Wednesday, February 10, 2016

GAO: SEC’s Priorities Have Changed Since Climate Change Disclosure Guidance

By Amanda Maine, J.D.

The Government Accountability Office issued a report on how companies disclose climate-related supply chain risks in SEC filings and through other channels. The report determined that the SEC has taken some action to determine if investors need additional information on climate-related risks, but noted that the agency’s plans have evolved since it issued climate-related disclosure guidance in 2010. The report follows up on a request from 34 legislators for an update on the SEC’s efforts to implement the guidance.

Broad categories of disclosure. The SEC’s guidance identified four broad categories of climate change risks and examples of how they could trigger disclosure rules. The first category, legislation and regulation, could include increasing costs faced by companies from improving facilities to reduce emissions to comply with regulatory limits. The second category, international accords, includes the impact of international regulations such as the European Union Emissions Trading System.

The third category, indirect consequences of regulation or business trends, might include a decreased demand for goods that produce a significant number of greenhouse emissions. The final category, physical impacts, would include the impact of severe weather that could cause property damage or disruptions to operations, as well as the impact of weather on major customers or suppliers.

Climate-related disclosure. To identify climate-related supply chain risks which companies disclosed in their SEC filings, the GAO examined EDGAR filings and interviewed SEC staff, as well as reviewed studies by non-governmental organizations. The report found that the SEC does consider climate-related supply chain risks during its routine monitoring activities, including the review of a company’s initial registration, periodic filing reviews, and selective reviews of transactional filings.

The report noted that climate change disclosure advocate organization Ceres has reported that between 2010 and 2013, the SEC sent climate change-related comment letters to 23 companies, 17 of which were sent the year the guidance was issued. According to the SEC staff, the Division of Enforcement has not filed any actions relating to climate disclosure issues.

The report also examined how companies provide climate-related supply chain risk information through channels outside the SEC, including to nongovernmental organizations, on company websites, and in response to reporting requirements in other countries.

Some action taken, but priorities have changed. The SEC’s guidance identified three specific actions it planned to take to determine whether investors need additional information on climate-related risks. The first planned action, monitoring the impact of the guidance as part of its ongoing disclosure review program, has been carried out, the report states. The Division of Corporation Finance studied the issue of climate-related disclosure in 2012 and in 2014 in response to direction from the Senate Appropriations Committee.

The other action items described in the guidance are 1) holding a public roundtable on climate-related disclosure and 2) discussing the issue with the SEC’s Investor Advisory Committee. The SEC has not acted on these items, and the SEC staff is not aware of any current plans to take action on these items, according to the report. The report notes that, at the time the guidance was issued, Congress was considering legislation to establish a cap-and-trade program for greenhouse gas emissions. This legislation was not enacted.

In addition, the report notes that the SEC’s priorities have changed since the guidance was issued. Statutory mandates under the Dodd-Frank Act of 2010 and the JOBS Act of 2012 required an incredible amount of rulemaking by the SEC. The report also advised that the issue of climate change disclosure has not risen to the level of importance of other issues that have arisen in the intervening time, in particular developments and rulemaking under the Dodd-Frank Act.

The report states that the SEC generally agreed with the GAO’s findings.

Tuesday, February 09, 2016

SEC Stands Up for Whistleblower Rule in Anti-Retaliation Appeal

By Amy Leisinger, J.D.

The SEC has filed an amicus brief urging the Sixth Circuit to defer to its rulemaking protecting employees from retaliation under the Dodd-Frank Act’s whistleblower provision regardless of whether they reported information to the SEC. According to the agency, the Act’s anti-retaliation provision is ambiguous as to whether it covers someone who did not report misconduct to the Commission and failure uphold the rule could deny Dodd-Frank protections to whistleblowers who report potential violations to other entities before reporting to the SEC (Verble v. Morgan Stanley Smith Barney LLC, February 4, 2016).

District court action. A former Morgan Stanley employee alleged that he was fired after his colleagues suspected he was acting as a confidential FBI source. He filed a complaint in the Eastern District of Tennessee for retaliation, but the court dismissed his Sarbanes-Oxley anti-retaliation claim and his False Claims Act allegations because the employee failed to meet prerequisite conditions. The court also dismissed the employee’s Dodd-Frank anti-retaliation claim, finding the Fifth Circuit’s reasoning in Asadi v. G.E. Energy (USA), L.L.C. persuasive and concluding in its opinion (covered in the Securities Regulation Daily Wrap Up for December 9, 2015) that the Dodd-Frank provision only protects whistleblowers who report misconduct to the SEC, unlike the SEC’s broader rule that does not require reporting to the Commission to qualify as a whistleblower.

SEC support of its rule. The SEC argues that the Dodd-Frank Act is ambiguous in part because, although the defined term “whistleblower” means an individual who reports wrongdoing to the SEC, one of the protected categories of reporting seems to include internal reporting. Because of this ambiguity, under Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., the agency states that the court should defer to the SEC’s rule as long as it is a reasonable interpretation of the statute. The SEC contends that there is tension between the statute’s broad description of protected whistleblowing activity and its narrow definition of “whistleblower.” “Surely Congress could have been more explicit and more direct if it in fact intended to protect only those disclosures that involve securities law violations, and only if the employee has made a separate disclosure to the Commission,” the Commission notes. To use the narrow definition of “whistleblower” renders the broader provision nearly superfluous, in the SEC’s view, because it would only provide protection if the employer were unaware that the employee had already reported to the Commission and would not have any “appreciable effect” in deterring employers from taking adverse action.

The agency also argues that a failure to defer to the rule could arbitrarily deny protection to individuals who first report misconduct to the Department of Justice or to self-regulatory organizations (SROs). The SEC points out that the Dodd-Frank provision directs the Commission to pay an informant an award based on the monetary sanctions collected in a “related action,” which includes a judicial or administrative action brought by the DOJ, federal banking regulators, and SROs. The anti-retaliation protections are generally coextensive with the award provision, the agency argues, and there is no basis to believe that Congress had intended for “disparate treatment based purely on the happenstance of which agency the individual reported to first.” In addition, according to the agency, endorsing Asadi would deny recourse to an individual making a covered disclosure to an SRO who is fired before being able to make a similar report to the SEC.

