The MSRB’s rules for municipal advisers cover principles of fair dealing, fiduciary duties, professional standards, education requirements, and fees. Here is a mini primer on the MSRB’s rules:
  • Final SEC rules for municipal adviser registration (Release No. 34–70462, September 20, 2013). 
  • Rules on fair dealing—MSRB Rule G-17 and the related interpretive guidance deal with principles of fair dealing for municipal dealers. MSRB Rules G-20 and G-37 cover gifts and political contributions. MSRB Rule G-37 has proven to be controversial for its pay-to-play limits. The amended rule drew a legal challenge by a trio of state Republican party organizations who dispute the SEC’s argument that the rule became effective by operation of law only rather than by the SEC’s approval, which could have violated a ban on such regulations for FY 2016 that was imposed by Section 707 of Title VII of the Consolidated Appropriations Act, 2016
  • Fiduciaries—MSRB Rule G-42 sets standards for non-solicitor municipal advisors, while MSRB Rule G-44 details supervisory and compliance duties. 
  • Professional standards—Municipal advisers must meet the qualifications developed under MSRB Rule G-3. The MSRB’s letter to congress touted the turn-out for the MSRB’s pilot exam. 
  • Records—MSRB Rules G-8 and G-9 set out the records and records retention requirements for municipal advisers. 
  • Fees—Several of the MSRB’s administrative rules also apply to municipal advisers. As an example, MSRB Rule A-12 establishes a fee structure for entities within the MSRB’s jurisdiction, including municipal advisers, through which the MSRB can fund its activities

Tuesday, September 20, 2016

Standardize derivatives infrastructure and leverage tech, ISDA urges

By Lene Powell, J.D.

The derivatives industry has done a good job of meeting tight deadlines for changing regulatory requirements, but in the process has built up a complex web of non-standard systems that some are nervous may not be robust in times of market stress, said the International Swaps and Derivatives Association (ISDA) in a new white paper. ISDA urged industry participants to work to reduce inefficiencies by standardizing data reporting, documentation, and business processes. Technological advances like cloud services and distributed ledger applications, including smart contracts, can also help drive efficiencies, said ISDA.

“Our members are looking for more effective, less costly and less complex processes, using technology where possible to cut down on manual processes,” said Scott O’Malia, ISDA’s CEO and a former CFTC commissioner. “ISDA is helping to respond to these issues, and our whitepaper highlights a number of areas where the Association can work with the industry and regulators to improve trade processing through the lifecycle.”

Standardize data. It is critical to standardize data standards, including data representation, naming conventions and formats, as well as globally consistent product identifiers and trade identifiers, said ISDA. In particular, a consistent global product identifier would facilitate regulatory reporting and harmonization and make it easier to aggregate derivatives trade data across borders.

A consistent product identifier could also be put to other uses, including product categorization for regulatory purposes and various post-trade activities including trade confirmation, reconciliation and compression. ISDA has published a paper identifying key principles for the construction of global product identifiers. Other areas of focus include standard naming conventions and associated definitions for package transactions, as well as trade identifiers that are globally unique to a specific transaction.

Standardize documentation. With documentation having historically been negotiated on a bespoke basis, legacy clauses may no longer be appropriate in the changing regulatory environment, ISDA noted. The association can help the industry work toward appropriate levels of standardization and incorporate these into new versions of relationship documentation. Even agreeing to restrict negotiation of these documents to certain standard elections could be a big step forward, ISDA observed. Solutions could be developed to help market participants electronically agree and store information upfront in an easily accessible form.

Standardize processes. Industry should collectively agree on and collaborate to define the most efficient market operating models, then technically encode them as common domain models (or CDMs) that systematically reflect how the market operates, said ISDA. CDMs would only be successful if they are used to drive trade execution, not just for reporting, and would need to be interoperable with existing standards.

Leverage technology. According to ISDA, the regulatory and industry communities would benefit from collectively developing a RegTech strategy, referring to common technical artefacts including software and standards that provide mutual benefit to both regulators and market participants in complying with regulations. Common regulatory eligibility models that effectively encode a consistent interpretation of rule eligibility would generate reference data that could be used by other infrastructures like trading platforms, subject to appropriate permission, to assist routing of transactions through the process. This would be particularly helpful in MIFID II reporting, for example, as the main technology challenge with MIFID II reporting requirements relates to interpretation of data.

In addition, emerging FinTech solutions could drive efficiencies and reduce costs. Regulators are taking an interest in blockchain or distributed ledger technology (DLT), and a number of DLT providers have developed and successfully completed test use cases for derivatives transactions. Smart contracts are a potential further application and could build on work already done by ISDA to develop standard forms of documentation, including definitional booklets and confirmation templates, in conjunction with FpML, said ISDA.

As a precursor or alternative to smart contracts, the industry could develop a processing model that operates on the basis of a single representation of a transaction, or “Golden Record.” Such a record could eliminate the need for many duplicative reconciliation processes and allow market participants and regulators to access an accurate and up-to-date instance of a transaction at any time, ISDA explained.

Next steps. As a first step, the industry needs to agree on common objectives, whether that be short-term solutions to current infrastructure challenges or longer-term objectives associated with process redesign, ISDA said. This effort will be led by ISDA’s Market Infrastructure and Technology Oversight Committee (MITOC).

ISDA identified a number of steps to accomplish by the end of 2016, including:
  • assess post-trade infrastructure, identifying inefficiencies, and developing near-term solutions;
  • coordinate the development of a plan for the creation of common domain models; and 
  • work with industry stakeholders to identify a venue to create an open-source repository or repositories for required artefacts. Stakeholders should agree to and circulate a roadmap for these repositories, roles and responsibilities and basic principles.

Monday, September 19, 2016

Banking group to SEC: Don’t defer to FASB

By Mark S. Nelson, J.D.

The American Bankers Association urged the Commission not to defer to the Financial Accounting Standards Board in a public comment it submitted on the Commission’s Disclosure Update and Simplification proposal. The letter was submitted by Michael Gullette, the ABA’s vice president of accounting and financial management. Comments on the proposal are due October 3.

