Thursday, October 08, 2015

SEC Allows Briefing on Constitutional Challenge to ALJ Appointment

By Anne Sherry, J.D.

The SEC is allowing a pair of KPMG accountants to brief whether the administrative law judge who sanctioned them was appointed in violation of the Constitution. The ALJ temporarily barred the respondents from practicing after finding they engaged in improper professional conduct during KPMG’s 2008 audit of the holding company for TierOne Bank. Commissioners Gallagher and Piwowar recently said that the courts, not the agency, should decide this constitutional question (In the Matter of Aesoph, Release No. 34-76097, October 7, 2015).

Background. The initial decision found that, while the auditors correctly identified TierOne’s loan losses as presenting a fraud risk and a significant risk of material misstatement, the actual audit test work was inadequate considering the associated audit risk and materiality. The administrative law judge barred the engagement partner for one year and the senior manager for six months. The engagement partner had raised due process objections, which the ALJ addressed, but did not include a challenge under the Appointments Clause.

Supplemental briefing. The Appointments Clause challenge came on October 6, when the respondents filed a joint motion to submit supplemental briefing addressing the validity of the ALJ’s appointment. The SEC granted that request, allowing the auditors to file briefs limited to the issues of whether the SEC’s administrative law judges are “inferior officers” and whether their manner of appointment violates the Appointments Clause. The respondents’ brief is due October 21; the Enforcement Division has until November 2 to respond.

Question gains momentum. There has long been a perception that administrative proceedings give the SEC a home-field advantage, but the backlash intensified recently with a growing number of respondents fighting the constitutional battle, as described in a recent white paper. Last month, the SEC announced two proposals that would amend its rules of practice to slow down administrative proceedings and modernize procedures.

The release is No. 34-76097.

Wednesday, October 07, 2015

Director’s Close Ties to Interested Party Rendered Demand Futile

By Anne Sherry, J.D.

Shareholders are excused from demanding that directors of a public company investigate allegations of wrongdoing surrounding a transaction between the public company and a private company. Reversing the Delaware Chancery Court, the Delaware Supreme Court found that the plaintiffs did more than allege a close personal relationship between a director and an interested party; they also pleaded facts suggesting the director’s employment depended on that party. Taken as a whole rather than in isolation, these facts supported an inference that a majority of the board was not disinterested (Delaware County Employees Retirement Fund v. Sanchez, October 2, 2015, Strine, L.).

Parties and background. Sanchez Resources, LLC is wholly owned by the family of A.R. Sanchez, Jr.; the family also owns 16 percent of the public company, Sanchez Energy Corporation, which depends on the LLC for its management services. The plaintiffs, shareholders of the public corporation, sued the board derivatively over a transaction that allegedly involved a gross overpayment by the public company to the benefit of the private. The chancery court, “in a thorough and careful opinion,” held that the plaintiffs had insufficiently pleaded that demand was excused under either prong of Aronson.

Directors. The parties agreed that two of the five public company board members were not disinterested, so the outcome turned on whether there was a doubt as to the independence of another director. The complaint challenged the independence of a director with close ties to the private-company chairman. First, the complaint pleaded that the two men had been close friends for over 50 years. Second, it pleaded that the public-company director owed his job and his personal wealth to his connection with the chairman.

Totality of the pleading. The chancery court carefully analyzed Aronson and justified its decision that demand was not excused, but on de novo review, the Supreme Court came to a different decision. Instead of considering the personal relationship and business relationship between the men as separate issues as the chancery court had done, the high court considered the pleaded facts in context, drawing inferences in the plaintiffs’ favor. In a holistic and plaintiff-friendly view of the relationship, the plaintiffs created a reasonable doubt as to the director’s independence.

The case is No. 702, 2014.

Tuesday, October 06, 2015

SEC Plans to Vote on Final Resource Extraction Disclosure Rule by June 2016

By John Filar Atwood

The SEC has complied with a court order to file an expedited schedule for promulgating final rules regarding disclosure of payments by resource extraction issuers, saying that it will vote on the rule on or before June 27, 2016. The Commission advised the court that this is an extremely demanding timeframe given the agency’s current workload and the divisive nature of the resource extraction disclosure issue (Oxfam America, Inc. v. SEC, October 2, 2015).

Background. The Dodd-Frank Act requires the SEC to issue rules requiring resource extraction issuers to include in an annual report information relating to any payment made by the issuer, a subsidiary of the issuer, or an entity under the control of the issuer, to a foreign government or the U.S. government for the purpose of the commercial development of oil, natural gas, or minerals. Under Exchange Act Section 13(q), a resource extraction issuer must provide, in an interactive date format, information about the type and total amount of the payments made for each project related to the commercial development of oil, natural gas, or minerals, and the type and total amount of payments made to each government.

The Commission adopted final rules in August 2012, but those rules were later vacated by the U.S. District Court for the District of Columbia. The D.C. district court remanded the issue to the SEC to fix any defective sections of the rules. The Commission did not propose any revisions, so Oxfam America, Inc. filed a lawsuit seeking to compel the SEC to take action on the rules.

Court order. In early September, the U.S. District Court for the District of Massachusetts ordered the SEC to file an expedited schedule for promulgating final rules regarding disclosure of payments by resource extraction issuers. The Commission was given 30 days in which to file the expedited schedule.

In the notice of proposed expedited rulemaking, the SEC advised the court that it proposes to hold a vote on the adoption of a final rule within 270 days of the notice. In order to meet that schedule, the Commission expects to hold a vote on a proposed rule before the end of 2015, and to afford members of the public a comment period of at least 45 days.

Challenging timetable. The Commission informed the court that 270 days would be a demanding rulemaking schedule under any circumstances, but is particularly challenging now because of the unprecedented volume of enforcement, rulemaking, and other regulatory work in which the agency is engaged. The SEC also cautioned that the rulemaking raises a number of policy issues that have caused sharp disagreement among members of the public, which further complicates the task of expediting the rulemaking.

A further complicating factor, according to the SEC, is that the Commission’s composition will likely change to a significant degree before the proposed June 2016 vote. Finally, the SEC advised the court that it may be delayed by unforeseen events such as a government shut-down, relevant international developments, or unexpected legal developments. If any of these occur, the Commission will promptly notify the court and seek an extension of time to complete the rulemaking.

The case is No. 1:14-cv-13648-DJC.

Monday, October 05, 2015

SEC Admits Two ALJs Not Appointed by Commissioners

By Mark S. Nelson, J.D.

The SEC said in its answer to Barbara Duka’s suit disputing the constitutional validity of the agency’s enforcement regime that two of its administrative law judges were not appointed directly by the commissioners. A federal judge previously halted the SEC’s in-house proceeding against Duka, but the agency’s appeal of that decision is still pending in the Second Circuit (Duka v. SEC, October 2, 2015).

