Monday, November 20, 2017

House FSC approves Dodd-Frank repeals plus capital formation, Fed bills

By Mark S. Nelson, J.D.

The House Financial Services Committee engaged in a two-day markup session of nearly two dozen securities and banking bills spanning a range of topics, including Dodd-Frank Act repeals, hedge funds and private equity, business development and closed-end companies, capital formation, proxy advisers, non-bank financial institutions, Fed oversight, and Iran disclosures. The markup and approval of all 23 bills followed a prior House FSC hearing that considered many of the same bills (See vote scorecard).

Dodd-Frank Act repeals. A trio of bills would repeal two of the specialized securities disclosure obligations imposed by the Dodd-Frank Act plus the settlement title of the reform bill. The provisions to be repealed would include:
  • Conflict minerals—Repeal of Dodd-Frank Act Section 1502 (H.R. 4248). 
  • Mine safety—Repeal of Dodd-Frank Act Section 1503 (H.R. 4289). 
  • Restoring Financial Market Freedom Act of 2017 (H.R. 4247)—Repeal of Dodd-Frank Act Title VIII regarding payment, clearing, and settlement. 
By comparison, the Financial CHOICE Act (H.R. 10) would repeal the entirety of the specialized disclosure provisions, including the authority for the SEC’s resource extraction issuer’s rule (Congress disapproved the SEC’s resource extraction issuers rule earlier this year via the Congressional Review Act), plus required studies of inspectors general and of core and brokered deposits. The Treasury Department's report on capital markets, published as part of a review of financial regulations in light of core principles announced by the Trump Administration, recommended repeal of provisions on conflict minerals, mine safety, and resource extraction issuers, and that related SEC rules be withdrawn. The report also urged Congress to transfer the subject matter of these provisions to other agencies if lawmakers were to continue the specialized disclosure regime.

With respect to conflict minerals, the SEC’s recent guidance rolling back the due diligence requirement did not otherwise eliminate the need for U.S. companies to comply with the conflict minerals rule and many firms continued to make the same level of disclosure in 2017 as they had in prior filings. Similar European regulations will come online in January 2021 and will impact European Union importers whose conflict minerals imports are above specified volume thresholds.

Hedge funds and private equity. The Investor Clarity and Bank Parity Act (H.R. 3093) would amend the Bank Holding Company Act to permit hedge funds and private equity funds to use the same name or a variation of a name that the fund has in common with a banking entity that is an investment adviser to the fund if the fund meets certain requirements, which include that the investment adviser not be an insured depository institution, share a name with such institution, or use “bank” in the fund’s name. Currently, BHCA Section 13 (12 U.S.C. §1851) provides that federal regulators can permit banking entities to engage in certain activities despite the Volcker rule ban on many forms of proprietary trading, including organizing or offering a private equity or hedge fund if, among other things, the fund does not share the banking entity’s name.

Friday, November 17, 2017

CFTC Commissioner Behnam reflects and inflects in Georgetown

By Brad Rosen, J.D.

“The CFTC is at an inflection point, where strategic regulatory decisions are critically important to determine the future of market transparency, resiliency, and systemic risk”, declared Commissioner Rostin Behnam, the newest member of the Commodity Futures Trading Commission in his first official speech as a commissioner. Behnam made his long- awaited remarks on November 14 before the Georgetown Center for Financial Markets and Policy at George University, Behnam’s undergraduate alma mater. Behnam was sworn in as a commissioner on September 6, 2017.

In the speech, titled The Dodd-Frank Inflection Point: Building on Derivatives Reform, Behnam provided a sweeping foundational survey of the history of futures regulation in the U.S., starting with the Futures Trading Act of 1921 through the current day, with stops along the way that included the passage of the Commodity Exchange Act in 1936, the establishment of the CFTC in 1974, as well as the 2009 G20 Pittsburgh Summit, which laid the framework for regulating the over-the counter-derivatives markets and the passage of the Dodd-Frank Act in 2010.

Behnam noted that the 2008 financial crisis and weaknesses in the global regulatory system it revealed led to Congress enacting the Dodd-Frank Act, which largely incorporated the international financial reform initiatives for over-the-counter derivatives laid out at the G20 Pittsburgh Summit. These initiatives included: (i) moving standardized contracts to exchanges or electronic trading platform (when appropriate); (ii) mandatory clearing for most bilateral contracts through central counterparties (“CCPs”); (iii) reporting executed trades to trade repositories; and (iv) instituting higher capital requirements for non-centrally cleared contracts.

Behnam argued that it is critical for the CFTC to continue supporting key Dodd-Frank reforms in a manner that is both reflective and forward looking. By this he means it is important to reflect on both the success and failures of policy changes that have been made to date and to keep a vigilant eye on new challenges, innovations, and threats to the financial markets. Behnam asserted, “[o]ur mission is to protect the market and the public from fraud, abuse, and systemic risk”, and recalled, “[w]e cannot forget that millions of jobs were lost and homes foreclosed upon before we were authorized to take action.”

With respect to the further implementation of Dodd-Frank reforms, Behnam identified four areas where the commission needs to make further progress as follows.

Mandatory clearing of standard swaps. Following the implementation of the CFTC clearing mandate in 2013, more than 80 percent of interest rate derivatives and credit default swaps are now centrally cleared. However, mandatory clearing has raised new challenges and concerns with regard to the role and size of the global portfolio of cleared derivatives. Accordingly, aggressive efforts to monitor and consider the potential systemic repercussions of the clearing mandate need to be analyzed and pursued by commission staff.

Exchange trading of standardized swaps. The trading of standardized swaps on CFTC-regulated exchanges (designated contract markets or “DCMs”) or on multi-participant trading systems or platforms first established in the Dodd-Frank Act (swap execution facilities or “SEFs”) is another key area of reform. The main policy goal of the exchange trading requirement is to further transparency in the OTC markets. Like the clearing mandate, the exchange trading policy initiative is sound and the market has moved swiftly to adapt to the regulatory changes.

Swap data reporting. Before Dodd-Frank, there simply was little, if any, relevant market data regarding the size, complexity, and potential risks underlying over-the-counter derivatives. Through robust data collection, market risks and unexpected events can be better assessed and possibly predicted. However, given the CFTC’s limited resources and technology capabilities, the Commission does not have the bandwidth to seek to collect or maintain data that does not serve a proven purpose of protecting markets, market participants, and customers. Nonetheless, the CFTC must prioritize building on the current data requirements established in Dodd-Frank in a way that sets clear parameters for what data must be collected and submitted, when it must be submitted; and, equally important, what form the data must take.

Capital and margin requirements for non-centrally cleared swaps. Capital serves as a loss absorbency mechanism in times of extreme market stress. The CFTC has completed its margin rules, but has yet to finalize capital requirements for the swap dealers who are not prudentially regulated. Regulators must continually monitor market ecosystems to ensure that regulations, including capital and margin requirements, are properly set to ensure market resiliency, safety, and liquidity in times of market stress.

Key priorities. Behnam also stated two of his key priorities and objectives that he will focus on during his early days as a Commissioner. The first is his sponsorship of the CFTC’s Market Risk Advisory Committee (MRAC), the Commission’s open forum to examine risk across broad swaths of the markets. The second, and following in the footsteps of Chairman Giancarlo, Commissioner Behnam will embark on a listening tour across the country and meet with market participants, such as commercial manufacturers, financial institutions, and farmers and ranchers. The stated goal of this undertaking is to get a better understanding of the risk management challenges that these various end users encounter.

Thursday, November 16, 2017

BakerHostetler hosts webinar on preparing for the 2018 proxy season

By Jacquelyn Lumb

National law firm BakerHostetler hosted a webinar on preparing for the 2018 proxy season during which panelists talked about the role of proxy advisers, SEC rulemaking, and emerging issues. The panelists agreed that, while many subscribe to a proxy advisory firm’s services, they do not necessarily follow its recommendations. Companies should engage with proxy advisory firms before the proxy season is underway and before their preliminary proxy has been filed.