Commission deferral to FASB. Overall, the ABA letter cited the lack of equivalent standards on industry-specific topics, costs, and the differing treatment of SEC registrants and non-registrant public business entities as reasons for the Commission to remain engaged in setting accounting disclosure requirements. But the letter observed that the FASB generally lacks targeted disclosures akin to the Commission’s Industry Guide 3 for bank holding companies. The letter also noted the forward-looking character of MD&A disclosures and the historical character of audited financials, while also spotlighting recent trends that could blur these distinctions.

Banking topics in proposal. The Commission first recognized the FASB’s U.S. GAAP standards as “authoritative” in the 1970s and, more recently, determined under revised criteria established by the Sarbanes-Oxley Act that the FASB is a private-sector accounting standards setter whose standards are “generally accepted.” The Commission monitors FASB’s work and Commission disclosure requirements are periodically incorporated into U.S. GAAP. The proposal’s aim is to determine whether the Commission should retain, modify, or eliminate some of its disclosure requirements, or whether the Commission should refer them to the FASB for inclusion in U.S. GAAP.

As a result, the Commission identified several areas for public comment, including two FASB projects, of which one would conclude that the omission of immaterial information from the notes to financial statements does not result in an accounting error. Still other proposals to eliminate redundant or overlapping Commission disclosure requirements could more directly impact banks:
  • Redundancies—The Commission proposed to delete some disclosure requirements. For bank holding companies, proposals regarding Rules 9-03 (balance sheets) and 9-04 (income statements) of Regulation S-X are of prime interest. 
  • Overlapping requirements—The proposal would delete some requirements that are reasonably similar to or are encompassed by U.S. GAAP, IFRS or other SEC requirements, or which are incremental to these standards or SEC requirements. Proposed revisions that may impact banks include: (i) repurchase and reverse repurchase agreements; and (ii) accounting policies for derivative financial and commodity instruments. 
  • Integrations—According to the proposal, the Commission could integrate some disclosure requirements that overlap with, but are incremental to, related Commission requirements. The proposal’s spotlight on foreign currency restrictions contained in Regulation S-X could be of interest to banks. 
  • Modifications and referrals—Another set of overlapping Commission rules could be modified, eliminated, or referred to the FASB because they overlap with, and are incremental to, U.S. GAAP. Topics highlighted by the proposal that may be of interest to banks include: (i) REITs; (ii) assets subject to lien; (iii) obligations and related cured/waived defaults, changes in obligations, or financing arrangements; and (iv) repurchase and reverse repurchase agreements.

Friday, September 16, 2016

Massad recommends one-year delay in drop of swap dealer de minimis threshold

By John Filar Atwood

CFTC Chair Timothy Massad said today that he will recommend, through a Commission order, a one-year extension of the date on which the swap dealer de minimis threshold is scheduled to drop from $8 billion to $3 billion, thereby subjecting many more companies to the swap dealer registration requirements. Unless the Commission takes action, he noted, the threshold will be lowered at the end of 2017, which means firms would have to start tracking their activity starting January 1, 2017 to determine whether they must register as swap dealers.

In remarks at the North American OTC Derivatives Summit, Massad said that adopting the extension would give the CFTC and industry participants more time to consider the issue. He noted that some in the industry have suggested that the Commission should just make $8 billion the permanent threshold, but he believes a delay is the appropriate course of action for now.

Background. The de minimis threshold determines when an entity’s swap dealing activity requires registration as a swap dealer, which triggers oversight by the CFTC, and disclosure, recordkeeping, and documentation requirements. The threshold was set jointly by the CFTC and the SEC in 2012. The agencies established a threshold at $3 billion in notional amount of swap dealing activity over the course of a year, but provided a phase-in period during which the threshold is $8 billion.

CFTC report. The CFTC staff last month issued a final report on the de minimis threshold, which supplements a November 2015 preliminary report and assesses the threshold against the available market data. Massad said that the report estimates that based on current data, if the threshold were at $3 billion today instead of $8 billion, and levels of activity remained the same, more companies would be required to register as swap dealers. However, the outstanding notional amount of interest rate (IRS) and credit default swaps (CDS) that would be covered would increase only about one percent.

Massad acknowledged that many smaller banks are concerned that they would be required to register if the threshold were to fall. Their activity is tied to their lending business, in which they provide swaps to help commercial borrowers hedge their exposures. He noted that the smaller banks do not have significant market shares in the IRS or CDS market, and swap activity is not a large part of their overall banking activities, so it is important to consider the costs that might be imposed on them if the threshold were lower.

Thursday, September 15, 2016

NASAA enforcement report provides stats on actions and penalties, most common failures

By Amy Leisinger, J.D.

The North American Securities Administrators Association (NASAA) has released its 2016 Enforcement Report, noting that state securities regulators conducted over 5,000 investigations in 2015 and brought just over 2,000 enforcement actions, with restitution and fines totaling nearly $800 million. According to the organization, for the first time since data collection began, more registered industry members than non-registered members were named in enforcement actions.

“The vigorous, fair and effective enforcement of state securities laws through formal administrative, civil and criminal actions is a critical priority for NASAA members,” said NASAA President Mike Rothman.

Enforcement statistics. In its report on 2015 data, NASAA found that its U.S. members brought enforcement actions against 812 registered industry members, compared to 791 unregistered members. In the aggregate, in addition to payment of costs and expenses, respondents in enforcement actions paid more than $538 million in restitution to investors and $230 million in fines and received criminal penalties totaling 1,282 years, which includes incarceration, probation, and deferred adjudication. State securities regulators also limited the activity of potential and existing licensees and registrants, NASAA noted, with approximately 3,000 license requests withdrawn and over 700 requests denied. In addition, more than 250 individuals had their licenses revoked and/or found themselves barred from the industry.

In 2015, NASAA stated, most state enforcement actions involved some type of fraud and the most common fraudulent investment products involved real estate or oil and gas ventures State securities regulators also launched numerous investigations and enforcement actions involving variable and indexed annuities, hedge funds, life settlements, and structured products. The most common type of fraud remains Ponzi schemes, and victims were often targeted online or as a result of age or identifiable affinity group, the organization noted.