The SEC’s answer to Duka’s amended complaint acknowledged that ALJs James Grimes and Cameron Elliot were not hired by the commissioners themselves. The answer also concedes that the SEC’s ALJs enjoy more than one layer of tenure protection. But the SEC said other aspects of Duka’s claims were too conclusory to merit a reply, or the agency denied the allegations.

In July, the SEC’s Chief ALJ, Brenda Murray, briefly stepped into the Duka administrative proceeding when she assigned a new ALJ. Duka’s in-hosue case was being handled by ALJ Elliot, but the mid-year order removed Elliot and instead appointed Grimes. Chief ALJ Murray gave no explanation for the change. ALJ Grimes cancelled Duka’s hearing that was set to begin in September after a federal judge ordered the SEC to stop the administrative proceeding.

Duka, the ex-Standard & Poor’s Ratings Services executive, is one of a small group of SEC enforcement targets that has taken on the agency in federal court by asserting the SEC’s ALJs are hired through a process that involves another federal agency resulting in the ALJs enjoying too many lawyers of good cause removal. Central to this claim is the assumption that the SEC’s ALJs are inferior officers under Article II of the U.S. Constitution, a conclusion the SEC has disputed in each of the suits against it, and in two recent Commission opinions (Raymond J. Lucia Companies and dissent; Timbervest).

The case is No. 15-cv-357.

Friday, October 02, 2015

Stein Calls for Dramatic Reforms to Bring Transparency to Dark Venues

By Jacquelyn Lumb

In remarks before the Securities Traders Association’s annual market structure conference, Commissioner Kara Stein focused on the need for transparency in today’s markets. Transparency is not just about disclosure, she said, but also about verification. The market is built on trust, confidence, and integrity, she explained, and she called for dramatic reforms to bring more transparency to alternative trading systems, or dark pools.

Call for more transparency. Stein acknowledged that transparency cannot solve all problems, but in her view, it goes a long way toward leveling the playing field and empowering investors. Dark pools have been around for decades, she added, but their presence in the market is growing ever larger and it is not clear that they continue to perform as originally intended. While originally intended to allow trading of large blocks of securities by institutional investors in a way that would help them obtain the best price, Stein said that studies have shown that the average execution size of dark pools in the U.S. has decreased to fewer than 200 shares.

As more trading is routed to dark venues, Stein said that market price discovery may be distorted and conflicts of interest may not be readily apparent. In addition, recent enforcement actions have revealed serious problems in how a number of ATSs operate. She questioned whether these cases are isolated incidences or symptoms of systemic problems. Without improved transparency, there is no way for investors to know, she said.

Stein called on the SEC to adopt reforms to bring more transparency to dark venues. All market participants should be able to understand how they operate, she said, and ATSs should compete on a level playing field where market participants can choose the best trading venue for their purposes. For a start, she said more execution and order data should be publicly available. In Stein’s view, the modernization of the SEC’s disclosure rules for order execution and routing should be priorities and could be implemented fairly quickly.

Consolidated audit trail. Stein also reviewed plans for a consolidated audit trail that will allow the SEC to track every order and trade in the markets. Although the SEC adopted a final rule to mandate the construction of CAT, as it is known, the process has not yet begun, she said. The SEC has largely outsourced the responsibility for CAT, she noted, which has not worked. Stein has advocated for a CAT project manager and for more resources, but has seen little progress.

Stein said that repeated, and not entirely understood, market disruptions undermine market integrity and damage investor confidence. The implementation of CAT and an upgraded MIDAS analytical tool will help modernize the SEC’s oversight of the securities markets, to the benefit of the agency, the markets, and investors, she said.

Stein also suggested that in a world where programming errors are just as damaging to investors as improper sales practices, the regulatory approach has to evolve. Organizational charts should not shield individuals from accountability, she said. So-called technical glitches are typically followed by a series of finger pointing, she explained. Stein raised the idea of licensing certain technical personnel to increase accountability.

Stein said it is time to refocus on the fair and efficient allocation of capital and that transparency would go a long way to restoring confidence in the integrity of the marketplace.

Thursday, October 01, 2015

SEC Settles Proceedings Against High Frequency Trader for Market Structure Rule Violations

By Jacquelyn Lumb

High-frequency trading firm, Latour Trading LLC, has settled SEC charges that it violated the market access rule and Regulation NMS, which resulted in its receipt of executions and exchange rebates that it should not have received and that other market participants might have received were it not for Latour’s violations. Latour, without admitting or denying the findings, agreed to pay a $5 million civil penalty and more than $3 million for the disgorgement of gross trading profits, rebates paid by the exchanges, and prejudgment interest (In the Matter of Latour Trading LLC, Release No. 34-76029, September 30, 2015).

Non-compliant orders. The SEC found that from October 2010 through August 2014, Latour sent approximately 12.6 million orders for more than 4.6 billion shares that did not comply with Regulation NMS. The firm lacked direct and exclusive control over its financial and regulatory risk management controls, as required by the market access rule, and lacked adequate post-trade surveillance tools to detect the non-compliant trades.

Coding error. Latour’s non-compliant intermarket sweep orders were largely the result of a software coding change made by its parent company in 2011 without the firm’s knowledge or approval. The coding change contained an error which affected the software that Latour used to send the orders to the market. Latour also made a number of changes to its routing logic which resulted in its sending some orders that did not comply with Regulation NMS. The firm corrected some of the problems by October 2012, but due to the lack of adequate post-trade surveillance tools, it sent additional non-compliant orders before the remaining issues were resolved in 2014.

Impact on markets. In the news release announcing the settlement, Enforcement Director Andrew Ceresney said that firms such as Latour, which do not have control over their trading systems, can undermine the integrity of the markets by sending millions of orders that violate the SEC’s and the stock exchanges’ rules that promote fair and orderly trading. Robert Cohen, the co-chief in the Division’s market abuse unit, added that market structure violations can have a real, if sometimes subtle, impact on the market. Latour’s actions allowed it to receive executions and rebates that might have gone to other market participants, he said.

The release is No. 34-76029.

Wednesday, September 30, 2015

CFTC Chairman Massad Expects Cybersecurity Proposal, Uncleared Swaps Margin Final Rule by Year End

By Lene Powell, J.D.

In remarks at a derivatives industry conference, CFTC Chairman Timothy Massad discussed issues relating to market infrastructure stability, saying he expects the CFTC to propose risk management and cybersecurity requirements for core infrastructure sometime this fall. Massad also anticipates that the CFTC will finalize a proposed rule on margin for uncleared swaps by the end of the year. In addition, Massad does not believe that derivatives should be exempt from the Supplemental Leverage Ratio but said there are questions as to how customer collateral should be treated for purposes of capital requirements.