Proxy advisory firms. Institutional Shareholder Services reports that it holds 61 percent of the market share with 1,700 clients. Glass Lewis has 1,200 clients. Egan Jones has a smaller shop and is the least influential of the three, but one panelist noted that its guidelines are much stricter. For example, in Egan Jones’ view, a director who has served for 10 years is an affiliated outsider who is no longer fully independent. The firm also has stricter guidelines on auditor ratification and over-boarding.

Shareholder proposals. Shareholder proposals seeking proxy access are in decline and by the end of the upcoming proxy season over 80 percent of the S&P 500 companies are expected to have a proxy access policy. Other hot topics include board refreshment, diversity, and the board’s skill matrix; environmental, social, and governance issues; and shareholder engagement. The panelists said they had the most success in negotiating the withdrawal of proposals relating to board diversity after providing assurances that the companies would look to a diverse pool of candidates with every new opening on the board. However, these companies now must follow their assurances with action.

Withhold recommendations. The panelists said that among the issues that may result in a withhold recommendation by a proxy advisory firm in the election of directors is where a director has attended less than 75 percent of the board meetings, where the director serves on too many boards, where the board has failed to take action on a shareholder proposal that gained majority support, and where the board either adopts or retains what is considered an anti-shareholder rights provision.

Say on pay. With respect to say on pay, both ISS and GL pay attention to pay for performance, the structure of the compensation program, problematic pay practices, and the compensation committee’s communications and responsiveness.

Pay ratio disclosure. 2018 will be the first year for the mandatory pay ratio disclosure. Advisory firms are not expected to react the first year, but one panelist predicted that the media will have a field day. Another panelist said that after the election, he thought the pay ratio rule would be revoked, and another wondered if the SEC would come up with a regulatory maneuver to delay the mandate. Instead, the SEC and the staff issued guidance on how to comply with the requirement.

Hedging and clawbacks. Two other Dodd-Frank Act rules that were proposed by the SEC but not yet adopted relate to hedging and clawbacks. One of the panelists said the hedging proposal was a bit more palatable but the clawback proposal was pretty prescriptive. Neither is likely to be adopted any time soon, in one panelist’s view, although some companies have adopted policies in those areas. If the SEC ultimately adopts a clawback provision, companies may have to amend existing policies to reflect the new rule.

Wednesday, November 15, 2017

ESMA joins chorus of warnings against ICOs

By John Filar Atwood

The European Securities Markets Authority (ESMA) has joined securities regulators from around the globe in issuing a formal warning about the risks of initial coin offerings (ICOs). Guidance on ICOs and cryptocurrencies in recent months has come from, among others, the U.S. SEC, the Canadian Securities Administrators, the Bank of Russia, and the Australian Securities and Investments Commission. China and South Korea have instituted an outright ban on ICOs.

ESMA warned that ICOs are highly speculative and could result in the total loss of investment. In addition, they may fall outside a country’s existing offerings rules, and therefore enjoy none of the protections that accompany regulated investments.

In addition, ICOs may be vulnerable to fraud or illicit activities, owing to their anonymity and their capacity to raise large amounts of money in a short timeframe. ESMA noted that several recent ICOs were identified as frauds, and it is possible that some ICOs are being used for money laundering purposes.

ICO definition. An ICO is a way to raise money from the public using coins or tokens. In an ICO, a business or individual issues coins or tokens and sells them in exchange for virtual currencies such as bitcoin or ethereum. ICOs are conducted online, and the tokens are typically created and disseminated using distributed ledger or blockchain technology.

Some tokens serve to access or purchase a service or product that the issuer develops using the proceeds of the ICO, according to ESMA. Others provide voting rights or a share in the future revenues of the issuing venture. Some tokens are traded and/or may be exchanged for traditional or virtual currencies at coin exchanges.

Few exit options. Among the risks identified by ESMA are that investors may not be able to trade their tokens or to exchange them for traditional currencies. Not all tokens are traded on virtual currency exchanges, EMSA noted, and when they are their price may be very volatile.

ESMA also noted that most ICOs are launched by businesses that are at an early stage of development with an inherently high risk of failure. Tokens generally have no intrinsic value other than the possibility to use them to access or use a service or product that is to be developed by the issuer. ESMA warned that there is no guarantee that the services or products will ever be successfully developed.

The information that is made available to investors is in most cases unaudited, incomplete, unbalanced, or even misleading, according to ESMA. ICO information tends to emphasize the potential benefits but not the risks, ESMA added, and is not easy to understand.

Finally, ESMA advised that the distributed ledger or blockchain technology that underpins the tokens is still mostly untested. The code used to create, transfer or store the tokens may be flawed, ESMA warned, preventing investors from accessing or controlling their tokens. The technology may not function quickly and securely during peak trading periods, and tokens may be susceptible to theft through hacking, ESMA concluded.

Tuesday, November 14, 2017

Strong FCPA enforcement levels the playing field for honest companies, say SEC, DOJ officials

By Lene Powell, J.D.

International bribery used to be commonplace in competing for overseas contracts. In some countries, it was even tax-deductible. As an accepted practice, bribery rewarded bad actors, punished ethical companies and individuals, facilitated organized crime and authoritarian rule, and weakened the rule of law.

But strong anti-corruption laws and increasing coordination between the SEC, Department of Justice, and foreign counterparts has achieved extraordinary results, said SEC and DOJ officials at a conference marking the 40th anniversary of the Foreign Corrupt Practices Act (FCPA) and the 20th anniversary of the Organization for Economic Cooperation and Development (OECD) Anti-Bribery Convention. As Steven R. Peikin, co-director of the SEC Enforcement Division, observed, international resolutions featuring criminal liability and massive fines are sending strong messages of deterrence to companies and individuals who might otherwise see bribery and corruption as a way of maximizing their commercial advantage.

And according to Acting Assistant Attorney General Kenneth A. Blanco, tireless work really has made a difference over the past few decades in changing international acceptance of corruption. “Because of the efforts of the OECD Working Group on Bribery, and our law enforcement partners at home and overseas, we have transitioned from a world in which bribery of foreign officials was considered a sound business strategy, to one in which bribery is treated like the corrosive crime that it is,” said Blanco.

International coordination. Peikin sees a “sharply upward trajectory” in the level of cooperation and coordination among regulators and law enforcement worldwide. In the past fiscal year alone, the Commission has publicly acknowledged assistance from 19 different jurisdictions in FCPA matters.

Peikin and Blanco both pointed to Odobrecht and Braskem, the largest FCPA case in history, as an outstanding success. In that case, a Brazilian petrochemical manufacturer agreed to pay $957 million as part of a global settlement including the SEC, DOJ, and authorities in Brazil and Switzerland. The company pleaded guilty in the U.S. and, importantly, must cooperate with the ongoing investigations of individuals in the respective countries. So far approximately 80 people have been charged in connection with the cases.

In addition to helping in gathering evidence and building the case, international coordination allowed penalties to be apportioned fairly between the countries and avoided duplicative fines, said Blanco. This fairness in applying penalties gives companies the proper incentives to cooperate fully with the relevant jurisdictions.

Another massive resolution was In the Matter of Telia Company AB, in which Swedish telecommunications giant Telia Company AB agreed to pay more than $965 million to settle charges that the company and a subsidiary violated the Foreign Corrupt Practices Act by paying bribes to win business in Uzbekistan. That case involved coordination with Dutch and Swedish law enforcement.

Individual accountability. Holding individuals accountable can be a challenge, said Peikin. Often, the individuals involved are foreign nationals who reside overseas. Even when they can be charged in the U.S., in many cases they have limited or no assets in the U.S., limiting the options for enforcing any monetary judgments obtained. But given that holding individuals accountable is critical to the goals of deterrence, incapacitation, and just punishment, he expects that the SEC continue to have “intense focus” on the question of individual responsibility in every FCPA investigation.

Blanco also noted a focus on individual accountability, and said that since 2016 the DOJ has brought more than 35 criminal cases against individuals and 17 cases against corporations in connection with foreign bribery charges. In 2017 so far, the DOJ has announced convictions or guilty pleas by 17 individuals in FCPA-related cases. This is more than in any previous year and there is more to come, he said.