State priorities. The report also identified enforcement priorities of state securities agencies, including, among others, classic Ponzi and pyramid schemes and gatekeeper fraud. More than half of NASAA members reported Ponzi schemes as one of their top five types of fraud for the survey period, according to NASAA, and while pursuing scheme masterminds, regulators focus on institutions that enable the schemes through oversight failures. In addition, members must often take enforcement action against gatekeepers or intermediaries (such as attorneys and accountants) that abuse their positions to carry out investment fraud. These individuals and entities provide important services for the benefit of investors, and their participation and/or complacency in fraudulent activities is particularly malevolent in light their positions of trust, NASAA concluded.

Wednesday, September 14, 2016

Chamber’s CCMC outlines to-do list for next administration

By Anne Sherry, J.D.

Regulatory reform, a uniform fiduciary standard, and creation of a presidential oversight commission are some of the items on the Chamber of Commerce’s wish list for the next administration. The Center for Capital Markets Competitiveness released a 72-page agenda of reforms aimed at promoting financial stability and driving economic growth. The CCMC agenda also argues that the SEC should be reorganized, put a system in place for issuing conditional orders, and improve clarity around policy interpretations.

Principal recommendations. The policy agenda would rework many of the agencies or programs that came out of Dodd-Frank. This includes reconstituting the Financial Stability Board through a treaty; reforming the Financial Stability Oversight Council to shed more light on the SIFI designation process; and restructuring the Consumer Protection Bureau into a commission subject to congressional oversight. CCMC also recommends creation of a Presidential Commission on Financial Regulatory Restructuring; a bicameral congressional committee to study fintech; and a Financial Reporting Forum to identify and address emerging issues.

More broadly, CCMC would have the next administration place the regulatory processes of the Fed and other banking regulators on par with other agencies, modernize rule-writing by requiring economic analysis and examination of existing regulations, and reform the shareholder proposal process and thresholds. “The SEC has abdicated its duty to determine if shareholder proposals will interfere with company ordinary business operations and if shareholder proposals on similar topics conflict with one another,” the agenda asserts. If the SEC refuses to reverse the Whole Foods and Trinity decisions, Congress should pass legislation giving these decisions back to the states.

A reorganized SEC. Calling the agency’s structure “complicated, confusing, and inefficient,” CCFC recommends that the SEC reorganize and streamline into a smaller number of divisions. Two dozen divisions and offices report directly to the chairman, not including 11 additional regional offices that report to the chairman to some purposes. “One person cannot be responsible for supervising an agency of 4,000 with a budget of more than $1 billion and simultaneously vote as one member of a collegial body on every enforcement action, rule proposal and rule adoption, and disciplinary opinion,” CCMC asserts.

Policy interpretations. The Center would also apply this streamlining approach to the SEC’s interpretation and application of its rules. The use of a disparate array of policy communications (interpretive releases, exemptive orders, no-action letters, FAQs, speeches, and settlements) is a burden on regulated persons, according to CCMC. The group would reform the use of no-action letters and expand the use of exemptive rules. It also urges the SEC to avoid regulation by enforcement, examination, and speech. Where industry best practices should be codified, this should happen through the rulemaking process. Finally, the chairman and commissioners should play a greater role in the interpretation and application of regulatory policy, which may require amendment to the Sunshine Act.

Conditional approval for new investment products. The Chamber of Commerce once again urges the SEC to create an optional alternative process to conditionally approve a new investment company product or exchange-traded product. The Investment Company Act provides broad statutory authority to exempt investment products, but the application and approval process can be expensive and time-consuming. A conditional approval process could address this issue, as long as the applicant had sufficient time to justify its upfront costs and the SEC retained sufficient authority to take regulatory action, if necessary.

SEC enforcement reform. CCMC recommends that the SEC formally adopt a policy of using administrative proceedings only in certain circumstances. The agency should also create a process for challenging the choice of forum prior to institution of the proceeding. A review of the Rules of Practice is also in order, CCMC asserts, for example to provide adequate opportunities for pretrial discovery and depositions.

With respect to Wells submissions, the Enforcement Division should create a consistent process, provide adequate access to its investigative files, and afford reasonable advance notice of an enforcement action to any party that has made a Wells submission or request advance notice.

CCMC also recommends steps to reassess and clarify the SEC’s policy of requiring admissions; examining alternative case resolution methods; improving Commission oversight of enforcement; increasing transparency and dialogue; and submitting litigation releases and press releases to personnel outside of the Enforcement Division for review.

Tuesday, September 13, 2016

Tilton renews attack on SEC’s administrative courts

By Amanda Maine, J.D.

In an ongoing battle with the SEC, Lynn Tilton and her Patriarch Partners entities have filed suit against the Commission, requesting declaratory and injunctive relief from the SEC’s administrative proceedings. Tilton’s latest complaint attacks the Commission’s administrative law judge regime as unconstitutional on equal protection grounds, in addition to attacking the SEC’s procedures as unconstitutionally infringing on the due process rights of respondents in SEC administrative proceedings (Tilton v. SEC, September 9, 2016).

Earlier proceedings. The SEC first brought administrative proceedings against Tilton and her Patriarch affiliates, which specialize in restructuring distressed companies, in March 2015, alleging that they provided false and misleading information and engaged in a deceptive scheme regarding three collateralized loan obligation funds that they managed (the Zohar Funds). Two days after the Commission issued its order instituting administrative proceedings, Tilton sued in federal district court to enjoin the proceedings on the grounds that that SEC administrative law judges (ALJs) are unconstitutionally appointed “inferior officers” under the Appointments Clause, and not employees as argued by the SEC. The district court dismissed her request to enjoin the SEC’s proceedings against her for lack of subject matter jurisdiction, and the Second Circuit affirmed. Tilton’s hearing before the SEC’s ALJ is now scheduled for October 24, 2016.

Due process arguments. Tilton’s complaint recites a scathing litany of accusations about the SEC’s treatment of respondents in its administrative proceedings, in particular those who have challenged the Commission’s in-house court system of hearings before ALJs. Among the patterns and practices that violate the due process rights of these respondents, according to Tilton, include delaying formal charges while Enforcement staff conducts its investigations. Tilton pointed out that the SEC began investigating the Zohar Funds more than five years ago, but under the rules governing the current administrative proceedings, an SEC ALJ is required to issue an initial decision within 300 days of the issuance of the OIP, putting respondents at a “severe disadvantage,” the complaint explains.