Cybersecurity. Mandatory clearing requirements put in place by the Dodd-Frank Act have increased the ability of the CFTC to monitor and mitigate risk, with 75 percent of swap transactions now being cleared, compared to 15 percent in 2007. However, mandatory clearing is not a panacea, and the CFTC is working on measures to enhance system stability. In addition to looking at recovery and resolution planning for clearinghouses, the CFTC is stepping up efforts to protect against cyber threats, as well as technological and operational risk generally, said Massad.

System safeguards are already part of the core principles and regulations for clearinghouses, exchanges, and other institutions. Massad said the CFTC is focusing on these issues in its examinations, to determine if institutions are following good practices and paying enough attention from the board level on down. The CFTC is working on a proposal to make sure that institutions are doing adequate testing of risks and their protective measures against cyberattacks and other technological disruptions. Massad expects that the proposal will incorporate principles-based standards on testing and that it will be issued this fall.

Capital and margin. Massad discussed a number of issues related to capital and margin requirements. First, regarding differences in margin methodologies between the E.U. and U.S. and resulting tension over “equivalence,” Massad noted that the E.U. has granted equivalence to many jurisdictions with margin practices similar to the U.S. Dialogue is continuing, and he hopes that equivalence can be granted soon. 

Also related to clearinghouse resiliency is the issue of the supplemental leverage ratio, which imposes extra capital requirements on the largest banks. One question is whether customer collateral held by a bank should be treated as an asset of the bank, since it cannot be used by the bank. On this point, Massad said one possible solution is that under GAAP, cash will not be treated as an asset of the bank if certain conditions are met, like the bank agreeing to waive any investment income. Another question is how to measure the exposure arising from a clearing member’s guarantee of the customer trade. If the clearinghouse rules require it to use the collateral first, before seeking recourse against the clearing member, should that not be taken into account in deciding how to measure the exposure?

Turning to swap dealers, Massad observed that margin for uncleared swaps is critical because there will always be a large part of the swaps market that is not centrally cleared. A CFTC proposed rule currently under consideration requires swap dealers to post and collect margin on uncleared swaps with one another, and with certain financial counterparties. The CFTC has been working closely with U.S. banking regulators as well as European and Japanese regulators, and the goal is to ensure that the respective rules are similar. Massad said he expects that the CFTC final rule will come out before the end of the year, and will use the same overall threshold as E.U. and Japan for defining material swaps exposure and follow the same implementation schedule. Regulators are continuing to work on requirements for margin models, lists of eligible collateral, and collateral haircuts.

Tuesday, September 29, 2015

SEC Fails in Quest to Compel Former Bank Employees to Disclose Secret Smartphone Passcodes

By Joanne Cursinella, J.D.

The Commission could not compel former bank employees to divulge the secret passcodes they devised for smartphones issued to them by their former bank employer because the codes were the employees’ personal thought processes and not business records that can be compelled over Fifth Amendment objection (SEC v. Huang, September 23, 2015, Kearney, M.).

Background. The employer bank provided the defendants with the smartphones, but the employees were to create the passwords to access them. According to the court, the bank also requested that employees not keep records of these personal passcodes for security reasons. When they left the bank, the former employees returned the smartphones, and the bank gave the phones to the Commission as part of an insider trading investigation of the employees.

The SEC believes that the phones contain information germane to their investigation but cannot access the data without the defendants’ passcodes, so the Commission filed this motion to compel them to relinquish the codes. The SEC unsuccessfully argued that, as former bank data analysts, the defendants are corporate custodians in possession of corporate records, so they cannot assert their Fifth Amendment privilege in refusing to disclose their passcodes. The former employees disagreed with this characterization and claimed that providing the passcodes to their phones is "testimonial" in nature and that compelling them to do so violates the Fifth Amendment.

Former employees prevail. Each party relied on case law to establish its claims, all non-smartphone scenarios involving the interplay between corporate records and encrypted information on computers. The Commission claimed that corporate records cases govern the analysis and that corporate custodians may not invoke the Fifth Amendment to avoid producing corporate records.

But the court found the former employees’ characterization more on point. The court focused not on whether the privilege applies to underlying documents, but on whether the acts of decryption and production were testimonial and found that it was in this case. The SEC is not seeking business records, the court said, but rather the defendants' personal thought processes, so the defendants may properly invoke their Fifth Amendment rights.

No foregone conclusion. The Commission then argued that the "foregone conclusion" doctrine applies to override the former employees’ invocation of the Fifth Amendment privilege. That doctrine states that an act of production is not testimonial if the proponent can show with "reasonable particularity" “at the time it sought to compel the production, it already knew of the materials, thereby making any testimonial aspect a ‘foregone conclusion.’” Once again, the court disagreed. That doctrine applies when the contents are known. Here, the Commission only surmised that there was relevant information on the smartphones and this was insufficient, the court said. Accordingly, the court ordered that the former employees could not be compelled to provide their passcodes.

The case is No. 15-269.

SEC Provides Additional Volcker Rule Guidance

By John Filar Atwood

The SEC staff has advised entities relying on the Volcker Rule that the required annual CEO certification should be submitted no later than March 31, 2016. The staff provided this and other guidance in an update to its responses to frequently asked questions regarding the Commission’s rule under Section 13 of the Bank Holding Company Act (the Volcker Rule).

The staff has been periodically adding to the Volcker Rule FAQ document since June 10, 2014, and the latest update addresses the question of when a banking entity is required to submit the annual CEO certification for prime brokerage transactions. The SEC’s rule provides that a banking entity may enter into any prime brokerage transaction with any covered fund in which a covered fund managed, sponsored, or advised by the banking entity has taken an ownership interest, so long as certain conditions are met, including the submission of a written CEO certification each year.

CEO certification. The staff believes that banking entities that are required to provide the annual CEO certification for prime brokerage transactions as of the end of the conformance period should submit the first CEO certification after the end of the conformance period but no later than March 31, 2016. A banking entity may provide the required annual certification in writing at any time prior to the March 31 deadline, according to the guidance.

The conformance period for investments in, and relationships with, a legacy covered fund currently ends on July 21, 2016. The staff advised that banking entities that engage in prime brokerage transactions with legacy covered funds should submit their first CEO certification by March 31 following the end of the relevant conformance period, but in any case annually within one year of its prior certification. The staff noted that the CEO has a duty to update the certification if the information in the certification materially changes at any time during the year when he or she becomes aware of the material change.

Objective factors. The staff also provided guidance on a second question regarding whether a banking entity’s compliance program for market making-related activities may include objective factors on which a trading desk may rely to determine whether a security is issued by a covered fund. The staff said that for purposes of meeting the final rule’s exemption for market-making, a reasonably designed compliance program for a trading desk engaged in market making-related activity may include objective factors on which the trading desk may rely to determine whether a security is issued by a covered fund.