Further defending its rulemaking, the agency also stresses the importance of internal company reporting in deterring, detecting, and stopping unlawful conduct that may harm investors. It argues that its rulemaking implementing Dodd-Frank’s monetary award provisions was carefully calibrated not to disincentivize employees from reporting internally, and the agency likewise clarified the statute’s anti-retaliation prohibition to provide support for internal reporting and protect employees regardless of reporting to the Commission.

If the rule is invalidated, authority to pursue enforcement actions against employers that retaliate against individuals who report internally would be “substantially weakened,” and the court should defer to the SEC’s rule and interpretation, the agency concluded.

The case is No. 15-6397.

Monday, February 08, 2016

Bebo Asks Justices to Take Case on SEC In-House Courts

By Mark S. Nelson, J.D.

Laurie Bebo will give the Supreme Court another chance to take up a case disputing the SEC’s in-house enforcement apparatus by arguing in a certiorari petition that the Seventh Circuit misapplied the high court’s jurisdictional test in ruling she could not challenge the constitutionality of the SEC’s administrative law judges in a federal district court. The justices are still considering a similar petition filed last year by a different SEC respondent, while the Second, Fourth, and Eleventh circuits mull cases like Bebo’s. The Commission will hear Bebo’s administrative appeal later this year (Bebo v. SEC, February 3, 2016).

Seventh Circuit amiss? Bebo’s petition to the high court is not the first time that parties in similar cases have criticized the Seventh Circuit’s opinion for what it supposedly did not do—look at all three Thunder Basin factors more holistically. A series of Supreme Court opinions (Free Enterprise; Elgin; Thunder Basin; McNary) developed a rubric for evaluating when a federal district court can hear claims related to an administrative proceeding where the agency’s governing statute requires a final agency decision to be appealed to a federal appellate court.

Lawyers for Bebo told the court it should hear her case because the Seventh Circuit skipped a step in this analysis by ignoring the text, structure, and purpose of Exchange Act Section 25 and instead jumped straight to the Thunder Basin factors: (1) no meaningful judicial review; (2) claims wholly collateral to the administrative charges; and (3) claims outside the agency’s expertise. When the appeals panel got to this stage, said Bebo, it inaptly focused on whether Bebo would be denied meaningful judicial review (the court said no), despite noting that her claims may be wholly collateral to the ALJ proceeding and could lie beyond the SEC’s expertise.

Although a recent D.C. Circuit decision, on its face, would appear to go against Bebo because the court found no district court jurisdiction for claims similar to, yet not identical to Bebo’s, Bebo nevertheless pressed the case as an example of how the Seventh Circuit got the jurisdictional analysis wrong. In Jarkesy, the D.C. Circuit noted the Seventh Circuit’s almost singular focus on the meaningful judicial review factor, but went on to say that it views the Thunder Basin factors as “guideposts for a holistic analysis” and declined to state if that one factor could bar district court jurisdiction.

Bebo also spotlights the Seventh Circuit’s focus on the fact that the Commission had begun an administrative proceeding against her before she sued the SEC in federal district court. Bebo said this raises the specter that district court jurisdiction in these types of cases turns on whether an administrative respondent filed a federal lawsuit before the agency started its own proceeding.

Circuit split in principle. The Supreme Court’s rules emphasize the highly discretionary nature of the court’s docket and the several ways the justices might be persuaded to hear a case, including the mainstay argument that a case is compelling because two federal circuit courts have entered conflicting decisions on the same important matter. Bebo argues that a “conflict in principle” exists between decisions in the Second and Seventh Circuits.

Bebo leans heavily on the Second Circuit’s Touche Ross & Co decision in which that court said a challenge to the SEC’s authority to discipline accountants could be heard in federal district court because there was no need to develop a factual record requiring agency expertise. Bebo also noted that the district court in that case had jurisdiction even though the administrative proceeding was in progress.

Moreover, Bebo argued that the Supreme Court has asserted its power to interpret laws ever since the justices decided Marbury v. Madison nearly 213 years ago. According to Bebo, the ALJ issue is one of national importance that should be decided by the court, not the SEC.

The other petition. A petition filed last November by Gordon Pierce also seeks to get the SEC ALJ issue before the Supreme Court, albeit from a different procedural standpoint. The SEC twice charged Pierce in separate orders instituting proceedings: the first OIP resulted in a final decision ordering him to disgorge $2 million; a second OIP handled by a different ALJ produced a final decision that Pierce appealed (and lost) in the D.C. Circuit. Pierce would have the Supreme Court decide if the SEC’s ALJ’s run afoul of the Constitution and whether he can raise this issue for the first time in a petition for rehearing en banc.

Intervening events twice offered Pierce hope that he might upset the SEC’s decisions against him. First, Pierce asked the Commission to vacate the decision from the first OIP and for the appeals court to rehear its decision denying his petition for review of the second OIP after a judge in the Northern District of Georgia halted an SEC proceeding. The D.C. Circuit refused to hear Pierce’s case anew, but the Commission has yet to rule on Pierce’s amended bid to vacate the decisions from both OIPs. Since then, the SEC has issued several opinions backing its ALJs in the face of constitutional challenges (See, Timbervest; Raymond J. Lucia Companies).

A generalized objection to the SEC’s in-house court is that the agency’s rules of practice impose an accelerated and circumscribed process without the trappings of federal courts’ more extensive procedure and evidence rules. For many SEC administrative respondents, these worries became urgent after the Dodd-Frank Act granted the Commission authority to impose new types of penalties in in-house proceedings.

The Commission recently proposed to ease some of the burdens on respondents and to create an electronic filing system for administrative cases. But a bill sponsored by Scott Garrett (R-NJ) (H.R. 3798) would go even further by giving respondents a new path to federal court.

The case is No. 15-997.

Friday, February 05, 2016

SEC Should Require Gender Pay Discrepancy Disclosure, Adviser Says

By John Filar Atwood

Pay equity is an indicator of a well-managed, well-governed company, according to investment adviser Pax Ellevate Management, which has asked the SEC to require public companies to disclose gender pay ratios every year. If the Commission does not adopt the requirement, the adviser asked that it at least provide guidance to companies regarding voluntary reporting on pay equity to their investors.