Other practices that result in a denial of due process to respondents include supplying them with insufficient notice of the charges against them (including the refusal to identify the particular statutory provisions allegedly violated, the investors who were allegedly defrauded, or the transactions at issue); using discovery and evidentiary rules to skew proceedings in the SEC’s favor, such as “deliver[ing] voluminous and disorganized investigative files to respondents” and employing experts who are not subject to the federal courts’ standards for experts in Daubert v. Merrell Dow; making it difficult for respondents to obtain exculpatory material; and “arbitrarily and reflexively” denying respondents’ requests to take depositions, which, according to Tilton, have been fruitless under the SEC’s existing rules no matter how compelling the reason except for the unavailability of the deponent (a rule, the complaint points out, which does not apply to a witness for the Division of Enforcement).

Alleged targeting of ALJ critics. Tilton is not the first respondent in an SEC administrative proceeding to challenge the SEC’s ALJ regime (see, e.g., Hill/Gray, Jarkesy, Bebo, Raymond J. Lucia). Tilton’s complaint points to a number of respondents who, she alleges, have been “targeted” by the Commission due to their constitutional challenges of the SEC’s in-house court proceedings in federal district court.

The complaint notes that, in response to the scrutiny over the SEC’s use of its administrative proceedings as an enforcement tool, the Commission proposed and later adopted amended rules to its Rules of Practice which afford respondents greater procedural protections. However, Tilton observes, the parts of the amended rules that would be most helpful to the current challengers to the ALJ regime, such as rules allowing for depositions and flexibility in the timing of hearings, do not apply to these particular respondents, including Tilton. The amended rules apply only to proceedings in which the prehearing conference has not yet been held as of September 27, 2016 (the effective date of the rules).

The application of the amended rules, according to Tilton, has been “carved out” by the Commission against respondents who “had the temerity to mount facial challenges to the constitutionality of the SEC’s internal administrative tribunals” and who wished to seek to have their cases heard in federal court. The SEC’s “deliberate decision” to withhold application of these provisions to the challengers of its administrative proceedings violates the equal protection rights of those individuals, including those of Tilton and other respondents who have recently challenged the ALJ process, the complaint argues.

Relief sought. Tilton’s complaint requests, among other things, that the court declare as unconstitutional the SEC’s administrative proceedings which, it asserts, deny respondents opportunities to develop and present their defenses. The complaint also requests an order directing the SEC to apply its amended rules of practice to Tilton and other similarly situated SEC respondents. In addition, Tilton demands a trial by jury on the triable issues described in the complaint.

The case is No. 16-cv-7048.

Monday, September 12, 2016

SEC seeks comment on DTC’s plan to impose global locks and deposit chills

By John Filar Atwood

The SEC is requesting public feedback on the amended version of Depository Trust Co.’s (DTC) proposal to alter the way in which it imposes restrictions on deposits of securities (deposit chills) and on book-entry services for securities (global locks). According to DTC, the changes are needed because wrongdoers have found ways to circumvent the prior system for implementing those restrictions.

Deposit chills and global locks. Previously, upon detecting suspiciously large deposits of a thinly-traded eligible security, DTC imposed a deposit chill as a measure to maintain the status quo. DTC required the issuer to confirm by legal opinion of independent counsel that the eligible security fulfilled the requirements for eligibility. The deposit chill was maintained, sometimes for years, until the issuer provided a satisfactory legal opinion.

DTC imposed a global lock on an eligible security when a governmental or regulatory authority brought an action alleging violations of Securities Act Section 5 with respect to the security. A global lock could be released when the enforcement action was withdrawn, dismissed on the merits with prejudice, or otherwise resolved in favor of the defendants. DTC noted that many enforcement actions are only resolved after several years and often without any definitive determination of wrongdoing.

Avoiding the restrictions. With respect to deposit chills, DTC believed that wrongdoers were taking into account DTC’s restriction process and avoiding it by shortening the timeframe in which they complete their scheme, dumping their shares into the market, and moving on to another issue. Similarly, global locks were proving ineffective because they dealt with enforcement actions alleging securities law violations that occurred in the past, and so could not affect the violative behavior. According to DTC, by the time of an enforcement action, the wrongdoers had long since transferred the subject securities. In addition, although a global lock barred book-entry settlements within DTC, it did not affect trading, which occurred outside of DTC.

DTC determined that its procedures for imposing deposit chills and global locks are more appropriately directed to current trading halts or suspensions imposed by the SEC, FINRA, or a court of competent jurisdiction. This would allow the restrictions to target more effectively suspected securities fraud that is ongoing at the time the restriction is imposed.

Rule change. In its release, the SEC explained that DTC’s proposal would add a new rule to DTC’s bylaws to establish the circumstances under which it would impose and release a deposit chill or a global lock. The rule also would set forth the fair procedures for notice and an opportunity for the issuer of the security to challenge the deposit chill or global lock.

If either FINRA or the SEC halts or suspends trading of an eligible security, DTC will impose a global lock. DTC also will impose a global lock if ordered to do so by a court of competent jurisdiction, or if it becomes aware of a need for immediate action to avert an imminent harm, injury, or other adverse consequence to DTC or its participants. According to DTC, the imposition of a global lock will prevent settlement of trades that continue despite the halt or suspension and prevent the liquidation of a halted or suspended position through DTC.

The proposed rule change also provides the conditions for releasing the restrictions. In the case of a global lock imposed when either FINRA or the SEC issues a trading halt or suspension, DTC will release the global lock when the halt or suspension of trading of the eligible security has been lifted. In the case of a restriction imposed by order from a court of competent jurisdiction, DTC will release the restriction when a court of competent jurisdiction orders DTC to release it. In other instances, DTC will release the restriction when it determines that the release would not pose a threat of imminent adverse consequences to DTC or its participants.