The staff clarified that objective factors would not be considered part of a reasonably designed compliance program if the banking entity designed or used such objective factors to evade the Volcker Rule and the SEC’s final rule. However, the staff does not believe that it would be reasonable for a trading desk to rely solely on either or both the name of the issuer or the title of the issuer’s securities. These factors alone would not convey sufficient information about the issuer for a trading desk reasonably to determine whether a security is issued by a covered fund, the staff said.

Use of third party. The staff also addressed a related question regarding whether a market maker may meet its compliance program requirements by making use of a shared utility or third party service provider that uses objective factors if the market maker reasonably believes the system of the shared utility or third party service provider will identify whether a security is issued by a covered fund. The staff said that a reasonably designed compliance program for a trading desk engaged in market making-related activity may permit the trading desk to use a shared utility or third party service provider in those circumstances.

The staff noted that whether a compliance program is reasonably designed will depend on the facts and circumstances. A compliance program that is reasonably designed for a trading desk engaged in market making-related activities may not be reasonably designed for other activities conducted by a banking entity. The FAQ guidance only addresses the compliance program for a trading desk engaged in market making-related activity.

The staff advised that a banking entity’s reliance on objective factors, a shared utility or a third party service provider must be subject to independent testing and audit requirements applicable to the banking entity’s compliance program. If independent testing of the compliance program shows that the objective factors used by the banking entity, shared utility or third party service provider are not effective in identifying whether a security is issued by a covered fund, then the banking entity must promptly update its compliance program to remedy those issues, the staff stated. In addition, if at any time the banking entity discovers it holds an ownership interest in a covered fund in violation of the final rule implementing the Volcker Rule, it must promptly dispose of the interest or otherwise conform it to the requirements of the final rule, according to the staff.

Monday, September 28, 2015

Judge Nixes SEC Bid to Hear In-House Case as Eleventh Circuit Mulls ALJ Issue

By Mark S. Nelson, J.D.

The federal judge who has heard most of the recent challenges to the SEC’s in-house courts has denied the agency’s request to stay the preliminary injunction she previously issued halting an administrative proceeding against Laurence Gray and the advisory firm he has led since its founding. The SEC appealed that order to the Eleventh Circuit, but the district court’s latest order still gives the SEC options that include using its in-house courts (Gray Financial Group, Inc. v. SEC, September 24, 2015, May, L.).

Seventh Circuit under microscope. Judge May initially granted Gray Financial a preliminary injunction in August. More recently, the SEC had asked her to stay that injunction while the Eleventh Circuit hears the agency’s appeal. The August injunction was based on Judge May’s conclusion that Gray Financial was likely to win its claim that the administrative law judge in the SEC proceeding was not appointed in compliance with the U.S. Constitution.

As for the SEC’s bid to stay the preliminary injunction, Judge May noted her prior orders in Gray Financial and in two other ALJ cases before her worked against the SEC. But the judge also focused on the Seventh Circuit’s Bebo decision, which held that a Wisconsin district court judge lacked jurisdiction to hear Laurie Bebo’s similar claims about the SEC’s enforcement regime.

According to Judge May, Bebo is distinguishable because of its inapt reliance on the Supreme Court’s Elgin opinion, and because Bebo was already participating in the administrative proceeding. By contrast, Gray Financial sued the SEC before the agency brought administrative charges. The Seventh Circuit’s opinion had explained that some of the SEC ALJ cases looked instead to the Supreme Court’s Free Enterprise decision.

Moreover, Gray Financial could be harmed if it was forced to submit to a likely unconstitutional administrative hearing. Judge May also noted that the Eleventh Circuit refused the SEC’s bid to stay her order halting an administrative proceeding in another case disputing the SEC’s in-house courts.

SEC has options. Yet Judge May’s latest order against the SEC bears close reading for what it does not bar the agency from doing. The judge said the Commission can still preside over the Gray Financial matter itself, or it can appoint its own ALJ, a solution she has previously urged in her several opinions dealing with the SEC’s ALJs. The SEC also could bring its case in a federal district court.

Judge May’s order effectively closed Gray Financial’s district court case while the SEC appeals. But the judge told the parties to give her an update on the case after the Eleventh Circuit issues its opinion.

The case is No. 15-cv-492.

Friday, September 25, 2015

CFTC Chides TeraExchange Over Bitcoin Hoopla, Wash Trades

By Mark S. Nelson, J.D.

The CFTC ordered TeraExchange LLC to abide by the Commission’s wash trading rules and the core principles for swap execution facilities after finding the exchange let two trading firms make wash trades and pre-arranged trades in the exchange’s new Bitcoin swap. TeraExchange had lauded the trades as the first ever Bitcoin swaps transactions on a regulated exchange, but that boast fell apart when CFTC officials and the National Futures Association began to investigate them as suspected wash trades (In the Matter of TeraExchange LLC, Release No. 15-33, September 24, 2015).

TeraExchange paid no penalty in the settled administrative matter, nor did it admit or deny the CFTC’s findings. But the lack of any penalty drew a terse dissent from Commissioner Sharon Bowen. “Tera Exchange facilitated wash trading and prearranged trading in violation of the Commodity Exchange Act,” she said. “That is why we brought this case. I fundamentally disagree with the notion that they deserve no penalty.”

Just testing system? At the crux of the CFTC’s order telling TeraExchange to stop breaking the rules for wash trades and pre-arranged trades is the concept of testing business systems to ensure they can logistically handle actual trading scenarios. TeraExchange is a provisionally registered swap execution facility, but its permanent SEF registration is still pending.

In an email to a trading firm, and in later separate correspondence with the CFTC’s Division of Market Oversight and the NFA, TeraExchange said the offsetting Bitcoin trades were intended to “test the pipes.” But other facts uncovered by the CFTC suggested the trades were pre-arranged to spur public interest in TeraExchange’s virtual currency prowess.

TeraExchange had arranged for two unnamed firms to execute the first ever Bitcoin swap transactions on a regulated exchange. Technically speaking, the trade involved a non-deliverable forward contract that followed the relative values of Bitcoin and the U.S. dollar. As part of a round-trip trade, one firm agreed to buy, and then sell, a Bitcoin swap with a notional value of $500,000, as fixed by reference to the Tera Bitcoin Index. The trades happened merely six minutes apart.

The CFTC said TeraExchange had Skype calls with the two trading firms as their offsetting trades were executed despite the exchange’s “onboarding” requirements for traders and its rulebook, which ban fictitious or wash trades. The day after the trade, TeraExchange issued a press release touting the first Bitcoin swap transaction, while its then-president boasted of the prior day’s trades while attending a meeting of the CFTC’s Global Markets Advisory Committee.

Core principles. The nascent SEF marketplace has had its share of ups and downs as firms try to launch their trading venues and swaps regulators, like the CFTC, try to fine tune their rules. Just today, Commissioner J. Christopher Giancarlo reiterated his wider concerns about the CFTC’s SEF rules in a speech unrelated to the TeraExchange order.