Pax Ellevate is the adviser to Pax Ellevate Global Women’s Index Fund, and is chaired by Sally Krawcheck, the former CFO of Citigroup who also held management positions at BofA Merrill Lynch and Smith Barney. She co-authored Pax Ellevate’s rulemaking petition, in which the adviser noted that the U.S. has the widest male-female pay gap among the 38 countries surveyed in the International Labor Organization’s 2014-2015 wage report.

Material risk. Pax Ellevate views pay inequality as a material risk to investors that leaves companies vulnerable to litigation, regulatory and reputational problems. Conversely, pay equity can be a driver of greater gender diversity in corporate leadership, the adviser noted, and research studies have correlated gender diversity with superior financial performance over the long term.

Pay discrimination can be costly, the adviser said, observing that there are currently 1,880 wage enforcement actions related to gender in the U.S. Most are settled out of court but still require payment of the settlement amount over and above the time and expense of defending the lawsuit, the adviser said.

Signs of trouble. Disclosure is important, in Pax Ellevate’s opinion, because careful investors often look for signs of trouble before problems arise. In order for investors to see signs of trouble, the data must be publicly available. In addition, the adviser believes that wage disparities by gender continue to exist, in part, because of the secrecy that surrounds compensation at many public companies.

In its petition, the adviser noted that the pay disparity issue dovetails with two other hot topics in the corporate governance area—gender diversity on boards of directors and the disparity between executive pay and the median compensation at companies. On the first issue, the SEC has issued guidance under Regulation S-K requiring disclosure of whether, and if so how, a nominating committee considers diversity in identifying nominees for director. The pay ratio issue was addressed in the Dodd-Frank Act and a subsequent rule adopted by the SEC.

While neither the new pay ratio rule nor Regulation S-K specifically addresses gender pay disparity, Pax Ellevate said, the logic behind them is the same. They both address the fact that companies that discriminate against any class of employees, or allow large pay disparities to exist among classes of employees, bear increased regulatory, litigation, and reputational risk.

The adviser also argued that the materiality of gender pay ratios falls within the definition of materiality set forth in Staff Accounting Bulletin No. 99, which deems a matter material if a reasonable person would consider it important. Pay equity is an increasingly important indicator of a company’s ability to attract, retain, and develop a first-class workforce, the adviser stated. Reasonable investors would consider the information important, it added, so it should be disclosed.

Logical next step. Pax Ellevate pointed out that the new pay ratio rule already requires companies to collect the data that would be needed to report on gender pay ratios, which would alleviate any burden associated with additional data collection. Reporting pay ratios by gender is the natural next step in providing investors with a more complete picture of how companies are managing compensation issues, the adviser concluded.

Thursday, February 04, 2016

SEC Study: NYSE Trading Suspension Resulted in Migration to Other Exchanges

By Amanda Maine, J.D.

The SEC issued a research paper analyzing the movement of trading following the NYSE’s suspension of trading for over three hours in July 2015. The paper was published on the SEC’s equity market structure website.

The trading suspension, which the NYSE ordered on July 8, 2015, and which lasted between 11:32 a.m. and 3:10 p.m., stemmed from a technical issue related to a software release. The SEC’s paper details the impact of the trading suspension on trading volumes, market share, spreads, and market depth.

The paper notes that, as would be expected, traders migrated to other exchanges, in particular Nasdaq, during the suspension of trading. The paper also states that the data suggests that the trading suspension had the greatest impact on smaller and less actively trading NYSE stock spreads. Large cap stocks were most responsible for the declining average inside dollar depth of stocks listed on the NYSE, while small cap stocks showed a depth increase.

At a media briefing, SEC staff advised that the data is consistent with the prevailing narrative that U.S. equity markets are resilient in the face of an outage of one of its national exchanges. The staff also advised that the report contained no broad conclusions and that its findings could not be extrapolated to other events.

The paper is based solely on publicly available information, particularly the consolidated and exchange market data feeds accessed through the SEC’s Market Information Data Analytics System (MIDAS) system.

Wednesday, February 03, 2016

House Passes Bill to Expand Accredited Investor Definition

By Mark S. Nelson, J.D.

The House has once again begun a new year by moving forward on a few securities bills, including one that would broaden the definition of accredited investor. Two other bills that add to the SEC’s responsibilities also will go to the Senate. A press release issued by House Financial Services Committee Chairman Jeb Hensarling (R-Tex) said the securities bills will help to grow the U.S. economy.

The Fair Investment Opportunities for Professional Experts Act (H.R. 2187), sponsored by Rep. David Schweikert (R-Az), would revise the Securities Act’s definition of “accredited investor” to add registered brokers and investment advisers, and to include persons who have professional knowledge of a particular investment based on their demonstrable education or experience. Other revisions track language in Rule 501 of Regulation D but, in the case of net worth, would require an adjustment for inflation every five years. The bill passed the House on a recorded vote of 347-8, after having been reported out of the FSC by a vote of 54-2.

Under a bill offered by Rep. John Carney (D-Del), the SEC Small Business Advocate Act of 2016 (H.R. 3784), the SEC would need to establish the Office of the Advocate for Small Business Capital Formation to report to the Commission on the treatment of small businesses by the agency and SROs, to identify regulations in need of change, and to identify problems that hinder access to capital by small businesses, but especially for minority- and women-owned businesses. The bill, which also would create a related advisory committee, sailed through the FSC and passed the House by voice vote.

A final securities bill, the Small Business Capital Formation Enhancement Act (H.R. 4168), as with the accredited investor bill, required a recorded vote that resulted in passage by a margin of 390-1. Representative Bruce Poliquin’s (R-Me) bill would alter the Small Business Investment Incentive Act of 1980 to require the Commission to review and promptly issue a public statement on the findings of the government-business forum on capital formation. The SEC also would have to disclose any action it plans to take based on those findings.

The Carney bill, H.R. 3784, also would make a technical amendment to the Small Business Investment Incentive Act to allow the Commission to act through the Office of the Advocate for Small Business Capital Formation. The new SEC office would consult with the proposed advisory committee. These revisions would work in tandem with Rep. Poliquin’s bill.

Tuesday, February 02, 2016

Order of No Restitution in Commodities Fraud Was Within Court’s Discretion

By Lene Powell, J.D.

The First Circuit dealt disappointment to both sides in a CFTC enforcement action, ruling that a federal district court correctly ruled that an individual had committed commodity pool fraud and failed to register as a commodity pool operator, but did not have to pay restitution. The CFTC did not show that the district court had abused its discretion in declining to order restitution (CFTC v. JBW Capital, LLC, January 29, 2016, Lynch, S.).