Initial comments. The proposal is an amended version of a proposal initially released in May on which the SEC received eight comment letters. Among other things, initial commenters suggested that allowing DTC to impose restrictions based upon the threat of “imminent harm” was too vague. DTC responded that it does not expect to use this authority very frequently, but that it is necessary to allow DTC the flexibility to protect itself from imminent harm that could arise from circumstances that would neither justify nor be impacted by a trading halt or suspension.

Commenters also said that restrictions imposed under the “imminent harm” standard should be automatically removed after a short period or should expire after 10 days. DTC responded that it would not be effective or practical for it to premise its proposed rule change on the assumption that the SEC or FINRA could take action quickly enough to protect DTC and its participants. DTC added that imminent harm to DTC or its participants could arise from circumstances that would not be addressed by a trading halt or suspension, such as the impending deposit of illegally distributed securities at DTC.

Friday, September 09, 2016

AIG’s former chairman Greenberg challenges New York’s Martin Act in cert petition

By Kevin Kulling, J.D.

Maurice “Hank” Greenberg, former chairman of American International Group Inc. (AIG), has filed a petition for a writ of certiorari asking that the United States Supreme Court declare that a portion of New York’s Martin Act is preempted by federal law. Greenberg is currently defending a Martin Act fraud action based on events that occurred while he was at AIG (Greenberg v. People of the State of New York, August 30, 2016).

Long history. Greenberg served as president and CEO of AIG from 1968 until 1989, as its chairman and CEO from 1989 until his retirement in 2005, and as a member of the board of directors from 1967 to 2005.

The case has a long history, dating back to May 2005, when former New York Attorney General Eliot Spitzer filed the original complaint against AIG and Greenberg. While issues in the case have been narrowed over the years, the remaining claims in the case relate to two reinsurance transactions that fall under the New York Martin Act and the New York Executive Law.

On June 2, 2016, the case was returned to the trial court following a decision by New York’s highest court that rejected Greenberg’s challenge to the availability of equitable relief and his assertion that disgorgement was preempted by federal law.

State law preempted. Greenberg claims in his cert petition that the use of the Martin Act in his case is preempted by federal law.

The petition argues that the National Securities Improvement Act of 1996 (NSMIA) broadly and expressly preempted state securities law. Congress enacted three statutes in the 1990s—the Private Securities Litigation Reform Act of 1995 (PSLRA), NSMIA in 1996, and the Securities Litigation Uniform Standards Act of 1998 (SLUSA)—to address the erosion of uniformity in the national securities markets caused by state laws and proceedings, according to the petition.

To that end, the petition says, NSMIA expressly preempted state securities regulation. Preemption was deliberately chosen for the express purpose of eliminating the overlapping regulation of national securities markets by the federal government and the attorneys general or other regulators of fifty states, the petition argues.

Fraud and deceit exception. The federal provisions include a single exception to the broad application of preemption. The exception is for enforcement actions for fraud and deceit. The New York statutes at issue, however, do not fit the definition of fraud under federal law because they do not require proof of scienter, according to the petition.

The New York attorney general has argued that the Martin Act falls within that exception to NSMIA preemption for enforcement actions concerning fraud or deceit.

The petition urges the Supreme Court to decide whether the exception to federal preemption for state enforcement actions alleging fraud or deceit applies to the New York attorney general’s prosecution of an action under state statutes that do not satisfy the federal definition of fraud because they do not require proof of scienter.

Greenberg argues that the exception to NSMIA preemption for state enforcement actions with respect to fraud or deceit should be interpreted narrowly and consistently with the federal definition of fraud. The New York statutes at issue are far broader than the federal definition of securities fraud or even common law fraud, the petition concludes.

Under the Martin Act, liability for fraudulent practices can be imposed without any proof of scienter, a concept that has been accepted since the Act was enacted in 1921, according to the petition.

The case is No. 16-284.

Thursday, September 08, 2016

New York City’s Bar recommends disclosure improvements under Reg. S-K

By Jacquelyn Lumb

The Financial Reporting Committee of the Association of the Bar of the City of New York addressed a number of topics in response to the SEC’s request for comments on the disclosure requirements under Regulation S-K. In its August 30 comment letter, the committee focused on the audience for Reg. S-K disclosure, MD&A, the presentation and delivery of important information, and the use of a company profile disclosure model. The comment period closed July 21, 2016.

Opposition to tiered disclosure. The committee urged the SEC not to adopt tiered disclosure based on differing levels of sophistication and industry knowledge but, instead, through its rulemaking and comment process to encourage clear and plain English disclosure. In the committee’s view, effective disclosure for the most sophisticated analyst does not have to be incomprehensible to individual investors who lack particular industry knowledge.

Management overview. The committee continues to support its earlier proposal that the SEC adopt a rule to require registrants to provide an overview of the past year and their expectations and concerns in the year to come. The SEC should encourage companies to communicate the information in a plain English manner similar to how a CEO might report to the board of directors. This disclosure would not substitute for the more detailed financial and business information required by Reg. S-K, but would allow management to exercise judgment in presenting an overview of where the company has been and where it is going, the committee explained.

Cross-referencing and hyperlinks. The presentation and delivery of information is one of the most important to address and one of the easiest to improve, in the committee’s view, first by encouraging cross-referencing and hyperlinks to reduce duplicative disclosure. For example, the committee suggested cross-referencing from MD&A to the financial statement disclosures about critical accounting policies and recently issued accounting pronouncements. The committee acknowledged the challenges relating to external hyperlinks, including the auditor’s responsibility to review information outside of the financial statements, but urged the SEC to encourage hyperlinks within filings to the extent possible.

Improve EDGAR formatting. Another recommendation was to improve the formatting of documents in the EDGAR system. The expensive print-ready format many companies pay to produce, once “EDGARized,” is far less user friendly. The formatting in EDGAR should be modernized, according to the committee, but until that is completed, the SEC should adopt a rule to require that print-ready, non-EDGARized pdf versions of documents be filed with the EDGAR versions. The committee noted that Canada’s filing system permits filings in pdf form.

Company profiles. The committee urged the SEC to seriously consider the company profile disclosure model under which certain information would be kept on a website and updated periodically. The information could be part of the EDGAR system or a company website and would include governance documents, material contracts, executive compensation-related documents, effective registration statements, and ownership-related documents such as Forms 13D and 13G, among other relevant categories.