Statute of limitations. One of the principal challenges in bringing an FCPA case is the interplay between the length of time it takes to conduct an FCPA investigation and the statute of limitations, said Peikin. The misconduct may have aged by the time the SEC learns of it, and FCPA cases often take a long time to develop because they are complex and require the collection of evidence abroad.

Compounding this is the recent Supreme Court decision in U.S. v. Kokesh, in which the Court held that Commission claims for disgorgement are subject to the general five-year statute of limitations, said Peikin. Kokesh has already had an impact and the SEC has had no choice but to redouble efforts to bring cases as quickly as possible. But this makes sense in any case, he said, because cases have the highest impact and litigation efforts are most effective when the SEC brings cases close in time to the alleged wrongful conduct.

Monday, November 13, 2017

Risk alert, roundtable offer guidance to municipal advisors

By Anne Sherry, J.D.

An SEC-hosted regulatory roundtable on the nascent regulatory regime for municipal advisors took an optimistic outlook, even as an OCIE risk report identified compliance deficiencies uncovered in examinations. Panelists from the MSRB, SEC, and FINRA see the rules as providing opportunities and a level playing field for firms, while mitigating issues in the marketplace and giving tools to regulators. Mark Zehner of the SEC’s Division of Enforcement quipped that he hopes the regime puts him out of a job.

Examination deficiencies. The risk alert is a short document that both identifies the forms and compliance obligations relating to municipal advisors and identifies OCIE staff’s observations in over 110 examinations of MAs. The regulatory roundtable closed out a compliance outreach program held at the SEC’s Atlanta office. When Ritta McLaughlin (MSRB) opened the discussion by asking what keeps the panelists up at night, OCIE examiner Nadine Sophia Evans referred to the risk alert. It is critical for advisers to understand their obligations, and the examinations revealed books-and-records deficiencies, inadequate policies and procedures, written supervisory procedures that do not reflect what the firm is actually doing in practice, and “the elephant in the room” of registration issues. Evans added that MAs should look at the spirit of the rules to focus on what the regulators were ultimately trying to achieve.

Other panelists echoed the concerns about failures to register and what FINRA examination manager Gene C. Davis called a “lackadaisical” approach toward compliance. Rebecca Olsen of the SEC’s Office of Municipal Securities questioned whether form documents are really being used thoughtfully, after reflection and customization for each particular deal.

A rosy outlook. Despite these qualms, the panel seemed unanimously optimistic about the regulatory regime’s impact on the industry. Zehner said that a good class of registered MAs is the antidote to the problem of clients getting railroaded into unsuitable investments. The regime should give MAs confidence that they will be protected and their interests will be addressed. Gail Marshall, chief compliance officer of the MSRB, hopes that MAs will see the entities represented by the panel as resources and not “mean regulators.” She cited OCIE’s risk alert and added that the MSRB has educational resources and webinars, a needs analysis example, training plan template, and FAQs.

Practical advice. The panelists also offered some practical advice focused around dynamic procedures and best practices. When asked what an MA should do if a client wants to take on more risk than the advisor thinks is suitable, Olsen said the advisor should go through the normal steps and diligence to come up with a recommendation for the client. If the client is unswayed, the advisor does not need to disengage, but may want to document the engagement well. Zehner added that the MA needs to remember that the client is not the individual, but the entity. He cited an enforcement example where a mayor was so adamant that the advisor had gotten the numbers for feasibility runs wrong that the advisor changed them. The mayor was happy and all was well—until the bonds went into default.

As for processes and procedures, Evans suggested that MA firms create a cheat sheet of compliance dates and requirements and do regular (monthly or bimonthly) checkups. Davis agreed, clarifying that when the panelists talk about processes, they don’t mean simply keeping a manual that states what fiduciary duties are owed. It means having a checklist, asking whether a particular procedure was followed or disclosure made. Making a point of documenting deals with memoranda and referring back to them later is another example of a process, he said. Zehner affirmed that documentation is critical, adding that if enforcement staff see a contemporaneous memo, it demonstrates that the firm was not trying to hide the ball.

Friday, November 10, 2017

SEC staff reminds registrants of availability of Rule 3-13 waivers

By Jacquelyn Lumb

Chief Accountant Mark Kronforst in the SEC’s Division of Corporation Finance, speaking at the Practising Law Institute’s conference on securities regulation, reminded registrants that the staff is willing to grant waivers from certain disclosures in order to facilitate capital formation. He referred to remarks by Chairman Jay Clayton to the Economic Club of New York last July in which Clayton advised that issuers can request modifications to their financial reporting requirements in certain circumstances under Regulation S-X Rule 3-13 where it may not be material to the total mix of information available to investors. Clayton said the staff is placing a high priority on responding with timely guidance.

The Division of Corporation Finance’s Office of the Chief Accountant has updated its Financial Reporting Manual to include contact information for waiver requests. According to the manual, the staff has the authority, where consistent with investor protection, to permit registrants to omit or to substitute required financial statements. The requests should be submitted via email and a link is provided in the manual.

One of the panelists noted that there was little transparency with respect to waivers that have been granted. Kronforst said to talk to the staff if there is a problem with the reporting requirements, especially if it affects capital formation, such as acquisitions under Rule 3-05. The staff has been responding in about five days. Kronforst reiterated that there is no need for a certified letter or a FedEx delivery for the request. The email link that is provided is fine, he advised.

John White, a former director of the division and now a partner at Cravath, Swaine & Moore, provided an example of a request in which he was involved. A foreign private issuer was seeking an initial listing in the U.S., but its auditor had a conflict from three years back that would impair its independence under the rules. A waiver was granted to permit the company to provide two years of audited IFRS financial statements with the third year’s financial statements provided but unaudited. White said it was a critical waiver in obtaining a listing in the U.S.

Kronforst added that the staff may request financial statements that have not been provided. That is fairly rare but it allows the staff to adapt the rule as it deems appropriate.

New GAAP. The panel discussed what SEC Chief Accountant Wesley Bricker refers to as new GAAP—the standards on revenue recognition, leasing, and financial instruments. Bricker said it is close to “exam time,” and these standards should be at or near the top of registrants’ agendas. Michael Gallagher with PricewaterhouseCoopers reported that most registrants are choosing the modified retrospective approach to the revenue recognition standard. The full retrospective method requires a lot more work, he noted.

The PCAOB issued an audit alert on the revenue recognition rules. Gallagher said the alert does not include any new requirements, but reminders of certain requirements that are relevant to the auditors’ consideration of companies’ implementation of the new standard in upcoming interim reviews and year-end audits, such as the SAB 74 disclosures about the transition. Gallagher said SAB 74 is a useful risk management tool. He emphasized the importance of internal controls and good processes during the transition.

Non-GAAP. Kronforst advised that the staff continues to pay attention to the use of non-GAAP measures, but the comments have slowed to a trickle, a status that he hopes will continue. Bricker noted that if there are any material changes in a company’s GAAP policy, the auditor is briefed about it, and he recommended that audit committees consider doing the same for any material non-GAAP changes.

Segment reporting. The staff continues to issue comments on segment reporting, according to Kronforst, but he predicted it will not be a major topic on this year’s speaking circuit. A lot of people are asking about comments on revenue recognition by early adopters. Kronforst said the sample size is too small at this time to provide any guidance.

In closing, the panelists were asked to provide their takeaways from the discussions. Gallagher said the new standard on leases has lots of sleeper issues and will be a lot of work. Kronforst reiterated the availability of Rule 3-13 waivers. He said there is a lot of lore out there, so rather than relying on guidance from 1992, ask the staff. Bricker highlighted the revised auditor’s report. He suggested that audit committees may want to try a dry run and flesh out their communication strategy.

Thursday, November 09, 2017

House tax reform: a closer look at carried interest and RSUs

By Mark S. Nelson, J.D.

House Ways and Means Committee Chairman Kevin Brady (R-Texas) offered a second set of amendments that deal directly with carried interest and restricted stock units. Chairman Brady had already introduced a substitute bill that made numerous conforming amendments to the original tax reform bill and removed a proposed limit on the exemption for income under treaty. The next step is for the committee to wrap up its days-long markup session and vote on whether to advance the reform package to the full House.