Commodity pool fraud. Without registering with the CFTC, John B. Wilson and his company JBW Capital solicited over $2 million from 25 family members and acquaintances and used the funds to trade commodity futures. The trades did not go well, and Wilson issued false account statements to conceal the losses. The scheme eventually collapsed. In the CFTC’s enforcement action, the district court granted summary judgment to the CFTC, finding that Wilson had committed commodity pool fraud under Commodity Exchange Act Sections 4b(a)(1) (general fraud) and 4o(1) (fraud by CPOs and commodity trading advisors). The court ordered a civil monetary penalty, but not restitution. Both sides appealed.

The First Circuit agreed with the district court’s fraud findings. Wilson made numerous false and misleading statements, and the scienter element for “willful” behavior in the commodities fraud context can be met by a showing of “reckless” conduct, without reaching whether Wilson made the statements “knowingly.” That Wilson also lost some of his own money on the trades was irrelevant. The statements were material because there was a substantial likelihood that a reasonable investor would have considered information about the fund’s net asset value and the recovery plan important to his or her investing decisions. The CFTC did not have to show that the investors relied on Wilson’s statements, because reliance is not an element of Section 4b(a)(1).

Failure to register. The First Circuit also agreed with the district court’s ruling that Wilson had failed to register as a CPO, as required by CEA Section 4m(1). Wilson did not dispute that he was required to register, but claimed he had relied on the advice of counsel that he did not need to register. CPO registration is a strict liability offense and has no “state of mind” element, said the First Circuit. Whether or not he believed he was required to register was irrelevant.

Because Wilson was a CPO, he was also liable for fraud specific to CPOs under CEA Section 4o(1).

No restitution. The First Circuit first clarified that restitution includes total losses suffered by the victims, while disgorgement is limited to "the amount with interest by which the defendant profited from his wrongdoing."

Despite the district court’s less than precise language, the circuit court was satisfied that the lower court declined to order restitution because the CFTC did not adequately show that restitution was appropriate, not because it believed it lacked the authority to order restitution. In its original decision, the district court said it decided not to order restitution because the CFTC did not present evidence on the amount of retained profits or ill-gotten gains. In its denial of the CFTC’s motion for reconsideration, the district court clarified that the decision whether to order restitution was within its discretion, and referred to its disagreement with the CFTC as “a difference of opinion.” The district court did not make an error of law, and its choice not to order restitution was not an abuse of discretion, the First Circuit said.

The case is Nos. 14-2173 and 14-2224.

Monday, February 01, 2016

Wolters Kluwer News: Publication Opportunity for Current Law Students

The Wolters Kluwer Legal Scholar program, in its third year, allows current law students to compete for the chance to have their work published in a Wolters Kluwer publication. Wolters Kluwer will accept submissions through Friday, April 1, 2016.

One submission per category may be submitted by any student currently enrolled in an ABA-accredited law school. Categories for submission are:

  • Health law (including Medicare, Medicaid, life sciences, and health reform)
  • Cybersecurity (including banking and financial privacy, securities, health care, and insurance)
  • Products liability and consumer safety
  • Employment law (including wage/hour, labor, and discrimination)
Depending on the number of entries, one to two winners per category will be selected and published in a Wolters Kluwer publication, to be determined based on the submission’s topic.

Winners will be notified by April 22, 2016. The winning submissions will be featured in a Wolters Kluwer publication the week of April 25, 2016, along with a biographical paragraph about the author.

For for information and full contest rules, visit Legal Scholars.

Decentralization, Transparency Should Dictate Whether a Cryptocurrency Is a Security, Group Says

By Amy Leisinger, J.D.

A research firm has issued a report detailing a framework for regulation of cryptocurrency and related technologies. According to Coin Center, a non-profit research center focused on policy issues facing this ever-evolving industry, some cryptocurrencies should be treated as securities and some should not, based on the application of longstanding Howey test for investment contracts and the underlying policy goals of securities regulation.

Software and operational variables among cryptocurrencies affect their status and potential risks, the group explains, and a governing framework may need to depend on a determination of whether a cryptocurrency resembles a security. Larger, decentralized cryptocurrencies like Bitcoin do not readily fit the definition of a security and do not present risks generally addressed by securities regulation, but smaller and more uniquely designed ones may fit the definition and present risks that can and should be addressed, according to the report.

Howey test application. Under the Supreme Court’s Howey test, an investment contract means a contract or transaction where a person invests money in a common enterprise and is led to expect to profit from the efforts of a third party. While there may be a “provocative argument” that investments in Bitcoin and similar cryptocurrencies fall within the SEC’s jurisdiction, Coin Center states, several variables exist within these types of currencies and others with different software and operational structures. Specifically, the report explains, coin supply and distribution processes and network transaction recording, centralization, and transparency may vary greatly among cryptocurrency types, and the rights of holders and potential profits to developers differ in accordance with individual systems.

Recommendations. To avoid stifling innovation, the report opines, regulators should avoid limiting highly decentralized cryptocurrencies like Bitcoin because they lack general commonality and discernible third parties to be relied on by investors. In addition, sidechained cryptocurrencies connected with Bitcoin and those acquired for use-value or specific rights and privileges do not necessarily involve an expectation of profits.

Likewise, Coin Center continues, cryptocurrencies distributed through competitive mining involve no investment of money or potential loss of a “purchase” and provide limited opportunity for profit to developers. Transparency also plays a crucial role in relation to these particular cryptocurrencies, according to the report, and regulation may be unnecessary in light of the ability of participants to monitor, control, and/or object to potential risks.

However, regulators should take action to protect investors against cryptocurrencies that fit within the Howey test and present increased risks to users, according to Coin Center. Closed-source cryptocurrencies should be regulated because profits may come only from promoter’s hype and may be usurped by the promoter before development is complete, the report states. Further, those with heavily marketed pre-sales and a small mining and developer community should be treated as securities when indications exist that profits come primarily from the efforts of a discrete, profit-motivated group. In addition, cryptocurrencies with permissioned ledgers or a highly centralized group of transaction validators lead to user reliance upon transaction validations and the value of the network is based on faith in that group.