As a subsequent step, the committee said the SEC could consider identifying information in Forms 10-K and 10-Q, such as the business and risk factors section, to include in the profile. The use of a company profile model would reduce the burden on companies and benefit investors by shortening the length of periodic reporting documents, the committee explained.

The committee added that it is not suggesting a continuous disclosure approach, but one where companies would update information on the same time schedule as that required for their periodic filings.

Shearman & Sterling. The New York office of Shearman & Sterling also weighed in on what it sees as the most significant issues raised in the concept release, including the appropriate level of investor sophistication at whom disclosure should be aimed, and whether to mandate disclosure regarding environmental, social, and governance issues (ESG).

Level of sophistication. With respect to investor sophistication, the firm expressed concern that many issuers believe they have to frame their disclosure for the least sophisticated investors, but most of the users of this disclosure are institutional investors, professional investment managers, and research analysts. Individual investors are more likely to rely on third parties to analyze the disclosure, according to the firm, and the SEC should recognize the level of sophistication of the main users of these filings in drafting any reforms.

ESG disclosures. As for ESG disclosures, the firm said the focus should remain on material financial and business information necessary for voting and investment decisions. ESG disclosures should not become a mandated general disclosure practice, in the firm’s view. Shareholders have legitimate reasons to be interested in ESG disclosures, but the firm pointed to existing methods to engage on these issues, including shareholder proposals and direct engagement with management.

Wednesday, September 07, 2016

Court finds SLUSA divested state court of jurisdiction over federal claims

By Kevin Kulling, J.D.

A federal court in Delaware has concluded that a state court was divested of jurisdiction over “covered class actions” under the Securities Act. As a result, the court denied a motion to remand the action that alleged MoneyGram made materially false statements in a prospectus supplement associated with an offering of the company’s stock (Iron Workers District Council v. MoneyGram International, September 2, 2016, Stark, L.).

The state court action. Investors originally filed an action in the Superior Court for the State of Delaware against MoneyGram International alleging that materially false statements were made in a prospectus supplement associated with an offering for the sale of MoneyGram stock. The action alleged violations of Securities Act Sections 11, 12(a) (2), and 15.

MoneyGram filed a notice of removal, contending that the federal court had subject matter jurisdiction because the claims arose under federal law and the Securities Litigation Uniform Standards Act (SLUSA) divested state courts of jurisdiction over “covered class actions.”

In turn, investors filed its motion to remand, arguing that federal courts do not have exclusive jurisdiction over “covered class actions” but that Sections 16(b) and (c) of the Securities Act only provide for the removal of covered class actions arising under state law.

Tuesday, September 06, 2016

CII and CAQ support applying SOX Section 404 to some smaller reporting companies

By John Filar Atwood

The Council of Institutional Investors (CII) and the Center for Audit Quality (CAQ) support the SEC’s proposed amendments to the definition of “smaller reporting company” (SRC), particularly the plan to require companies with a public float of more than $75 million to continue to be subject to Sarbanes-Oxley Act Section 404(b) reporting. CII and CAQ believe that Section 404(b) is an important investor protection because it provides reasonable assurance from the independent auditor that a company maintained effective internal control over financial reporting.

SEC’s proposal. The Commission has proposed amendments to the definition of “smaller reporting company” that would expand the number of registrants that qualify as SRCs. Under the amendments, a company with less than $250 million in public float would qualify as an SRC. The current threshold is $75 million.

The second half of the definition also would be changed to provide that registrants with zero public float would qualify as an SRC if their revenues were below $100 million in the previous year. The existing definition qualifies companies with zero public float and less than $50 million in revenues in the most recent fiscal year.

CII and CAQ said in their comment letter that they support the amendments and recognize that they would generally promote capital formation by increasing the number of companies that can qualify as an SRC. They also expressed support the proposal’s handling of the relationship between the definition of an SRC and definition of accelerated and large accelerated filers.

Accelerated filers. Although the SEC proposes to increase the SRC threshold to $250 million in public float, it would retain the existing threshold of $75 million in public float for defining an accelerated filer. The proposal also includes an amendment to the accelerated filer definition to eliminate a previous provision that an accelerated filer cannot be an SRC.

CII and CAQ said that the strongly support this approach because it maintains the current accelerated filer public float threshold and provides for the continued protection to investors of approximately 750 additional companies that would qualify for SRC status under the proposal. This is important, according to CII and CAQ, because accelerated filers that are not emerging growth companies must comply with the SOX Section 404(b) auditor attestation requirements.

CII and CAQ are opposed to any amendments that would erode Section 404(b) or increase the accelerated filer public float threshold. In their view, this would significantly impact the quality of financial reporting by public companies to the detriment of investors by allowing many more companies to avoid the Section 404(b) requirements.

SOX 404(b). CII and CAQ pointed to a Government Accountability Office study that found companies exempted from Section 404(b) experience more financial restatements, as compared to non-exempt companies. CII and CAQ also cited academic research that shows that the cost of capital for companies that voluntarily comply with Section 404(b) is lower than peer companies and has decreased for public companies since enactment of the Sarbanes-Oxley Act, especially for smaller companies.

CII and CAQ urged the SEC to adopt the proposals as they are currently written, and expressed their opposition to any efforts to further weaken Section 404(b).

Friday, September 02, 2016

Giancarlo blasts CFTC for not delaying start of uncleared swap margin requirements

By Lene Powell, J.D.

CFTC Commissioner J. Christopher Giancarlo criticized the CFTC and U.S. banking regulators for proceeding with a September 1 start date for certain margin requirements for uncleared swaps even though the U.S. is ahead of most other jurisdictions in implementing globally agreed margin standards. Sticking to the “arbitrary” deadline will likely allow overseas competitors to take tens of billions of dollars of business from U.S. firms, and will weaken the ability of U.S. regulators to get other jurisdictions make progress on implementation, warned Giancarlo.

“This is yet another example of the failure of U.S. policymakers to negotiate harmonization in regulations as called for in the September 2009 G-20 Leaders’ Statement in a manner that does not place American markets at a competitive disadvantage,” Giancarlo wrote in a statement.