The Brady amendment (summary) would make numerous changes to the original tax reform bill text. Overall, the amendments will hearten some who fought for changes to the tax reform bill’s treatment of employee shareholders and songwriters, but may rankle others because of newly proposed anti-fraud measures related to the earned income tax credit and a five-year sunset for persons eligible for the dependent care assistance exclusion. The Brady amendment was adopted by a vote of 24-16. The Senate is expected to publish its tax reform bill soon and Sen. Tammy Baldwin (D-Wis) has already urged senators to include her bill on carried interest in the Senate’s tax reform package.

Carried interest. The House tax reform package initially did not include provisions for closing the carried interest loophole. The Brady amendment would lengthen the current one-year holding period for some partnership interests to three years in the case of certain applicable partnership interests. The Treasury Secretary could provide that the longer holding period would be inapplicable to assets not held for investment on behalf of others. The amendments to the Internal Revenue Code would be effective for taxable years after December 31, 2017.

Under the amendment, “Applicable partnership interest” would be defined as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.” But the definition would not apply to certain interests held by those employed by entities that only provide services to other entities. The definition also would be subject to exceptions for: (1) partnership interests held by a corporation; or (2) capital interests in a partnership entitling a taxpayer to a share of the partnership’s capital based on either capital contributions or the value of the interest under Code Section 83.

“Applicable trade or business” would mean a regularly-conducted activity that includes raising or returning capital and either investing in (or disposing of) or developing specified assets. “Specified assets” includes securities, commodities, and derivative contracts.

Representative Sander Levin (D-Mich) attempted to clarify the impact of the Brady amendment on carried interest in an exchange with the committee’s sole witness, Thomas Barthold, chief of staff for the Joint Committee on Taxation (JCT), a nonpartisan committee of the U.S. Congress. Representative Levin first asked what impact the longer holding period would have. Barthold said that sales of partnership interests within the three-year period would be treated as short-term sales and, thus, subject to ordinary income tax rates. As a result, Bathold said the amendment should be a revenue raiser.

Representative Levin then asked Barthold for the impact of the remainder of the carried interest amendment, specifically whether more or fewer entities would be subject to limits as compared to Rep. Levin’s bill on closing the carried interest loophole. Barthold replied by describing the outlines of the carried interest amendment, including its application to specified assets. When pressed by Rep. Levin, Barthold conceded that he had not yet completed a quantitative analysis of the amendment, but he said the amendment was likely narrower than Rep. Levin’s bill.

Wednesday, November 08, 2017

What is the level of proof needed to invoke the Basic presumption of reliance?

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to consider the proof required to establish the Basic presumption of reliance. The petitioner, Brazilian oil giant Petrobras, maintains that in a decision granting class certification, the Second Circuit erroneously concluded that the Basic presumption can be based entirely on factors unrelated to whether the alleged misstatement had even an indirect impact on share price. The petition also asks the Court to address Rule 23's requirement that class membership can be ascertained through administratively feasible means (Petroleo Brasileiro S.A. - Petrobras v. Universities Superannuation Scheme Limited, November 1, 2017).

Kickbacks. The action was brought by purchasers of debt securities in Petrobras. Once one of the largest companies in the world, Petrobras's value plummeted after the exposure of a multi-year, multi-billion-dollar money-laundering and kickback scheme, carried out by a cartel of Brazilian construction contractors, suppliers, and corrupt Petrobras executives. According to the investors, Petrobras, which denied any wrongdoing, was complicit in concealing information about the kickback cartel from investors and the public.

The district court certified two classes for money damages: one asserting claims under the Securities Act, and the other under the Exchange Act. Petrobras appealed, arguing that court erred in finding a class-wide presumption of reliance under the "fraud on the market" theory. The company also challenged the court's conclusion that the proposed classes were ascertainable and administratively manageable.

The Second Circuit affirmed the district court’s ruling that the Exchange Act class was entitled to a presumption of reliance under Basic. Petrobras argued that the district court gave undue weight to the plaintiffs' empirical test, which measured the magnitude of responsive price changes in Petrobras securities without considering the direction of those changes. The panel, however, declined to impose a blanket rule requiring district courts to rely on directional event studies and directional event studies alone at the class certification stage. The panel also rejected the argument that the district court should have applied a "heightened" ascertainability requirement, under which any proposed class must be "administratively feasible." According to the panel, courts must weigh the competing interests inherent in any class certification decision, and a class is ascertainable if it is defined using objective criteria that establish a membership with definite boundaries.

Basic presumption. The petition first asks the court to consider whether the legal standard to invoke Basic's presumption of reliance at minimum requires empirical evidence that a security general reacted in a directionally appropriate manner to new material information, or can the presumption be based entirely on other factors unrelated to whether the alleged misstatement had price impact. Petrobras asserts that the Second Circuit's ruling has dramatically lowered the threshold for class certification in securities fraud class actions and conflicts with the Supreme Court's ruling in Halliburton II. According to the petition, under the Second Circuit's decision, a plaintiff can benefit from the Basic presumption without showing even indirect evidence of price impact, and a defendant is prevented from using even direct evidence of price impact to rebut the presumption.

Under the Second Circuit's ruling, the petition maintains, a plaintiff can establish reliance by showing that a security had any price reaction without showing a predictable cause-and-effect relationship between the news and the price movement. If the price movement is in the wrong direction, there is no basis to presume that the price reflects the fraud such that the plaintiff could be presumed to have purchased in reliance on the alleged misrepresentation. Further, the Second Circuit made the presumption effectively irrebuttable by implying that directional event studies are of limited utility due to "methodological constraints."

The petition goes on to note that, in the 29 years since Basic, district courts have struggled with the standard for the presumption of reliance and differ greatly as to how market efficiency must be established. While the Cammer test is influential, the petition says, it has come under criticism for uncertainty and imprecision. And, courts have added more factors to the Cammer test, resulting in an ad hoc approach with similar circumstances yielding different determinations of market efficiency. This case, the petition contends provides a rare opportunity to resolve almost 30 years of confusion on an important issue.

Administrative feasibility. The petition asks further whether Rule 23 requires proponents of class certification to show that class membership can be reliably ascertained through administratively feasible means. Three circuits (the Third, Fourth, and Eleventh) have held so, the petition says, while four more (the Second, Sixth, Seventh, and Ninth) have taken the contrary position. In this case, the Second Circuit held that Rule 23 does not contain an independent feasibility requirement and requires only that a class can be defined using objective criteria that establish a membership with definite boundaries.

Here, Petrobras noted that its notes are traded over-the-counter across four continents, and there is no administratively feasible means to ascertain whether the notes were purchased in "domestic transactions," as required by Morrison. If putative class members cannot determine whether they are members, the petition asserts, they are unable to make fundamental decisions affecting their rights. In addition to due process concerns, the Second Circuit's decision allows a named plaintiff to demand billions of dollars on behalf of "domestic" purchasers without worrying about whether class members can be ascertained. The Second Circuit, the petition states in closing, has abdicated an essential gatekeeping function by not requiring an administratively feasible means of ascertaining class membership.

The petition is No. 17-664.

Tuesday, November 07, 2017

Enforcement Director James McDonald expounds on self-reporting/cooperation guidelines at Chicago-Kent conference

By Brad Rosen, J.D.

CFTC Division of Enforcement Director James McDonald provided some additional insights, details, and color regarding the division’s recent efforts to encourage self-reporting and cooperation among industry participants at the 9th Annual Chicago-Kent College of Law Conference on Futures and Derivatives held during the first week of November. In his remarks to an audience consisting primarily of the legal and compliance professionals serving the futures and derivatives industry, McDonald echoed many of the themes he articulated in a speech made before the NYU Institute for Corporate Governance and Finance in September of this year.

While previously indicating that a prospective respondent would receive a “substantial reduction in the penalty” that would otherwise be applicable in exchange for self-reporting, cooperation, and remediation, McDonald went somewhat further, explaining that the discount in the civil monetary penalty would run in the 50-75 percent range, generally speaking, provided the self-reporting thresholds required by the division were satisfied.