Finally, the report emphasizes that Bitcoin and related cryptocurrencies lacking indications of a security are less likely to pose significant risks, while smaller, less-transparent cryptocurrencies may require additional focus. The proposed framework “will hopefully enable regulators to more easily delineate between these inevitable scams and the legitimate innovations that will improve our lives, ensuring that a few bad apples do not spoil the bunch,” Coin Center concludes.

Friday, January 29, 2016

SEC Orders Canadian Adviser to Return $2.8M to Investors

By Matthew Garza, J.D.

The SEC has ordered a New York investment adviser and its Toronto-based manager to return $2.877 million to investors after finding that the manager lied about the performance of the fund and deviated from the fund’s established strategy by plowing most of investor funds into a single penny stock. The settled administrative order found that the adviser and its Canadian manager violated Securities Act Sec. 17(a), Exchange Act Sec. 10(b), Investment Advisers Act Secs. 206(1), 206(2), and 206(4), as well as Investment Advisers Act Rule 206(4)-8. In addition to reimbursing investors $2.877 million, he agreed to pay a $75,000 penalty and be barred from the securities industry (In the Matter of Peter Kuperman, Release No. 33-10009, January 28, 2016).

QED Management was founded in 2004 by Canadian citizen Peter Kuperman. The fund was established as a pooled investment vehicle and stated that its goal was to provide above-market returns with volatility equal to or less than the market by selecting industries and stocks through the use of a quantitative algorithm. From 2005 through 2008, the manager gathered approximately $1.2 million from a close relative and that relative’s business associates. He claimed to be using 285 varying metrics within the categories of momentum, growth, value, risk, and estimates to select multiple stocks likely to outperform the market. He represented that no more than 20 percent of the fund’s assets would be invested in a single security, and no more than 5 percent in an illiquid security.

Losses begin to mount. In 2009, the fund performed miserably, losing 79 percent in the first quarter. The manager instead reported higher returns by replacing the actual investments with hypothetical returns that would have been achieved if he had applied the fund’s strategy correctly. From 2010 to 2013, he gathered $2.2 million more from investors. In 2010, according to the Commission, the manager met two Canadian penny stock promotors with a record of securities fraud and agreed to invest in a shell company they were promoting after conducting no due diligence. He eventually sank $1.4 million into the illiquid stock and experienced heavy losses.

“Investment advisers must be completely candid when disclosing two key features that investors rely upon when making investment decisions: investment strategy and historical performance. This settlement enables investors in the QED Benchmark LP hedge fund to receive full monetary relief for losses suffered when they were misled on both fronts,” said Andrew Calamari, Director of the SEC’s New York Regional Office.

The release is No. 33-10009.

Thursday, January 28, 2016

Claim for Feeder Fund's Losses Is Derivative, Not Direct

By Anne Sherry, J.D.

An investor in a feeder fund could only bring a derivative claim, not a direct claim, against the master fund's general partners. The Delaware Supreme Court held that the investor failed to meet both parts of the Tooley test, which determines whether a claim is direct or derivative based on who suffered the alleged harm and who would benefit from any recovery. The case will proceed before the Eleventh Circuit, which certified the question on the direct/derivative divide (Culverhouse v. Paulson & Co. Inc., January 26, 2016, Seitz, C.).

The Eleventh Circuit asked whether an investor in a feeder fund has standing to bring a direct claim against the master fund’s general partners for losses incurred by the feeder fund. In Anglo American Security Fund, L.P. v. S.R. Global International Fund, L.P. (Del. Ch. 2003), the chancery court held that claims brought by former limited partners of a hedge fund against the fund and its general partner and auditor were direct. Although the analysis in Anglo American appeared consistent with the analytical framework laid out six months later in Tooley v. Donaldson, Lufkin & Jenrette, Inc. (Del. Sup. Ct. 2004), the appeals court noted that the Southern District of New York doubts whether Anglo American remains good law after Tooley.

Anglo American distinguished. The supreme court did not clear up the debate over Anglo American's precedential value. Instead, it distinguished its facts from those of the feeder-fund case. The limited partners in Anglo American were direct investors who had a direct relationship with the investment fund and its manager. By contrast, the feeder fund investors chose not to invest directly with the master fund and had a legal relationship with the feeder fund alone.

Corporate form. The court would not disregard the separateness of the feeder and master funds simply because the feeder fund is a pass-through entity that does not issue transferrable shares. Ignoring the funds' respective governing agreements would upset the contractual expectations of the funds' investors and managers, as well as call into question the same type of agreements in the established feeder/master fund investment model.

Tooley. Applying the facts to the certification request, the court found that the investor failed to meet both parts of Tooley. Because the investor chose not to invest directly in the master fund, neither the alleged harm from the master fund's losses nor the benefit of any recovery would flow to the feeder fund's investors in the first instance.

The case is No. 349, 2015.

Wednesday, January 27, 2016

SEC Approves, Seeks Comments on Amended FINRA Funding Portal Rules

By Mark S. Nelson, J.D.

Securities-based crowdfunding is getting closer to reality now that the Commission has approved rule changes proposed by FINRA to oversee funding portals. The approval was done on an accelerated basis, but the public will still be able to comment on the rule change, as modified by an amendment submitted by FINRA, within 21 days after the release appears in the Federal Register (Release No. 34-76970, January 22, 2016).

Regulation Crowdfunding, adopted by the Commission last October, will enable securities-based crowdfunding through broker-dealers and a new entity called a funding portal. These crowdfunding intermediaries are required to become members of a national securities association, for which the only option currently available is FINRA.

FINRA proposed a number of rules and forms to ensure that it has the tools needed to police funding portal activities, including rules for new member applications, funding portal conduct, investigations and sanctions, and arbitration and mediation. FINRA also proposed a new rule providing for notice to FINRA of its broker-dealer members’ engagement in transactions and other relationships with funding portals. The amendment seeks to align the meaning of “associated person” in the funding portal context to its meaning regarding broker-dealer members, but otherwise makes technical revisions.

According to the Commission’s order, the few commenters on FINRA’s proposal were generally supportive, although some of them raised issues about timing and other aspects of the proposed rules. The Commission said FINRA adequately dealt with these concerns and noted the broker-dealer regulator had spent lots of time developing its funding portal rules.