Uneven implementation. Giancarlo noted that the U.S., European Union, and other countries jointly agreed to a framework by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) that established standards for margin requirements for uncleared swaps and a timeline for phased-in implementation. Under this agreed timeline, certain margin requirements should begin as of September 1 for all jurisdictions.

The CFTC and U.S. prudential regulators (the FDIC, Federal Reserve, and others) have adhered to the September 1 timeline. However, the E.U., Australia, Hong Kong, and Singapore have since announced a delay in their implementation. In fact, the Financial Stability Board recently reported that just three of 24 jurisdictions will have uncleared swap margin requirements in force as of September 2016. Only Canada and Japan are joining the U.S. in keeping a September 1 start.

Competitive disadvantage for U.S. According to Giancarlo, beginning U.S. margin requirements on September 1 will lead to a higher margin structure than most of the rest of the world, giving major overseas derivatives markets a competitive advantage over American markets. As a result, overseas competitors will likely be able to take tens of billions of dollars in new customer business from U.S. firms. In turn, these new revenues will create an enormous incentive for European and Asian dealer firms to put pressure on their respective regulators to postpone future implementation of the margin rules. And U.S. regulators will lack negotiating leverage to pressure overseas regulators if there are further delays, said Giancarlo.

Other negative possibilities Giancarlo sees include U.S. industrial and other companies being at a disadvantage compared to overseas counterparts in their use of uncleared swaps to hedge risk. U.S. businesses may face higher costs, or may choose not to hedge their risks—undermining the purpose of the margin requirements and Dodd-Frank to reduce systemic risk.

Also, swap dealers are facing enormous challenges in finalizing account documentation by the deadline, Giancarlo said, adding that some have warned a liquidity crunch may result because certain dealers will not be ready to trade with other dealers.

Thursday, September 01, 2016

SEC staff comments on latest non-GAAP C&DIs spotlight ‘prominence’

A new paper by Mark S. Nelson, J.D., legal editor at Wolters Kluwer Legal & Regulatory U.S., surveys recent staff comment letters and issuer replies regarding the updated non-GAAP Compliance & Disclosure Interpretations issued by the SEC’s Division of Corporation Finance in May 2016. Although the bulk of the letters focus on the prominence companies give to non-GAAP financial measures, several other new or revised C&DIs also drew staff comments on companies’ disclosures.

The SEC’s focus on non-GAAP disclosures follows several high profile speeches, including by Chief Accountant James Schnurr, who said this past March that he had detected a “troubling increase” in issuers’ use of non-GAAP measures and the prominence analysts and the media attach to these measures. Schnurr noted that non-GAAP financial measures should “supplement,” not “supplant,” GAAP disclosures and he urged issuers’ managements and audit committees to remain alert to the SEC’s publicly available comment letter dialogs. Chair Mary Jo White, shortly after CorpFin issued the new C&DIs, reiterated much of what Schnurr said by reminding issuers that the Commission will act in this area through the disclosure review process, rulemakings, and potentially via enforcement proceedings.

To view the full paper, please click here.

Wednesday, August 31, 2016

End of the road reached in FOIA request saga

By Rodney F. Tonkovic, J.D.

A D.C. Circuit judge has denied the final extant FOIA request out of a slew filed by Gregory Bartko in an effort to overturn his convictions. At issue was whether the SEC's search for responsive records was sufficiently comprehensive. The court concluded that the Commission's search was reasonable and adequate and granted its motion for summary judgment (Bartko v. U.S. DOJAugust 26, 2016, Boasberg, J.).

FOIA request. Pro se plaintiff Bartko, who is serving a twenty-three year sentence, was convicted in 2010 of conspiracy, mail fraud, and the sale of unregistered securities. In May 2011, Bartko filed a FOIA request with the SEC, seeking records in six categories. Bartko sought evidence that would support his belief that an SEC attorney had colluded with the Assistant U.S. Attorney in charge of his prosecution. Bartko sent similar requests to several other federal agencies, including the Department of Justice, the Federal Bureau of Investigation, and the United States Postal Inspection Service.

The Commission's Office of FOIA Services (OFS) identified two matters in the SEC’s Atlanta Regional Office as possibly responsive and informed Bartko of this fact. Because one of the files was voluminous, Bartko narrowed his request to records relating to the SEC investigation of Capstone Private Equity Bridge & Mezzanine Fund, LLC, a fund created by Bartko in 2004. Searching for "Capstone," OFS found potentially responsive records, but was unclear whether they were in the previously-identified files.

His request having stalled, Bartko filed suit, and the Commission cross-moved for summary judgment while simultaneously delivering 1290 pages of records from one file. At issue was whether the SEC had properly invoked certain exemptions in withholding other documents and whether it had adequately conducted its search. The court concluded that Bartko's first contention was meritless but the Commission did not demonstrate that its search had been adequate. The court then directed the Commission to show why the other file was not searched for records responsive to the narrowed FOIA request.

Summary judgment. As requested, the Commission searched the file at issue and confirmed that it did not contain records relating to the Capstone inquiry. An attorney at the Atlanta Regional Office made a declaration in good faith that the file did not contain responsive materials, and this was sufficient to carry the Commission's adequate-search burden, the court said.

Bartko nonetheless maintained that the Commission's overall search was inadequate because it failed to produce a number of responsive records that he claims were in its possession at the time. In support, Bartko introduced a table listing what he believed to be responsive, non-exempt documents that were never been identified or released to him. The court said, however, that Bartko failed to adequately identify how these documents were responsive to his narrowed FOIA request. "That Bartko has identified other information of interest to him that the SEC did not produce does not render the agency's FOIA search inadequate, especially where he has not shown that such material is responsive to his request," the court said.

Finally, Bartko contended that responsive materials may exist outside of the two identified files. According to the court, an agency is merely required to explain that no other record system was likely to produce responsive documents, and the Commission did just that. The court found nothing obligating the Commission to search every file that Bartko believed might contain responsive materials after it demonstrated that its search methodology was reasonable.

The case is No. 13-1135.