Additionally, while noting that any cooperation must be full and substantial, McDonald indicated that the division will not require nor request that any party waive its attorney client or work product privileges, when queried by an audience member. However, he noted, a firm may be requested to share the non-privileged portions of an investigative report in connection any internal investigation.

McDonald echoed a number of other points which have been part and parcel of the division’s campaign to encourage self-reporting and cooperation, including:
  • a self-report must be made in a timely manner; 
  • there is no imminent threat or likelihood that the CFTC would otherwise learn of the purported wrongdoing; 
  • any cooperation must be full and substantial; 
  • the self-reporting cannot be otherwise mandated or required to be disclosed; 
  • the Division of Enforcement will expect remedial steps to be taken regarding the violation as well as undertakings to avoid similar occurrences in the future; 
  • an industry participant seeking the benefits associated with self-reporting should make contact directly with the Division of Enforcement (although a report to the NFA might suffice in some instances); and 
  • the Division of Enforcement will make it abundantly clear in terms of what it expects in order to be entitled to the self-reporting and cooperation benefits, and will apprise a prospective respondent if it views the party as veering off track. 
Whether or not to self-report and cooperate is the “question of the year,” according to Renato Mariotti, now a partner at Thompson Coburn, and formerly a federal prosecutor in the Securities and Commodities Fraud Section of the U. S. Attorney's Office.

Mariotti, who presented a session on conducting internal investigations at the conference, suggested that industry participants exercise caution when exploring self-reporting options, noting that CFTC’s approach lacks the specificity and mathematical certainty regarding the level of the benefit a respondent could expect in exchange for cooperation. “In a criminal case, I know exactly what type of credit my client will receive in exchange for his cooperation. And that’s important,” Mariotti observed.
While Director McDonald indicated that the division will not commit to specific penalty reduction amounts in exchange for cooperation, he insisted that industry participants who approach the division in connection with the self-reporting/cooperation initiative will be dealt with fairly. He reiterated, “The division will not play a game of ‘gotcha.’”

McDonald remains optimistic. He noted that in his travels and meeting with industry leaders, he continually hears that companies are striving to build “cultures of integrity.” When asked about industry response and feedback to the initiative and his remarks at NYU back in September, he responded, “It’s too early to tell, but the early indications look good.”

Monday, November 06, 2017

Enforcement forum participants discuss whistleblower developments

By Amanda Maine, J.D.

Jane Norberg, chief of the SEC’s Office of the Whistleblower, said that by the end of the 2016 fiscal year, her office had received more than 18,000 tips and expects to see an uptick in the number of tips for fiscal 2017. Norberg was a panelist on recent whistleblower issues at the Securities Docket’s annual enforcement forum.

Whistleblower award for government employee. Norberg was asked about a footnote in a recent whistleblower award order that stated that the award went to a government worker and how this could be reconciled with the prohibition on using one’s public office for private gain. Norberg, while stating that she could not provide confidential details on the award, assured that the government employee in this situation was covered under an exception. A member of the audience familiar with the case also spoke up, stating that the employee in question was not acting in his official capacity.

Circuit split on internal and external reporting. Panelists also discussed the implications of a federal circuit split on whether the Dodd-Frank Act’s whistleblower protections are available only to those who report misconduct to the SEC (Fifth Circuit) or whether they apply to both internal and external whistleblowers (Second and Ninth Circuits). The Supreme Court is set to hear arguments on November 28.

David Kornblau, formerly of the SEC’s Enforcement Division and currently a partner at Covington & Burling, explained that there will be risks for companies either way. He noted that the Chamber of Commerce has filed a brief siding with the Fifth Circuit interpretation, arguing that the more expansive interpretation would increase costs for companies. Kornblau also speculated whether requiring whistleblowers to first report wrongdoing to the SEC would be a disincentive to reporting their concerns within the company.

Norberg said that most whistleblowers are company insiders and that 80 percent of them reported the misconduct internally. If employees think they won’t be able to make a claim under the expanded Dodd-Frank whistleblower provisions without first reporting to the SEC, the likelihood of people reporting externally rather than internally will go up, she advised.

Phillips & Cohen partner Erika A. Kelton, who has extensive experience representing whistleblowers, said there needs to be a shift in corporate culture where employees are rewarded for reporting misconduct. Some companies may need to reconsider the structure of their incentive compensation policies to make sure that they are not unintentionally rewarding employees who do not report noncompliance.

Friday, November 03, 2017

No private right to sue FINRA for violations of its own rules

By Rodney F. Tonkovic, J.D.

An Eleventh Circuit panel has affirmed the dismissal of a complaint brought against FINRA for lack of a private right of action. The subject of FINRA disciplinary proceedings brought a number of tort claims against FINRA in a state court. The panel affirmed the district court's conclusion that removal to federal court was proper because a suit against FINRA for violating its own rules arises under the Exchange Act (Turbeville v. Financial Industry Regulatory Authority, November 1, 2017, Tjoflat, G.)

FINRA proceedings. Anthony Turbeville was a registered representative of a FINRA-affiliated broker. In 2009, FINRA filed a complaint alleging that Turbeville fraudulently recommended that elderly, unsophisticated buyers purchase certain collateralized mortgage obligations. A FINRA hearing panel barred Turbeville from association and assessed restitution and adjudication costs against him; FINRA's National Adjudicatory Council later affirmed this decision.

While the appeal to the NAC was still pending, Turbeville filed a defamation suit in Florida state court against the investors who had testified against him during the FINRA proceedings. A FINRA investigation concluded that there was cause to institute another disciplinary proceeding because Turbeville had violated FINRA rules against retaliatory action intended to influence ongoing FINRA proceedings. At the time FINRA issued its Wells notice regarding the investigation, Turbeville was not a member of a FINRA-affiliated firm and no longer worked in the industry. Turbeville disputed the investigator's findings and the Wells notice was removed from his BrokerCheck report.

Turbeville then filed suit against FINRA in the Florida state court, asserting that the investigation of the suit against his former clients exceeded FINRA's authority and jurisdiction under its own rules. He sued for defamation, abuse of process, intentional interference with a prospective advantage, and conspiracy.

District court dismisses. FINRA removed the suit to the federal district court and filed a motion to dismiss. The court determined that Turbeville's suit was a challenge to FINRA's application of its own rules, which were promulgated under the Exchange Act's grant of authority. So, a substantial federal question existed, and Turbeville's motion to remand was denied. The court then dismissed Turbeville's claims, concluding that FINRA had absolute immunity from liability in the exercise of its regulatory functions and that there was no private right of action for damages against FINRA.

Affirmed. The appellate panel affirmed. Removal to federal court was proper, the panel said, because a suit against FINRA for violating its own rules arises under the Exchange Act and thus falls within the Act's grant of exclusive jurisdiction to the federal courts. The panel also confirmed that no private right of action exists for members of self-regulatory organizations to sue the SRO for violating its internal rules.

Regarding the jurisdictional issue, the panel noted that while Turbeville's complaint invoked state tort law, it was on its face a challenge to FINRA's application of its internal rules in exercising its regulatory authority. The complaint's causes of action rested mainly on allegations that FINRA violated its own rules and exceeded its jurisdiction. To address the complaint, the court would necessarily have to interpret FINRA's rules and regulations, which are promulgated according to the Exchange Act's mandates. The interpretation of FINRA's rules, then, unavoidably involves answering federal questions, the panel said.

The panel then concluded that Turbeville's claim was properly dismissed because there is no private right of action for plaintiffs looking to sue an SRO for violations of its own rules. The panel noted that the Exchange Act is silent as to the existence of a private right of action, and the internal appeals and administrative-review processes created by the Exchange Act confirm further that no private right exists. Allowing an action like Turbeville's would, the panel remarked, authorize fifty state courts to supervise FINRA's conduct through the vehicle of state tort law. Ultimately, the panel stated, while the prescribed remedies might not fully assuage the reputational harm claimed by Turbeville, he chose to accept those limitations by affiliating himself with an SRO-governed firm.