Final Regulation Crowdfunding is effective May 16, 2016, but some of the provisions for funding portals will be effective January 29, 2016, in order to allow time for these entities to prepare for the effectiveness of the entire regulation.

The release is No. 34-76970.

Tuesday, January 26, 2016

NASAA Seeks to Close Gaps in M&A Broker Proposals

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

NASAA has expressed concern that regulatory gaps created by FINRA’s proposed rules for merger and acquisition (M&A) brokers could negatively impact firms doing business in that space. In a letter commenting on FINRA’s proposed Capital Acquisition Broker Rules, NASAA called for cooperation between the SEC, FINRA, and NASAA in order to better harmonize FINRA’s proposal with NASAA’s own model rule and state registration requirements.

In January 2014, the staff of the SEC’s Division of Trading and Markets granted no-action relief from the broker-dealer registration requirements of the Exchange Act to certain brokers who facilitate mergers, acquisitions, business sales, and business combinations. In September 2015, NASAA adopted a model rule that would exempt M&A brokers from state registration. In order to aid uniformity, the provisions of NASAA’s model rule were designed to parallel language contained in the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2015 (S. 1010) pending before Congress.

CAB proposal. NASAA observed that under FINRA’s proposal, firms that qualify for the SEC’s no-action relief would be permitted to register with FINRA as a capital acquisition broker (CAB) or, if already a FINRA member, switch their registration status to CAB registration. Once qualified as a CAB, firms would be subject to a particular set of FINRA rules aimed at regulating these firms’ business models. FINRA's approach may be problematic, however, because the no-action letter underpinning FINRA’s proposal differs from both the proposed federal legislation in S. 1010 and the NASAA model rule. As a result, there could be regulatory gaps in light of differences between the definitions of M&A brokers and the application of other provisions.

For example, NASAA explained, there are differences related to the scope and breadth of the statutory disqualification provisions contained in the SEC’s no-action letter and the NASAA model rule. Consequently, a firm may qualify in certain instances for both the no-action relief with the SEC and CAB registration with FINRA, but may still require full registration as a broker-dealer at the state level. Moreover, FINRA membership in any capacity, CAB or otherwise, could trigger state registration requirements. In NASAA’s view, these issues need further examination and analysis in order to achieve the goal of reducing the regulatory burdens on M&A brokers.

Monday, January 25, 2016

Massad Touts Recent Achievements, Discusses Early Priorities for 2016

By Joanne Cursinella, J.D

CFTC Chairman Timothy Massad presented his views on the Commission’s recent accomplishments and outlined some priorities for this year at the 2016 winter meeting of the ABA Derivatives and Futures Law Committee. Among the things he discussed were efforts in cybersecurity, registration of swap execution facilities, improving data registration, and margin requirements for uncleared swaps.

Cybersecurity. The Commission has proposed rules designed to make sure that the private companies, which run the core infrastructure under our jurisdiction—exchanges, clearinghouses, swap execution facilities and swap data repositories—are doing adequate evaluation of cybersecurity risks and testing of their own, Massad said. The proposals identify five types of testing as critical to a sound system safeguards program: vulnerability testing, penetration testing, controls testing, security incident response plan testing, and enterprise-wide assessment of technology risk. Such efforts are vital to mitigate risk and preserve the ability to detect, contain, respond to, and recover from a cyberattack or other type of operational problem, he added. The Commission hopes to finalize these rules before the end of the year after considering any feedback.

SEF trading. Massad announced the permanent registrations of 18 swap execution facilities (SEFs), which he called an “important step” in the progress toward the implementation of a new framework for trading on regulated platforms mandated by Dodd-Frank and the G-20 leaders. “It is bringing greater transparency, better price information and greater integrity to the process,” he added. The five SEFs that remain temporarily registered are being reviewed by the CFTC.

Massad pointed to research indicating that reforms put in place are working. Citing a recent report by the staff at the Bank of England noting that SEF trading has brought improved trading conditions, finding significantly lower transaction costs, and better liquidity. He said that notwithstanding the industry complaints about geographical fragmentation, they reported that this did not compromise liquidity.

Margin requirements for uncleared swaps. The Commission has adopted a strong final rule setting margin requirements for uncleared swaps. It is designed to reduce the risk that a default of a large financial entity would lead to further defaults by its counterparties, given the interconnectedness of our financial system, Massad said. The rule requires swap dealers and major swap participants to post and collect margin with financial entities with whom they have significant exposures. Further, it requires initial margin, which is designed to protect against potential future loss on a default, as well as variation margin, which serves as mark-to-market protection. The rule is “practically the same” as those adopted by the prudential regulators and very similar to the international standards as well as the rules that he expects Europe and Japan to adopt very soon.

Proposed rule on automated trading. Automated trading has brought many benefits to market participants –such as more efficient execution, lower spreads, and greater transparency, Massad said. But its extensive use also raises important policy and supervisory questions and concerns, he added. The Commission’s recent proposal focuses on minimizing the potential for disruptions or other operational problems that can be caused by automated trading and builds upon the steps the Commission and the exchanges have already taken on this front. The proposal requires pre-trade risk controls that facilitate emergency intervention in the case of malfunctioning algorithms. But it leaves the parameters of their limits to participants, since they should determine them, he said. The Commission hopes to finalize this rule in 2016.

Improving data reporting. Reporting of swaps transaction data was a key goal of the reforms agreed to by the leaders of the G-20 nations and one of the most important components of the Dodd-Frank Act, Massad said, and there is more work to do. In just one of the many CFTC actions, in December the staff proposed technical specifications for the reporting of 120 priority data elements. Public input is being requested on this and Massad hopes these rule changes can be finalized soon.

De minimis threshold. When the CFTC and the SEC wrote the “de minimis exception” it was without the benefit of much data. But we now have substantial information that we can use to have a discussion about what is the appropriate level at which to set the de minimis threshold, Massad said. The staff’s preliminary report, however, did not make a recommendation as to what the level should be. It instead explored the issues and invited public comment on the data, the methodology, and the issues discussed. Now, Massad said, the staff will begin the process of carefully studying the feedback received, producing a final report and making a decision on what, if any, action to take.