But despite SEFs’ bumpy road, the charges against TeraExchange involved an old transaction type that is not unique to SEFs, although it implicates the Commission’s core principles for these venues. The core principles, which are a pre-condition to SEF registration, mandate firms to adopt policies to prevent and detect abusive trading practices. Related CFTC guidance clarifies that banned practices include wash trading.

Elsewhere, the Commodity Exchange Act explicitly bans wash trades. The problem with wash trades is that the parties to them do not intend to take bona fide market positions that would otherwise produce legitimate changes in the parties’ financial positions. The CEA also bans pre-arranged trades that can appear on the open market, but without the attendant risk of price competition. The CFTC’s order emphasized that TeraExchange’s self-certification of the Bitcoin swap to the agency indicated its consent to follow the agency’s rules prohibiting wash trades and pre-arranged trading.

The release is No. 15-33.

Thursday, September 24, 2015

The SEC’s ALJs: Channeling the Appointments Clause

The SEC’s ability to conduct administrative proceedings instead of or in addition to bringing civil actions in federal court has come under attack as the Commission uses its Dodd-Frank Act powers to impose civil penalties against unregistered persons.

In the latest briefing from Wolters Kluwer Legal & Regulatory Solutions U.S., Mark S. Nelson, J.D. examines the ferocity with which a small but growing number of respondents in SEC administrative proceedings have chosen to take on the agency in federal courts. According to the challengers, the Supreme Court’s Free Enterprise decision means game over for the SEC’s ALJs. The briefing covers:
  • Channel Stuffing?
  • Getting to the Merits
  • Claims of ALJ bias
  • An Elegant Remedy?
  • What’s Next?
Download the briefing now.

Staff Concedes Unintended Consequences to Literal Reading of Investment Adviser Rule

By John Filar Atwood

The staff has agreed with the law firm Willkie Farr & Gallagher that in certain situations the application of the literal wording of Investment Advisers Act Rule 203(l)-1 may have unintended consequences. As a result, the staff agreed not to recommend enforcement action against an investment adviser that relies on the exemption from registration in Section 203(l) and the definition of “venture capital fund” in Rule 203(l)-1 if all of the requirements of the rule are met, except that a company fails to meet the definition of a “qualifying portfolio company” in the situations outlined by Willkie Farr.

Background. Section 203(l) provides that a person meeting the Investment Advisers Act’s definition of “investment adviser” is exempt from registering as an adviser if he or she acts as an investment adviser solely to one or more venture capital funds. Rule 203(l)-1 implements Section 203(l) by defining a venture capital fund, in part, as a private fund that immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments.

Under the rule, a “qualifying investment” is defined as an equity security issued by a qualifying portfolio company that has been acquired directly by a private fund from the qualifying portfolio company. Under Rule 203(l)-1(c)(4), a “qualifying portfolio company” is defined as any company that at the time of any investment by the private fund is not “reporting” or “foreign traded” and does not control, is not controlled by, or under common control with another company, that is reporting or foreign traded.

Willkie’s first example. In its letter to the Commission, Willkie Farr provided two examples to illustrate the unintended consequences of the rule. In the first example, a private fund whose manager is seeking to rely on the rule makes an investment in a qualifying portfolio company that is not a reporting or foreign traded company for purposes of the rule at the time of the investment. The law firm pointed out that if the investment causes the fund to have control over the non-reporting company, the fund manager could be deemed to have indirect control of the non-reporting company by virtue of the manager being considered to control the private fund.

In this example, Willkie Farr noted that if the non-reporting company were subsequently to conduct a public offering in the U.S. or abroad and became a reporting or foreign traded company, it would continue to be a “qualifying investment” of the private fund for purposes of the rule. A detrimental effect could arise, however, if the private fund makes an investment in a portfolio company meeting the definition of a qualifying portfolio company that provided the private fund with control over the portfolio company. Upon making that second investment, Willkie Farr said, control issues could arise that would make any follow-on investment by the fund manager in the second portfolio company a non-qualifying investment under a literal reading of the rule.

Willkie’s second example. In Willkie Farr’s other example, a second manager seeking to rely on the rule causes a private fund that it advises to make an investment in a portfolio company. The portfolio company was, at the time of investment, a company under common control with a reporting or foreign traded company because of direct controlling interests held by a fund that is advised by a manager that is not an advisory affiliate of the second manager and is not seeking to rely on the rule. In this case, according to Willkie Farr, an investment by the private fund in the portfolio company would appear to be a non-qualifying investment not only with respect to the private fund, but also any private fund advised by any other firm seeking to rely on the rule.

In its response to Willkie Farr, the staff noted the law firm’s assertion that the examples are inconsistent with the Commission’s intent in adopting the terms of the rule and its understanding of congressional intent in enacting Section 203(l). A literal reading of the rule could potentially significantly constrain the operations of the manager in managing the fund, according to the law firm.

Follow-on investments. Willkie Farr argued that it is consistent with the operations of a traditional venture capital fund for the fund to assume and maintain a controlling investment position in multiple portfolio companies. As a result, it would not be atypical for a venture capital fund to have investments in multiple qualifying portfolio companies that are under common control with a reporting or foreign traded company that is a qualifying portfolio company of the fund and/or the fund’s manager. A literal application of the rule, the law firm stated, would render a venture capital fund’s follow-on investment in each common controlled company a non-qualifying investment, a result that would be inconsistent with the Commission’s recognition generally of the importance of follow-on investments in the venture capital business.

Wednesday, September 23, 2015

Former Fannie Mae Execs Escape With Mild Spanking

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

Two former Fannie Mae executives have settled SEC charges that they misrepresented the GSE’s exposure to subprime mortgage loans. Former Chief Risk Officer Enrico Dallavecchia and former Senior Vice President Thomas A. Lund agreed to pay the Treasury amounts of $25,000 and $10,000, respectively. The two men also agreed to not sign any Sarbanes-Oxley certifications or file certain periodic reports with the Commission for a period of 12 months and to not violate the federal securities laws (SEC v. Mudd, September 21, 2015, Crotty, P.).

The announcement of the settlement follows more than three years of protracted litigation in which the SEC alleged that Dallavecchia, Lund, and former CEO Daniel H. Mudd knew and approved of misleading statements claiming that Fannie Mae had minimal exposure to subprime and Alt-A mortgage loans between December 6, 2006 and August 8, 2008. The SEC’s agreement with Dallavecchia and Lund is thought to put increasing pressure for a settlement on Mudd, against whom the litigation continues. Dallavecchia and Lund stipulated in their settlement that they would cooperate with the SEC in any related proceedings or investigations.