The case is No. 16-11083.

Thursday, November 02, 2017

PCAOB official reviews broker-dealer inspection results

By Jacquelyn Lumb

PCAOB Enforcement Director Claudius Modesti reported at the American Law Institute’s recent conference on accountants’ liability that among his group’s priorities is firms that alter work documents and the associated failure to cooperate in board inspections or investigations. The enforcement group also has cross-border concerns that sometimes overlap with improper documentation. He noted that 40 percent of the enforcement cases in 2016 related to non-U.S. audits and the number remains on track in 2017.

Significant cases. Modesti reviewed a number of significant cases, including Deloitte Brazil, which involved a lot of “firsts.” The proceeding resulted in the largest penalty ever imposed by the PCAOB and 14 audit personnel were sanctioned. The board received what Modest characterized as a gift when a person who participated in the document alteration chose to cooperate with the investigation. He noted that the firm did not have a whistleblower line or a policy for reporting misconduct and emphasized the importance of providing such an outlet.

In a proceeding against BDO Spain, the audit personnel had no training in complying with PCAOB audits. “You do not get to do a trial run in the U.S. financial system,” Modesti said. In addition to censures and fines, the firm was required to adopt systems to ensure that it would only take engagements that it could complete with professional competence and to provide training to its personnel.

The PCAOB settled 20 cases in which the respondents admitted the findings. Modesti said the board seeks admissions to address the most egregious cases. When asked about receiving credit for extraordinary cooperation, Modesti said he couldn’t forecast the types of credit the board would give, but he suggested that interested parties discuss what they are willing to do and the staff will try to work with them.

Broker-dealer audits. Peter Bresnan, a senior adviser to the director of enforcement, talked about evolution of the PCAOB’s oversight of the audits of broker-dealers, which came about as a result of the Dodd-Frank Act in 2010. He said the real investor protection angle came when broker-dealer audits were required to conform to PCAOB standards and the SEC enhanced its broker-dealer rules related to customer protection. After the adoption of the revised SEC rules, the PCAOB adopted new attestation and auditing standards.

There have not been any individual reports on broker-dealer inspections, just annual reports summarizing the findings. Bresnan noted that 96 percent of the audit firms inspected under the interim broker-dealer program had deficiencies the first year and the next year it was a bit worse. There are important differences in protecting investors of issuers versus broker-dealers, he noted, so the broker-dealer inspections focus on independence and other investor protection areas.

In the first year of broker-dealer inspections, Bresnan said the enforcement staff applied a relatively light touch with censures, penalties and remedial measures. The next year, the sanctions increased a bit, particularly for firms that were told they could not prepare the financial statements of their broker-dealer clients but did so anyway.

A number of “firsts.” In 2016, two firms self-reported violations and remediated the matters. At the end of last year, the PCAOB brought its first case involving other types of violations including the alteration of documents and violations of the SEC’s financial reporting rules.

On August 2, 2017, the board brought its first action against a global network firm for violations during a broker-dealer audit (In the Matter of PricewaterhouseCoopers LLP, Release No. 105-2017-032). Registered carrying broker-dealer Merrill Lynch, Pierce, Fenner & Smith Incorporated was found to have held billions of dollars of its customers’ securities in accounts with third-party institutions that were subject to liens by the third parties in violation of the SEC’s customer protection rule. PricewaterhouseCoopers (PwC) failed to obtain evidence to support its opinion on whether Merrill’s internal controls over compliance with the customer protection rule were effective and whether supplemental information with respect to compliance with the rule were fairly stated in all material respects in relation to Merrill’s financial statements as a whole. PwC was censured and ordered to pay a $1 million civil money penalty.

Wednesday, November 01, 2017

CME Group to launch bitcoin futures contract amid significant market interest

By Brad Rosen, J.D.

The CME Group announced plans to launch a bitcoin futures contract later in 2017. The new contract will be cash-settled and based on the CME CF Bitcoin Reference Rate (BRR) which serves as a once-a-day reference rate of the U.S. dollar price of bitcoin, according to the CME’s release.

Terry Duffy, CME Group Chairman and Chief Executive Officer, noted, "[g]iven increasing client interest in the evolving cryptocurrency markets, we have decided to introduce a bitcoin futures contract." "As the world's largest regulated FX marketplace, CME Group is the natural home for this new vehicle that will provide investors with transparency, price discovery and risk transfer capabilities," he added.

Since November 2016, CME Group and Crypto Facilities Ltd., have calculated and published the BRR, which aggregates the trade flow of major bitcoin spot exchanges during a calculation window into the U.S. Dollar price of one bitcoin as of 4:00 p.m. London time. The BRR is designed around the IOSCO Principles for Financial Benchmarks. Bitstamp, GDAX, itBit and Kraken are the constituent exchanges that currently contribute the pricing data for calculating the BRR.

CME Group and Crypto Facilities Ltd., also publish the CME CF Bitcoin Real Time Index (BRTI), in an effort to provide price transparency to the spot bitcoin market. The BRTI combines global demand to buy and sell bitcoin into a consolidated order book, and it is intended to reflect a fair, instantaneous U.S. dollar price of bitcoin in a spot price. The BRTI is published in real time and is suitable for marking portfolios, executing intra-day bitcoin transactions and risk management.

The CFTC has also been playing an increasingly prominent role by providing traders, investors and other market participants with information on various hot topics which confront a rapidly evolving virtual currency marketplace. In mid-October 2017, the commission released a guide, A CFTC Primer on Virtual Currencies, which sets forth the CFTC’s role and oversight of virtual currencies, its enforcement authority, as well as identifying the potential risks and unique pitfalls associated with virtual currencies.

In July, 2017, the CFTC granted LedgerX, a New York-based institutional trading and clearing platform for digital currencies, registration as a derivatives clearing organization (DCO), a development described as a historical milestone in the development of derivatives trading. Meanwhile, in the enforcement realm, in September, 2017, the CFTC brought a federal court action in the Southern District of New York for the first time against a Ponzi operator involved in bitcoin related scheme.

Coincident with the CME’s announcement regarding the bitcoin futures launch, the price of bitcoin hit a record topping $6350, a daily increase of over four percent, reaching a market capitalization in excess of $105 billion. Cryptocurrency market capitalization has grown in recent years to $172 billion. The bitcoin spot market has also grown to trade roughly $1.5 billion in notional value each day.

The bitcoin futures contract will be listed on and subject to the rules of the CME. The particular launch date will depend on relevant regulatory review periods.

Tuesday, October 31, 2017

Commissioner Piwowar addresses SEC’s ‘new path’ at market structure conference

By Joanne Cursinella, J.D.

The SEC is proceeding down a new path, and the current direction is such a complete change from the past few years that it can be called “SEC 180,” SEC Commissioner Michael S. Piwowar commented in his keynote address at the Unity Market Structure conference sponsored by FINRA and Columbia University. Market structure is not merely a subject we take up in response to a market event, a congressional inquiry, or a non-fiction book on high-frequency trading, he said. Rather, it sits at the core of the Commission’s mission, he claimed.

Current market strategy. From July 2010 through December 2016, the Commission’s policy agenda was determined by what Piwowar called “the Dodd-Frank Death March.” The mandates the Act placed on the SEC used up “an incredible amount of the agency’s resources and ultimately prevented the agency from working on important discretionary policy initiatives,” while simultaneously the SEC “also sunk a large portion of its scarce enforcement resources into a so-called ‘broken windows’ approach.”

But now, instead of mechanically plodding through implementation of the Dodd-Frank Act, the SEC is taking a fresh look at how the agency can better facilitate capital formation, the oft-forgotten third part of the SEC’s mission, Piwowar said. Issues surrounding market structure will be an integral part of new discussions. Comparing market structure to “the gears that turn the clock of the capital markets,” he said the details of market structure matter because they ensure the smooth operation of our complex financial markets.

In addition, market structure issues will take priority in the broader discussions around the financial markets, as evidenced by the Department of the Treasury’s recent report on capital markets, Piwowar claimed. That report contained an impressive level of focus and detail on market structure issues and provides strong support for the Commission’s ongoing efforts, he said.