Tuesday, August 30, 2016

Cheetah reinvents the legal research process: interview with Wolters Kluwer's Dean Sonderegger

In the September/October issue of AALL Spectrum, our Vice President of Legal Markets & Innovation, Dean Sonderegger, discusses the capabilities of the new Cheetah research platform and how Wolters Kluwer is reinventing the legal research process.

"The new platform came out of the mouths of customers," Sonderegger says. "The secret sauce is that our editorial team will organize the content and highlight the essential pieces . . . The result is that practitioners are able to move through primary content more efficiently."

Read the full interview with Dean here.

No SOX shield for ex-CEO complaining about disclosures he certified

By Anne Sherry, J.D.

The ousted founder and CEO of Orion Energy failed to persuade the Eastern District of Wisconsin that he was fired for blowing the whistle on disclosure shortcomings. The plaintiff unsuccessfully attempted to characterize his warnings about corporate waste and fiduciary duties as whistleblowing about fraudulent activity protected under SOX. The CEO's own certifications of the company's disclosures demonstrated that he did not subjectively believe there was fraud at the company (Verfuerth v. Orion Energy Systems, Inc., August 25, 2016, Griesbach, W.).

As the district court put it, the case "presents the unusual scenario in which a CEO claims to have been a 'whistleblower' about his company’s failure to disclose material facts to shareholders during the same period he himself was certifying that his company’s disclosures were complete." The plaintiff did not provide any information to the SEC or other agency, but argued that the board retaliated by firing him after he aired his concerns about the company's disclosures. Sarbanes-Oxley's whistleblower provision required him to prove, among other things, that he reported fraudulent conduct "to a person with investigatory authority," that he subjectively believed his employer was acting unlawfully, and that that belief was objectively reasonable.

The conduct the CEO complained about—corporate waste, fiduciary duty breaches, violations of codes of conduct or the attorney-client privilege—did not fall under SOX's umbrella of protected reporting. Under the plaintiff's theory, his disclosures were not just complaints about the underlying activity, but were simultaneously alerting the board that the failure to disclose the issues would constitute securities fraud. The court, however, identified a number of problems with this theory. First, the plaintiff's complaints to the board about the board's own alleged misconduct did not constitute whistleblowing, which requires disclosure to some other party.

Relatedly, Sarbanes-Oxley protects a whistleblower who provides information or assists in an investigation; a CEO's opinions about the company's reporting obligations are not covered. Accepting the plaintiff's theory "would mean that thousands of corporate executives, compliance officers and lawyers are 'whistleblowing' every time they give advice about information they believe should be disclosed. There is no indication the statute intended to protect such activity."

Furthermore, the board already knew about some of the plaintiff's complaints, such as stock manipulation that had allegedly occurred four years prior. Even if the failure-to-disclose theory itself held water, the plaintiff failed to explain why the undisclosed information was material and why he reasonably believed shareholders would lose value from its omission. Finally, the CEO's own certifications of the company's annual and quarterly reports meant that he could not establish his subjective belief that fraud was occurring.

The case is No. 14-C-352.

Monday, August 29, 2016

GAO examines conflict minerals reports, cites Commerce’s failure to fulfill Dodd-Frank responsibilities

By Jacquelyn Lumb

The Government Accountability Office, in its annual report to Congress on the effectiveness of the SEC’s conflict minerals rules, found that companies continue to experience difficulties in fulfilling their disclosure responsibilities. In addition, the Department of Commerce, which is required under the Dodd-Frank Act to assess the accuracy of the independent private sector audits that accompany the conflict minerals disclosure, has not filed any reports and has not developed any plans for conducting the assessments. Commerce advised that it has no knowledge, skills, or expertise to conduct the reviews of the audits or to establish best practices. The GAO recommended that Commerce develop the necessary expertise and establish a plan and a timeframe for conducting the required assessments.

Conflict minerals rules. The SEC adopted the conflict mineral disclosure rules in 2012 to require companies to report on the use of conflict minerals from the Democratic Republic of the Congo and adjoining countries. Congress intended that the rules would inhibit the ability of armed groups in the DRC and adjoining countries to fund their activities by trading in conflict minerals. The first filings were due by June 2, 2014 and annually thereafter on May 31.

The rules require companies to determine whether they manufacture or contract to have manufactured any products that contain conflict minerals; to conduct a country of origin inquiry about the source of the conflict minerals used; and to exercise due diligence to determine the source and chain of custody of the conflict minerals that are used. Companies that disclose that their products are DRC conflict-free must include documentation based on an independent private sector audit.

The GAO noted that the four conflict minerals enumerated in the Act are used by various industries in a wide variety of products. It examined 100 reports filed in 2015 out of 1,281 in the EDGAR database to determine the challenges that companies faced in their due diligence efforts with respect to the processing facilities in conflict minerals supply chains, efforts to mitigate those challenges, and Commerce’s actions with respect to its requirements under the Dodd-Frank Act.

Challenges to reporting. The GAO found that a number of sourcing initiatives have been developed to assist companies with their reporting obligations. However, a majority of companies reported that they were unable to determine the country of origin of the conflict minerals used in their products. About 19 percent more of the companies reviewed were able to make the determination in 2015 than in 2014. In some cases, companies advised that suppliers did not respond to their inquiries. Many supply chains involve multiple tiers which can delay a response. In addition, some processing companies purchase from multiple suppliers and commingle the products.

New approaches. The GAO reported that some companies plan to take certain actions to improve their due diligence efforts, including shifting their operations to supply chains that are certified conflict-free; inserting language in new contracts about their expectations relating to conflict minerals; continuing to seek information from suppliers whose responses were inadequate; and providing training to suppliers on conflict minerals due diligence.

Commerce initiatives. The GAO noted that Commerce produced annual reports in 2014 and 2015 which listed the known conflict minerals processing facilities worldwide in accordance with its responsibilities under the Act, but as of July 2016 had not submitted a report on its assessment of the accuracy of the independent private sector audits or other due diligence efforts by reporting companies. Six companies filed audit reports in 2015 and four did so in 2014. Commerce advised that it has now established a team to manage its assessment responsibility and that it would conduct a review of the 19 reports filed in 2016. It is exploring the use of the private sector to assess other due diligence processes. Until Commerce acts, the GAO said filing companies lack information about best practices for responding to the conflict minerals rule.