Subprime exposure. Among other things, the Commission has alleged that when Fannie Mae disclosed its subprime exposure for the first time in February 2007, the GSE claimed that only 0.2 percent of its single-family mortgage credit book of business consisted of subprime mortgage loans or structured Fannie Mae mortgage-backed securities collateralized by subprime mortgage loans. According to the Commission, this disclosure was materially false because it did not include an additional $57.1 billion worth of loans that fell within the company’s own subprime definition of loans made to borrowers with weaker credit histories.

After the sub-prime mortgage market collapsed, the director of Federal Housing Finance Agency placed Fannie Mae into conservatorship on September 6, 2008. On July 8, 2010, Fannie Mae's common stock was delisted from the New York Stock Exchange and the Chicago Stock Exchange.

Fannie Mae itself entered into a non-prosecution agreement with the SEC in December 2011, in which the GSE agreed to accept responsibility for its conduct and not dispute the SEC’s findings, while also agreeing to cooperate with the Commission’s litigation against the former executives. The SEC stated at the time that it had agreed to not prosecute Fannie Mae after considering the GSE’s unique circumstances, including the financial support provided to the company by the Treasury, the role of the FHFA as conservator, and the potential costs to U.S. taxpayers.

The case is No. 11-CV-9202-PAC.

Tuesday, September 22, 2015

JPMorgan Had No Control Over Madoff

By Rodney F. Tonkovic, J.D.

JPMorgan had no control over Bernard Madoff's Ponzi scheme, a federal district court has found. The plaintiff investors accused JP Morgan, which provided banking services to Madoff, as being an indispensable part of his scheme. The court dismissed the claim with prejudice, finding that it was untimely, that JPMorgan exercised no control over Bernard L. Madoff Investments Securities LLC’s day-to-day affairs, and that the complaint failed to plead a primary violation of the securities laws (Dusek v. JPMorgan Chase & Co., September 17, 2015, Steele, J.).

Background. This action was filed by 38 investors taken in by the Madoff Ponzi scheme. According to the complaint, BLMIS had a continuous banking relationship with JPMorgan and held a series of linked direct deposit and custodial accounts there. One of these accounts, the "703 Account," received and remitted the majority of funds invested in BLMIS by Madoff's victims, amounting to approximately $150 billion over the course of the scheme. In other JPMorgan accounts, Madoff held the funds obtained through his scheme in government securities and commercial paper.

At various times in the late 90s and again in 2008, JPMorgan employees raised questions about BLMIS, but these concerns were not communicated to JPMorgan's anti-money laundering personnel. JPMorgan also never filed a Suspicious Activity Report until after Madoff was arrested. Among the activities that raised suspicion were a check kiting scheme in which JPMorgan allowed round-trip transactions to continue for several years and BLMIS's submission of false quarterly FOCUS reports.

Beginning in 2006, JPMorgan began to offer derivative products based on the performance of the Madoff feeder funds. There was significant demand for these notes, and JPMorgan's position in the Madoff feeder funds eventually created approximately $250 million in risk exposure to BLMIS. JPMorgan remained committed to its position in the Madoff funds despite mounting concerns about Madoff's purported investment strategy.

By late 2008, however, a JPMorgan due diligence analyst penned a memo describing, among other concerns, the inability of JPMorgan or the feeder funds to validate Madoff’s trading activity or custody of assets. During the same period, JPMorgan redeemed its positions in the Madoff feeder funds. No one involved in the redemptions informed anyone in JPMorgan's Broker/Dealer Group about their concerns about the validity of Madoff’s returns or even that the redemptions occurred.

Madoff was arrested on December 11, 2008. In 2010, the trustee for the liquidation of BLMIS filed a complaint against JPMorgan asserting both bankruptcy and common law claims, but the common law claims were dismissed for lack of standing. Subsequently, a class action asserting nine claims under common law was brought against JPMorgan. In early 2014, JPMorgan entered into a global resolution in which it agreed to pay a $1.7 billion penalty for two felony violations of the Bank Secrecy Act and to pay $218 million to settle the class action. The class action included only net losers. As net winners, the plaintiffs in this matter were excluded from the settlement.

Controlling persons. The complaint alleged violations of the federal controlling persons provisions and RICO, as well as a number of claims under state law. In count one of the complaint, the plaintiffs alleged that JPMorgan controlled Madoff and BLMIS. The court, however, found that this claim was untimely because the complaint was filed on March 28, 2014, well after the expiration of the five-year statute of repose on December 11, 2013.

JPMorgan argued further that it did not control BLMIS or the Ponzi scheme as a matter of law. According to the plaintiffs, JPMorgan had complete control over Madoff because its banking services, which could have been terminated at any time, were indispensable to his scheme. These allegations, the court said, were insufficient to show that JPMorgan had power over BLMIS's general, day-to-day affairs, or any direct or indirect influence over its corporate policies. Moreover, there were no plausible allegations as to why JPMorgan would involve itself "in Madoff’s inevitably doomed Ponzi scheme in order to earn routine banking fees," the court remarked.

No actual damages. As an additional reason to dismiss Count One, the court found that the compliant failed to plead that the investors suffered actual damages. In this case, the plaintiffs were net winners, meaning that they withdrew funds from BLMIS that exceeded their initial investments and subsequent deposits. In other words, the plaintiffs suffered no actual pecuniary loss. A lack of actual damages is fatal to a fraud claim under Section 10(b), and a primary violation is an essential element of a controlling person claim, the court said.

RICO. Finally, the court dismissed the plaintiffs' claims asserting a violation under RICO for JPMorgan's knowing participation in Madoff's racketeering enterprise. This claim, the court explained, was barred under Section 1964(c) because the conduct giving rise to the claim amounted to securities fraud. Here, the plaintiffs alleged mail and wire fraud, which, the court said, was integrally related to the purchase and sale of securities.

The court accordingly dismissed with prejudice the complaint's federal law claims. Having dismissed these claims, the court found no independent basis for jurisdiction over the plaintiffs' state law claims and dismissed them without prejudice.

The case is No: 2:14-cv-184-FtM-29CM.

Monday, September 21, 2015

CFTC Fines Swap Dealer $150,000 in First Penalty for Large Trader Swap Reporting Violations

By Lene Powell, J.D.

The CFTC ordered an Australia-based financial services company to pay a $150,000 penalty for failing to submit accurate large trader reports for physical commodity swap positions in violation of Section 4s(f) of the Commodity Exchange Act (CEA) and CFTC Regulations 20.4 and 20.7. The order represents the CFTC’s first enforcement action of Dodd-Frank Act large trader reporting requirements for physical commodity swap positions (In the Matter of Australia and New Zealand Banking Group Ltd., September 17, 2015).

Large trader reporting. Under CEA Section 4s(f), as added by the Dodd-Frank Act, swap dealers that meet certain requirements must file daily large trader reports for reportable positions in physical commodity swaps (LTRs), which contain data as specified. The LTRs must also meet requirements for reporting and submitting information under CFTC Regulation 20.7.