Recent developments. The Commission’s Equity Market Structure Advisory Committee (EMSAC) has submitted practical recommendations to the SEC for consideration on issues such as market quality, execution quality and order handling disclosures, and an access fee pilot. Piwowar has been pleased both by the level of engagement of EMSAC members and by their thoughtful recommendations.

In addition to EMSAC’s work, Piwowar pointed to other positive advances in the equity market structure space. For example, the Commission approved a pilot to study the impact of wider tick sizes for small cap stocks. That pilot began in October 2016 and continues to collect data to help the Commission, academics, and market participants analyze the impact of these changes, Piwowar said. .Another recent market structure change worth noting, he said, is the shortening of the settlement cycle from T+3 to T+2, a change that was a long time coming. Piwowar commend the industry for their work to prepare for this change and drive it to completion.

Next phase. Piwowar is optimistic that the next phase of the Commission’s oversight of the securities markets will be known for its positive impact on market structure. First, there must be a review of market structure which must begin by exploring how the markets have evolved and become what they are today, he said. It must ask how competitive forces and regulation have combined to create our existing market structure and whether that result was intended or even desirable. The review should also try to uncover the incentives that drive the decisions of market participants. Only once the incentives at play have been identified can we make choices about which alternatives may best facilitate competition on choice, pricing, and innovation, Piwowar claimed.

The Commission must not conduct market structure work in a vacuum, though. It is vital that we receive the views and observations of the public to inform the market structure debate, Piwowar said. EMSAC has been a major driver of public dialogue on these issues, and we must continue to allow our review of market structure to benefit from vigorous public discourse, he added.

In addition to the EMSAC, Chairman Jay Clayton has announced his intention to form a new Fixed Income Market Structure Advisory Committee (FIMSAC), Piwowar noted. He fully expects the FIMSAC members to engage in difficult conversations, tackle challenging issues, and generate constructive recommendations for the Commission to consider. Of particular importance to Piwowar in the fixed income market structure space are areas like pre-trade transparency and the appropriate role of regulators vis-à-vis market-based solutions in providing that transparency. He hopes that the FIMSAC will provide insights into such issues.

Monday, October 30, 2017

SEC Enforcement co-director touts new retail investor, cybersecurity initiatives

By Amanda Maine, J.D.

Stephanie Avakian, co-director of the SEC’s Division of Enforcement, outlined the Division’s recent initiatives on protecting retail investors and strengthening the SEC’s cybersecurity efforts. Avakian’s remarks were delivered at a keynote speech at the Securities Docket’s annual enforcement forum in Washington, D.C.

Priorities identified. Avakian stressed that although the SEC, under the direction of new Chairman Jay Clayton, has made retail investors and cybersecurity priorities for the Division, the SEC’s broad mission of protecting investors has not changed. Avakian emphatically rejected the notion that the prioritization of these issues would direct resources away from other Commission enforcement activities, such as combatting financial fraud and policing Wall Street.

Retail investors. Chairman Clayton has emphasized the importance of the “Main Street investor.” In particular, the Commission should always take into account the long-term interests of “Mr. and Mrs. 401(k).” The SEC’s priorities under Clayton reflect this belief with the Enforcement Division establishing a Retail Strategy Task Force. The task force will employ the use of data analytics and technology to help detect widespread misconduct, Avakian said. While the task force does not have dedicated staff to conduct investigations themselves, it will refer possible targets for investigation across the Division, according to Avakian.

Avakian gave some examples about what kind of conduct would be targeted under the prioritization of misconduct against retail investors. The SEC will look at firms that charge undisclosed fees to investors, as well as practices such as “churning” that generate large commissions to advisers at the expense of investors. The SEC will also scrutinize incidents where financial industry professionals recommend risky investment vehicles to investors, such as those saving for retirement, for whom such investments are unsuitable.

She also stressed that enforcement alone is not enough to protect retail investors. The task force will be engaged in investor outreach as well, Avakian said.

Cybersecurity. Chairman Clayton issued a statement on cybersecurity last month emphasizing the importance of evaluating cyber risks. The cybersecurity issue hit closer to home with the Commission’s revelation of a cybersecurity breach of its EDGAR system last year. In the wake of cybersecurity incidents, Avakian outlined three main issues that the Division hopes to tackle with respect to cybersecurity. The first is targeting those engaging in activity such as hacking to gain an unlawful market advantage. As an example, she cited individuals who, through illegal hacking, obtain material, nonpublic information such as an upcoming merger and trade on that information prior to a public announcement of the transaction.

The Division will also focus on registered entities’ failures to take appropriate steps to ensure system integrity, Avakian said. The SEC has in recent years adopted several regulations aimed at the protection of systems that are risk-based and flexible. The Enforcement Division also coordinates with the Office of Compliance Inspections and Examinations (OCIE) regarding cyber concerns. OCIE has issued a Risk Alert detailing observations gained from inspections of SEC-registered broker-dealers, investment advisers, and investment companies about their cybersecurity preparedness.

A third issue regarding cybersecurity, according to Avakian, involves cyber-related disclosure failure. While the SEC has not yet brought a case on this issue, Avakian indicated that the increased scrutiny on cybersecurity could result in actions against companies that do not disclose cyber-related issues. She pointed to the Division of Corporation Finance’s guidance from 2011 about “meaningful and timely disclosures” about cybersecurity concerns. However, she assured that the Division has no intention of second-guessing decisions regarding cybersecurity disclosures if they are reasonable and well-informed.

Technology issues will be a priority for the Division, Akavian said. These include blockchain technology and initial coin offerings (ICOs). The SEC issued a statement in July indicating that ICOs can be treated like securities under the federal securities laws. Blockchain technology and ICOs have gained attention recently, and it makes sense to consolidate enforcement efforts to evaluate them, Avakian said.

Friday, October 27, 2017

Adviser’s fiduciary duty applies to annuity switches, NASAA contends

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

NASAA has urged the Illinois Supreme Court to reverse a lower court’s ruling and hold that heightened fiduciary duties applied to an investment adviser’s conduct in switching clients between indexed annuities. NASAA contends that the antifraud provisions of the Illinois Securities Law apply to the entire scope of an adviser’s relationship with his clients. Carving out an exception to those fiduciary obligations and holding advisers to a lower suitability standard when selling indexed annuities would erode important investor protections, according to NASAA (Van Dyke v. White, October 25, 2017).

Annuity switches. The appellee, Richard Van Dyke, had effected 33 indexed annuity transactions for 21 advisory clients, for which he earned approximately $183,000 in commissions. The transactions, which Van Dyke had solicited, involved the liquidation of the clients’ previous indexed annuity contracts and the purchase of new annuities with higher fees.

The Illinois Secretary of State then commenced an administrative enforcement action against Van Dyke, finding that his conduct in “switching” the annuity contracts breached his fiduciary duty to his clients under provisions of the Illinois Securities Law. The Secretary of State revoked Van Dyke’s adviser registration, permanently prohibited Van Dyke from offering or selling securities in Illinois, and imposed a fine of approximately $330,000. The Illinois Court of Appeals, however, reversed the administrative order, concluding that the annuities at issue were not "securities" under Illinois law and that the adviser’s conduct was not fraudulent.

Avoiding regulatory arbitrage and perverse incentives. NASAA urged the Illinois Supreme Court to look to federal precedent for guidance when interpreting Section 12(J) of the Illinois Securities Law, which makes it a violation for investment advisers to engage in fraudulent conduct. NASAA urged the state high court to join other state supreme courts in following the U.S. Supreme Court’s decision in SEC v. Capital Gains Research Bureau (U.S. 1963). These state court decisions have held that advisers (whether registered or not) owe their clients fiduciary duties under state securities laws.

NASAA acknowledged that the law is unclear concerning the applicable standard of care when a conflict exists between a dually-registered adviser’s competing duties under Illinois’ insurance and securities laws. NASAA believes, however, that the court should apply the higher standard—in this case the fiduciary duty standard. The investment adviser designation holds special meaning to investors apart from any other license the adviser may hold, NASAA stated. Accordingly, this special meaning requires that those who have earned the right to call themselves investment advisers are held to a higher standard in dealing with their clients.