Priorities. Cybersecurity and automated trading will remain priorities, Massad said. There are efforts both domestically and internationally to look at a range of issues to make sure clearinghouses are strong and safe, including recovery planning if there is a problem at a CCP. Other priories include finalizing the proposed rule on the cross-border application of the recently adopted rules on margin for uncleared swaps, and reproposing rules related to capital requirements for swap dealers and major swap participants. Massad will also ask the Commission to consider a number of changes to enhance SEF trading and participation. It is his intention to formalize through rulemaking proposals a number of “no action” letters and guidance the Commission has provided. Massad said they will consider some additional issues, as well, such as whether the Commission should play a greater role in the “made available to trade” determination process.

Friday, January 22, 2016

Court Closes Book on AbbVie Inspection Demand

By Anne Sherry, J.D.

The Delaware Supreme Court will not require drug maker AbbVie Inc. to turn its books and records over to an institutional investor. The pension fund plaintiff wanted to know whether director misconduct may have led to a failed corporate inversion deal that stuck shareholders with a $1.635 billion break-up fee. A majority of the court approved of the Chancery Court’s reliance on AbbVie’s exculpatory provision, but two justices expressed concerns about making exculpation a threshold issue in a Section 220 inspection case (Southeastern Pennsylvania Transportation Authority v. AbbVie, Inc., January 20, 2016, Strine, L.).

The proposed inversion deal with Shire plc, a Jersey-based biopharmaceutical company, would have allowed AbbVie to reduce its effective tax rate to approximately 13 percent by changing its country of residence. In September 2014, Treasury and the IRS announced their intent to close the inversion loophole, thwarting the deal. SEPTA demanded inspection of documents to inspect possible breaches of fiduciary duties and other corporate wrongdoing, but the Chancery Court shut down the request, holding that the plaintiff had no proper purpose for the information it sought.

Exculpation and inspection. The trial court’s decision interwove DGCL Section 220, which empowers shareholders to demand inspection of books and records, with Section 102(b)(7), which allows companies to exculpate directors from monetary liability for duty-of-care breaches. Because AbbVie had such an exculpatory provision, the inspection would only have a proper purpose if SEPTA could show a credible basis from which the court could infer a breach of the duty of loyalty.

On appeal, SEPTA protested that this holding heightened the threshold burden for parties seeking inspection, requiring them in effect to establish evidence of a non-exculpated breach. At oral argument, Justice Valihura pointed out that Section 102(b)(7) forecloses money damages only, not claims seeking equitable relief. By relying on this provision, she posed to AbbVie’s counsel, aren’t you asking the court to decide upfront that no equitable relief could be fashioned?

The high court ruling indicated that all five justices would affirm the Chancery Court’s decision because SEPTA did not meet its burden of showing a credible basis to conclude that even a breach of the duty of care had been committed. Justices Valihura and Holland would have stopped there, but the other three justices affirmed on the basis of the entire Chancery Court decision, including the 102(b)(7) facets. The Chancery Court’s reliance on 102(b)(7) was proper, in the majority’s view, because that was the primary ground on which AbbVie defended the case and the parties framed the issues.

The case is No. 239, 2015.

Thursday, January 21, 2016

Six Companies Must Allow Vote on Proposal Favoring Share Repurchases Over Dividends

By John Filar Atwood

Six companies have been notified by the SEC that they will have to include a shareholder proposal in their proxy materials that asks the companies’ boards to adopt a payout policy that gives preference to share repurchases over dividends as a means to return capital to shareholders. The companies argued that the proposal may be omitted on several different grounds under 1934 Act Rule 14a-8, but the staff of the Division of Corporation Finance rejected them all.

The identical proposal to the six companies was submitted by the same proponent, who believes that adopting a general payout policy that gives preference to share repurchases would enhance long-term value creation for the companies. Specifically, he noted that the distribution of a dividend may automatically trigger a tax liability for some shareholders, while share repurchases do not necessarily trigger that tax liability and give a shareholder the flexibility to choose when the tax liability is incurred.

Long-term value. The proponent also cited surveys of company executives finding that executives would pass up some positive net present value investment projects before cutting dividends. Creating long-term value is of paramount importance, the proponent argued, and repurchases have the advantage of not creating an incentive to forgo long-term value enhancing projects to preserve a certain dividend level.

The proponent acknowledged that some shareholders may be concerned that share repurchases could be used to prop up metrics that factor into executive compensation. He believes that any such concern should not interfere with the choice of an optimal payout mechanism because compensation packages can be designed so that metrics are adjusted to account for share repurchases.

Six companies. In their letters to the Commission, the six companies—Reynolds American Inc., Praxair, Inc., PPG Industries, Inc., ITT Corp., Minerals Technologies Inc. and Barnes Group Inc.—most often cited Rule 14a-8(i)(7) and (i)(13) as the basis for excluding the proposal. Paragraph (i)(7) is the ordinary business exclusion, and paragraph (i)(13) allows the omission of proposals that relate to a specific amount of cash or dividends.

The paragraph (i)(13) argument centered on the notion that by requiring share repurchases instead of cash dividends, the proposal was setting the amount of cash dividends at zero. In trying to convince the staff that the proposal deals with ordinary business operations, the companies stated that implementing a share repurchase program is reserved for management and the board of directors, and that the decision to repurchase shares, pay dividends, or both is an integral part of managing the company’s overall capital structure. The SEC staff was not persuaded by either argument.

The other bases that the staff decided would not enable the companies to omit the proposal included paragraphs (i)(1)—not a proper subject for action by shareholders, (i)(3)—the proposal is vague and indefinite, and (i)(10)—the company has already substantially implemented the proposal.

Wednesday, January 20, 2016

Amnesty International Wants Cobalt Included in Conflict Minerals Disclosure

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

Noting that cobalt currently falls outside the scope of the SEC's conflict minerals rule, two human rights organizations have called for mandatory human rights due diligence and disclosure concerning the cobalt used by multinational companies such as Apple and Samsung in their portable electronic devices and other consumer products. A joint report issued by Amnesty International and African Resources Watch (Afrewatch) documents the hazardous conditions faced by child miners of cobalt in the Democratic Republic of the Congo (DRC), which produces more than half of the world’s total cobalt supply. Despite these abuses, however, no country legally requires companies to publicly report on their cobalt supply chain.

“The abuses in mines remain out of sight and out of mind because in today’s global marketplace consumers have no idea about the conditions at the mine, factory, and assembly line,” said Afrewatch Executive Director Emmanuel Umpula in a news release. “We found that traders are buying cobalt without asking questions about how and where it was mined.”