Australia and New Zealand Banking Group Ltd. (ANZ) is a financial services company based in Australia, and is registered with the CFTC as a swap dealer. Between March 2013 and November 2014, ANZ filed LTRs that routinely contained errors. For example, ANZ often misidentified counterparty positions as its own positions as the principal. The bank also sometimes reported some non-zero positions as zero, did not identify any underlying commodity, and reported its positions in units of the underlying commodity instead of in futures contract equivalents. Due to the errors, ANZ inaccurately reported its positions, in one instance reporting a position more than 5,000 times its actual size. After ANZ responded to a CFTC special call in January 2014, the errors were discovered and ANZ submitted corrected historical LTRs.

$150,000 fine. The CFTC ordered ANZ to pay a $150,000 civil monetary penalty and cease and desist from committing further violations of the CEA and CFTC regulations. In imposing the penalty, the CFTC noted that accurate large trader reporting is essential to the agency’s ability to conduct effective surveillance of markets in U.S. physical commodity futures and economically equivalent swaps.

The case is CFTC Docket No. 15-31

Friday, September 18, 2015

Trinity Takes Wal-Mart Gun Proposal to the Top

By Anne Sherry, J.D.

Trinity Wall Street is pressing forward with its advocacy as a Wal-Mart shareholder notwithstanding the retailer’s decision to stop selling assault rifles. In a petition to the Supreme Court for a writ of certiorari, the church promises to present its shareholder proposal—which concerns board oversight of the sale of all especially hazardous products, not only high-capacity firearms—without revision should the Court reverse the Third Circuit’s holding that it could be excluded from Wal-Mart’s proxy materials (Trinity Wall Street v. Wal-Mart Stores, Inc., September 11, 2015).

Factual background. Trinity, an Episcopal church named for its Wall Street location, became involved in this issue after discovering that Wal-Mart was a prominent marketer of the model of assault rifle used in the 2012 mass shooting at Sandy Hook Elementary School in Newtown, Connecticut. Rather than putting an ad hoc proposal before the Wal-Mart board, Trinity decided to present a shareholder proposal for inclusion in the retailer’s 2014 proxy materials. The proposal asks the board to add policies to its charters for determining whether Wal-Mart should sell products that are especially dangerous to the public, pose a substantial risk to the company’s reputation, and would be considered offensive to the values integral to Wal-Mart’s brand.

Procedural background. Wal-Mart sought no-action relief allowing it to exclude the proposal, and the SEC advised that the proposal could be omitted under Exchange Act Rule 14a-8(i)(7). That subparagraph of the rule permits exclusion “if the proposal deals with a matter relating to the company’s ordinary business operations.” Trinity sued, and the district court in Delaware enjoined Wal-Mart from excluding the proposal. The Third Circuit reversed on the eve of the proxy materials’ going to press. The subsequent opinion focused on the Exchange Act rule’s ordinary business exclusion; a concurrence, which another judge joined in part to form a second, overlapping majority, also held that Trinity’s proposal could be excluded on vagueness grounds.

Cert petition. Trinity asks the Court to decide whether the Third Circuit erred in holding that Wal-Mart could exclude a shareholder proposal on the basis that the proposal, if adopted, could affect Wal-Mart’s decision about what to sell. Trinity also contends that the second Third Circuit majority departed from judicial neutrality in holding that SEC proxy rules were violated because the proposed board committee charter amendment was ambiguous.

Wal-Mart’s social profile. According to Trinity, it chose to make a board oversight proposal first because it felt that Wal-Mart, which does not sell adult magazines or music with parental advisory labels, would understand the connection between corporate social responsibility and the sale of products posing community, reputation, or brand risk. The petition notes approvingly that Wal-Mart was the first major retailer to pull products bearing the image of the Confederate flag from its shelves after the Charleston, South Carolina, church shooting. Trinity also identifies a conflict in Wal-Mart’s firearms policies in that the retailer sold weapons more suitable to mass murders than to hunting and target sports. Although Wal-Mart has since decided to stop selling assault rifles, it cited low customer demand as the reason, so Trinity maintains that “at the policy level this conflict remains unresolved.”

Social policy issue. Indeed, the crux of Trinity’s petition is that the shareholder proposal concerns social policy matters, not business operations. The district court held that the proposal was “best viewed as dealing with matters that are not related to ordinary business operations.” Even if the proposal did concern business operations, the court held, it fell within the exception set forth in a 1998 SEC interpretive release for proposals that raise significant social or corporate policy issues. The Third Circuit erred in overturning this decision and creating a new requirement that a shareholder proposal not be entwined with a core business function. In so doing, the appeals court extrapolated from a series of SEC no-action letters suggesting that proposals about what a manufacturer can manufacture must be included, while proposals about what a retailer can sell may be excluded. No-action letters are “informal, discretionary and devoid of any reasoning,” the church asserts, and the “core business function” test and manufacturer/retailer distinction are unworkable and make no policy sense.

Vagueness. Trinity also argues against the second Third Circuit majority’s reasoning that the proposal should be excluded for vagueness and ambiguity. Absent real incomprehensibility, any clarity objections go to the merits of the proposed amendment and not to whether it should be included. “In our Constitution there are phrases that are not particularly clear but that was not a reason why the Constitution should not have been submitted to the States for ratification,” the church submits.

Separation of powers. The petition posits that the Third Circuit put itself in the role of the SEC, even writing that the SEC can overrule its interpretation with new interpretive guidance if the agency chooses. “That is not the way it is supposed to work. This Court has made plan that the role of the judiciary in interpreting an agency regulation is to follow the interpretation of the agency so long as it is not ‘plainly erroneous or inconsistent’ with the regulation” (citing Auer v. Robbins (U.S. 1997)). The SEC’s guidance looks to the substance of the proposal and asks whether it concerns ordinary business or an important social or corporate policy question, Trinity concludes.

The case is No. 15-323.

Thursday, September 17, 2015

Mark Cuban Joins Increasing Clamor Against SEC Administrative Proceedings

By Amanda Maine, J.D.

Businessman Mark Cuban, calling himself a “first-hand witness to and victim of SEC overreach,” has filed an amicus brief in the Eleventh Circuit urging it uphold an injunction of an SEC administrative proceeding against Charles H. Hill, Jr. Cuban drew on his own experience during the SEC’s unsuccessful insider trading action against him to argue that the use of administrative law judges in complex litigation such as insider trading cases is unfair and against the public interest (Hill v. SEC, September 15, 2015).

Background. The SEC instituted administrative proceedings against real estate developer Charles L. Hill, Jr. in February 2015 alleging that he was involved in an insider trading scheme. Hill filed a motion in the district court for the Northern District of Georgia to declare the administrative proceeding unconstitutional and to enjoin the administrative proceeding from occurring until the court issues its ruling. The court found that Hill was likely to succeed on the merits of his case and enjoined the SEC’s administrative proceedings against him. The SEC appealed the court’s order to the Eleventh Circuit (see Securities Regulation Daily Wrap-Up for September 11, 2015 for coverage of Hill’s appellate brief).