A regulatory regime that holds advisers to the higher fiduciary duty standard when selling securities, but a lower suitability standard when selling annuities incentivizes investment advisers to skew their recommendations towards insurance products such as annuities, thereby facilitating a system of regulatory arbitrage, NASAA argued. If the lower court’s decision were allowed to stand, NASAA believes that investment advisers in Illinois will play off of the bifurcated system created by the ruling in an attempt to avoid breach of fiduciary claims when those claims are related to the purchase or sale of an insurance product.

The case is No. 121452.

Thursday, October 26, 2017

FinTech opportunities and challenges mapped out at FIA Expo in Chicago

By Brad Rosen, J.D.

In his address before the 33rd FIA Futures & Options Expo held in Chicago, Illinois, CFTC Chief Innovation Officer, Daniel Gorfine, provided updates for LabCFTC initiative launched earlier in the year, surveyed the fintech landscape including significant areas of innovation, and identified related opportunities and challenges, as well as the evolving role of the CFTC.

After his prepared remarks, Gorfine led a related panel discussion on the boom in FinTech startups which was comprised of a cross-section of industry experts representing incubators, venture capital investors and public sector entities. The session, titled "The Geography of Innovation: Which City Is Best Positioned to Support Capital Markets Fintech? A Transatlantic Debate," explored the relative merits of some the world’s leading innovation hubs.

LabCFTC. Established in May 2017, LabCFTC is the cornerstone of the commission’s FinTech efforts and initiatives. Its mission is to cultivate a forward thinking regulatory culture, lead the agency to become more accessible to emerging technology innovators, discover ways to harness and benefit from FinTech innovation; and become more responsive to rapidly changing markets.

At time of the launch of LabCFTC, Chairman J. Christopher Giancarlo noted, “the CFTC can no longer be an analog regulator in an increasingly digital world. LabCFTC is intended to help us bridge the gap from where we are today to where we need to be—Twenty-First century regulation for 21st century digital markets.” Gorfine also serves as the director of Lab CFTC.

Gorfine noted that since the LabCFTC was launched, staff has met with innovators in New York City and Washington, D.C., and plans on further meetings in Chicago. Silicon Valley, Austin, and Boston in the near future. In total, Gorfine’s group has met with over 100 entities ranging from startup to established financial institutions to leading technology companies.

LabCFTC has also released its first primer titled A CFTC Primer on Virtual Currencies, a publication which seeks to provide an overview of the cryptocurrency markets, identify the CFTC’s role educate the public regarding an potential risks associated with these instruments. Gorfine noted other primers are in the offing.

FinTech landscape. As a definitional matter Gorfine observed that, “FinTech innovation today covers broad swaths of financial activity—ranging from efforts to disrupt components of retail banking and wealth management to aspects of capital markets, trading, and market infrastructure.” On the retail-facing side, he noted these activities include payments, lending, crowdfunding, virtual currencies, and robo-advisory. On the capital markets side, Gorfine has witnessed significant activity involving distributed ledger and blockchain technologies, smart contracts; artificial intelligence and machine learning; algorithmic trading; cloud computing, and digital identity.

Gorfine is optimistic regarding the future stating “[t]here is little doubt that FinTech innovation has the potential to—and already is—benefitting the American public. Whether through increased efficiency, lower transaction costs, or improved access, our society stands to improve based on such innovation.” Nonetheless, at the same time he remains cautious, observing “[t]hese innovations are not without their risks, however. The disintermediation of traditional actors or their functions will strain rules written for a different, analog era. Proper recognition of new actors in markets will necessitate regulatory consideration, though always with the careful balance of not prematurely stemming innovation.”

Wednesday, October 25, 2017

Commission approves PCAOB’s revised audit report standards, CAMs

By Mark S. Nelson, J.D.

The Commission approved a set of changes proposed by the Public Company Accounting Oversight Board to make the auditor’s report more accessible to investors and other consumers of firms’ financial statements. The amended PCAOB standards replace some existing provisions and create new ones, while also explaining their application to emerging growth companies. Portions of the new standards unrelated to critical audit matters (CAMs) would be effective for companies with fiscal years ending December 15, 2017. Implementation of provisions dealing with CAMs would be phased: large accelerated filers with fiscal years ending June 30, 2019; all other companies with fiscal years ending December 15, 2020.

CAMs. Under the new standards, the auditor’s report would have to either communicate any CAMs in the current period audit or state that there were no CAMs. An item is a CAM if it arose from an audit of a company’s financials and was communicated (or was required to be communicated) to the company’s audit committee and the item is material and involves subject matter that is “especially challenging” to document. Auditors would use their judgement about CAMs, but in conjunction with other factors which require an auditor to explain “why” and “how” something became a CAM.

The revised standards also require disclosure of the year in which an auditor began consecutively working for a company. Auditors must include a statement that they are subject to the requirements about independence. The audit report also must be addressed to a company’s shareholders and directors.

SEC Chairman Jay Clayton said he “strongly support[s]” the goals of the PCAOB’s new standards, but he also warned of the potential for boilerplate communications and litigation. “I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships—with Main Street investors ending up in a worse position than they were before,” said Clayton.

Commissioner Kara Stein emphasized the benefits to investors. “The new auditor’s report should provide investors with more meaningful information about the audit, including significant estimates and judgments, significant unusual transactions, and other areas of risk at a company,” said Stein. Commissioner Michael Piwowar praised the SEC staff for its work in completing the approval, but also observed that “[i]t is of the utmost importance that such communications be well tailored and effective.”

Tuesday, October 24, 2017

Industry, academics weigh in on ethics, diversity, future of Dodd-Frank

By Amy Leisinger, J.D.

Social responsibility, board diversity, and ethical issues facing boards have become increasing pressing issues in corporate governance, according to panelists at a conference hosted by Loyola University School of Law’s Institute for Investor Protection. Shareholders expect more from companies than just growth and dividends, but increased focus on these issues and general corporate behavior could serve to achieve both social and financial goals simultaneously, they explained. Many related Dodd-Frank requirements remain up the air as the Trump Administration and Congress explore potential changes, but the panelists agreed that federal and state regulators will continue to step up efforts to support investor protection and boards can play an important role in the process.

Social responsibility. Loyola’s own Seth Green noted that business are spending billions of dollars on corporate social responsibility activities, increasing participation in sustainable investments, and enhancing environmental, social, and governance criteria. According to Green, companies are embracing social good and going beyond compliance and typical corporate governance standards to meet societal expectations and employees’ desires to make an impact and create social value throughout their careers. By intertwining social responsibility with actual business activities and making long-term investments in addressing social and environmental concerns, corporations can create value and increase growth, particularly in light of increasing consumer interest in sustainability, he said.

Ultimately, companies exist for benefit shareholders, and boards may not want to incidentally benefit shareholders primarily to help others, he explained. However, the industry is seeing an increasing competitive advantage to “doing good,” and, arguably, long-term benefits accruing to shareholders far in the future can be justified under the business judgment rule, Green said. To support the feasibility of socially responsible business, some states have adopted Low-Profit Limited Liability Corporation (L3C) structures, a new kind of organization that combines the financial and liability advantages of a traditional LLC with the social benefits of a non-profit. These entities require a primary purpose to further charitable, educational, or social goals with financial gains as a secondary consideration, he explained.

Ethics and board diversity. Many take issue with the increasing corporate focus on social and ethical concerns by arguing that the companies must be run for the benefit of shareholders, but Loyola Professor Steven Ramirez noted that management profits the most from corporate operations, not shareholders. Shareholders do not benefit from corporate misconduct, and, during the financial crisis, the industry saw a breakdown in accountability, according to Ramirez. Ethical outcomes are material to shareholders, and corporations should disclose what the firm is doing, he said. Holding management accountable and requiring disclosure of ethical structures while acclimating to shareholder demands for socially and ethically sound activities would lead to market-based ethicality and enhanced performance, he opined.