Artisanal mining in the DRC. The report observes that “artisanal” mining of cobalt became a source of livelihood for many people in the DRC when the largest state-owned mining company collapsed in the 1990s. These artisanal miners, who often end up working in unauthorized areas or trespassing on land controlled by industrial mining companies, mine by hand using basic tools to dig out rocks from tunnels deep underground. Artisanal miners include children as young as seven who scavenge for rocks containing cobalt in the discarded by-products of industrial mines, and who wash and sort the ore before it is sold.

The report takes the DRC government to task for failing to put in place and enforce adequate safeguards for artisanal miners. Miners face the risk of long-term health damage, working long hours with cobalt without protective equipment, and face a high risk of fatal accidents. According to UNICEF, approximately 40,000 children worked in mines across southern DRC in 2014, many of them mining cobalt. Children interviewed by Amnesty International stated that they worked for up to 12 hours a day in the mines, carrying heavy loads to earn between one and two dollars a day. The children said that they had to work, since their parents lacked formal employment and could not afford school fees.

Public reporting of cobalt supply chains. According to the report, companies along the cobalt supply chain are failing to conduct adequate human rights due diligence. The report notes that many companies contacted by researchers for the report denied sourcing cobalt from the DRC, but did not explain whom they sourced cobalt from. Considering the predominance of cobalt from the DRC in the global market, the report states that it is “unlikely” that all these large multinational companies are not sourcing any cobalt from the DRC.

In addition, many of these companies using cobalt in their downstream products are U.S.-listed companies which are already subject to reporting requirements for conflict minerals under the Dodd-Frank Act. Section 1502 of the Dodd-Frank Act requires these companies to check whether tin, tantalum, tungsten and gold used in their products are contributing to the funding of armed groups or fuelling human rights abuses in the DRC or surrounding countries.

Accordingly, the report recommends that countries where multinational companies trading in cobalt are headquartered should legally require those companies to: (1) conduct human rights due diligence on their mineral supply chains; and (2) report publicly on their due diligence policies and practices in accordance with international standards. The report also asks those countries to provide international cooperation and assistance to the government of the DRC to support its efforts to extend labor protections to all artisanal miners and remove children from the worst forms of child labor. Further, the report calls upon companies themselves to take remedial action, in cooperation with other relevant actors, if human rights abuses have occurred at any point in a supply chain relationship.

Tuesday, January 19, 2016

State Law, Due Process Prevent Dismissal With Prejudice ‘As to the World’

By Amy Leisinger, J.D.

The Delaware Chancery Court refused to dismiss an action against directors with prejudice as to all potential plaintiffs. The court found that, while Delaware law requires dismissal with prejudice as to the specific plaintiff, it does not contemplate or permit with-prejudice dismissal “as to the world,” as suggested by the defendants. Even if the law of derivative actions allowed for this type of outcome, the court stated, due process principles would prevent the court from imposing a judgment from binding any party other than the named plaintiff (In re EZCORP, Inc. Consulting Agreement Derivative Litigation, January 15, 2016, Laster, J.).

Dismissal efforts. Following a multiple filings in an action alleging violations of fiduciary duty and corporate waste by directors of EZCORP, Inc., the Delaware Supreme Court issued its Cornerstone decision holding that, to survive a motion to dismiss, a plaintiff seeking only monetary damages must plead non-exculpated claims against directors protected by exculpatory charter provisions. The plaintiff recognized that the complaint did not plead any non-exculpated claim and proposed to dismiss the complaint without prejudice. The defendants refused the proposal and instead argued for a dismissal with prejudice also binding on all other potential plaintiffs.

Substantive law. The court noted that Delaware law requires dismissal with prejudice as to a named plaintiff in an action dismissed following the filing of an answering brief, unless the plaintiff can show good cause for dismissal without prejudice. The shareholder showed no good cause to deviate from this general rule, but the plain language of the rule itself dictates with-prejudice dismissal as to only the shareholder, not “as to the world” in the manner urged by the defendants, the court found. Further, this type of broad bar would prohibit any shareholder, and even EZCORP itself, from litigating against the directors, regardless of what evidence may be discovered in the future.

Due process. The court further found that, even if substantive law allowed for with-prejudice dismissal to potential future plaintiffs, due process principles would prevent such a determination. With minor exceptions, “[a] person who is not a party to an action is not bound by the judgment in that action,” the court stated. To allow dismissal with prejudice as to any potential plaintiff would bar future actions before a plaintiff even had the authority to sue, and due process forecloses the judgment in this case from binding any party other than the named plaintiff, the court concluded.

The case is No. 9962-VCL.

Monday, January 18, 2016

Dr. King's Universal Appeal Will Never Fade

[In commemoration of Martin Luther King, Jr. Day, we republish a post by the late Jim Hamilton from January 18, 2010, honoring Dr. King and his legacy.]

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

In our age of sometimes bitter legislative partisanship, let us pause to remember the lessons of Dr. Martin Luther King, who we honor today. Dr. King appealed to our common humanity and a shared sense of social justice. I am fairly certain that, if he had seen our recent financial disaster, Dr. King would have decried the short-term risk taking and excessive bonuses. In his letter from a Birmingham jail, Dr. King wrote that, lamentably, it is an historical fact that privileged groups seldom give up their privileges voluntarily. Individuals may see the moral light and voluntarily give up their unjust posture; but, groups tend to be more immoral than individuals. Amen to that, Dr. King, and thank you for liberating the South from itself. I recently read that no international company, be it Toyota, BMW, Mercedes, or Siemens, would have ever come to and had a large presence in the segregated South. I believe that is a true statement.

Friday, January 15, 2016

Baker Hostetler Attorneys Identify and Discuss Key 2015 SEC Enforcement Actions

Marc D. Powers, Andrew W. Reich, and David M. McMillan of Baker & Hostetler LLP identify and examine the top enforcement highlights of 2015 and what to expect in 2016 in their recent article, “Top 10 SEC Enforcement Highlights of 2015.” At the top of the list is an analysis of the series of actions that highlight the growing debate over whether SEC administrative proceedings are unconstitutional, increasing SEC enforcement concerns in the digital age, and other key actions. The entire article is available here.