Undermining independence. In his brief, Cuban argued that subjecting Hill to an SEC administrative proceeding would cause irreparable harm because such proceedings are “inherently biased.” The SEC has maintained that its ALJs are not “officers,” which would render their method of appointment unconstitutional under the Appointments Clause, but are “employees.” Cuban pointed out that as “mere employees” of the SEC, ALJs cannot perform their duties within the constitutional and congressional dictates of impartiality and fairness. In administrative proceedings, “the SEC prejudges the case and then essentially asks its employee, the ALJ, to validate its judgment,” according to Cuban.

Cuban contrasted the proceeding against Hill with the SEC’s insider trading case against him, which was brought in federal district court and not before an ALJ. The presiding judge in his case was not a mere employee of either litigant, but an independent officer with the power and stature to ensure a fair proceeding, Cuban observed, and his adversary played no part in choosing his own judge. The jury returned a verdict in favor of Cuban in October 2013.

Lack of procedural rights. Cuban also cited his experience litigating against the SEC to criticize the SEC’s rules of practice for administrative proceedings as “woefully inadequate” for complex cases such as insider trading cases. He noted that a trial in an SEC administrative proceeding must take place within four months of the initiation of the litigation, where discovery alone took nearly three years in the SEC’s case against Cuban. There is also no way under the rules of practice to narrow the charges through motions to dismiss, as well as no interrogatories, no requests for admissions, no depositions, and no means of targeting document requests.

Cuban also pointed out that by litigating his matter in federal court, he was able to benefit from a motion to dismiss and from expansive discovery. While the district court’s granting of his motion to dismiss was overturned on appeal, the opinions addressing his motion provided the operation and boundaries of the SEC’s “untested theory on insider trading” that would not be available in an administrative proceeding, he explained. He was also able to take advantage of the broad range of discovery devices available under the Federal Rules of Civil Procedure, including depositions from witnesses that directly contradicted the SEC’s witnesses’ testimony. He would be unable to do so in an administrative proceeding, Cuban said. In addition, Cuban pointed out that the federal jury that returned a verdict in his favor on all charges was able to assess the evidence impartially, which a “structurally-biased ALJ” would be unable to do.

Inadequate appeals process. Cuban contended that the process for appealing the outcome of an administrative proceeding would not remedy irreparable harm. He argued that there is no substitute for a live assessment of witnesses by a neutral fact-finder and that the same Commission that reviews the ALJ’s decision views the ALJ as a “mere employee.” Even if eventually successful on appeal, a respondent in an administrative proceeding would have spent substantial resources in both time and money to arrive at the valid forum of a federal court, according to Cuban.

Public interest. Finally, Cuban argued that staying the administrative proceeding against Hill while the court considers his constitutional claims would not harm the public interest; in fact, the public interest would be harmed by the continued unpredictability created by the SEC’s use of administrative proceedings in complex cases. Noting that there are several constitutional challenges currently winding their way through the federal court system, he urged the Eleventh Circuit to uphold the lower court’s injunction to prevent the SEC from “cram[ming] more of these cases…into the administrative forum.”

The case is No. 15-12831.

Wednesday, September 16, 2015

ICI and Chamber of Commerce Opine on Proposed Clawback Rules

By Amy Leisinger, J.D.

The Investment Company Institute (ICI) and the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness (CCMC) have submitted comments on the SEC’s proposal on listing standards for recovery of erroneously awarded compensation. While generally supportive of the Commission’s efforts, the ICI urged the SEC to exclude all registered investment companies from the proposed requirements, and the CCMC argued that the proposal is “needlessly complex and overly prescriptive” and requested clarification and changes to a number of provisions.

Rule proposal. The SEC’s proposal directs the national securities exchanges and associations to adopt listing standards to require listed companies to implement policies for clawing back incentive-based compensation later found to have been awarded in error. Proposed Rule 10D-1 would require recovery from both current and former executive officers who received incentive-based compensation during the three fiscal years preceding an accounting restatement to correct a material error. The amount to be clawed back would be based on the compensation that exceeds what an executive officer would have received as reflected in the accounting restatement.

An executive officer does not have to be responsible for any misconduct or for the erroneous financial statements for the clawback provision to apply, and the rule provides exceptions to the clawback requirement: (1) when the expense of enforcing the recovery would exceed the amount to be recovered; or (2) when the recovery would violate the home country law of a foreign private issuer. The proposal would also require disclosure of listed companies’ recovery policies and their actions under those policies.

ICI comments. In its comments, the ICI expressed concern that the proposed rule would subject certain registered investment companies to new disclosure requirements. Exchange Act Section 10D and the proposed rule generally do not apply to registered mutual funds because they do not issue listed securities, and, in drafting the proposal, the SEC exempted the securities of most investment companies because of their compensation structures. However, the proposal provides only a conditional exemption listed registered management investment companies (such as ETFs and closed-end funds) if the company has not awarded incentive-based compensation to any executive officer in the last three fiscal years.

The ICI suggests an unconditional exemption for all listed funds, noting that the concerns underlying the Dodd-Frank Act do not apply to these types of funds. Further, the ICI states, removing listed funds from application of the proposed rule would be consistent with Commission positions excluding all registered investment companies from prior compensation rulings and would more accurately reflect the structure and accounting practices of the funds. The organization also notes that listed funds’ financial statements and accounting practices are less complex than those of operating companies and involve far fewer estimates and judgments. Accounting restatements are relatively rare for listed funds, and, as such, the cost of listed funds’ compliance with the proposed changes would outweigh any potential benefits, the ICI concludes.

CCMC comments. In its comments, the CCMC noted that clawbacks will drive good governance practices but only if required and executed in “balanced” manner. The prescriptive nature of the proposal will hinder the ability of exchanges to develop standards appropriately suited for particularized business circumstances, according to the group. The proposal creates a burdensome recovery process by requiring recovery of compensation in except under limited circumstances that impose undue costs on the issuer or its shareholders, according to the group, and the SEC should consider providing boards of directors the discretion to assign collection responsibility to the Commission when voluntary disgorgement cannot be obtained. In addition, according to CCMC, the SEC’s proposal to prohibit a listed issuer from indemnifying any executive officer against loss should be modified to take the same approach as in other regulations: stating that indemnification is contrary to public policy but leaving the final determination to the courts.

The proposal also should be modified to take into account the application of foreign laws and the potential effects on foreign private issuers to avoid creating disincentives for U.S. listing and to minimize economic burdens on investors and smaller reporting companies, the group explains. Further, in connection with a final Rule 10D-1, the SEC should clarify the concept of “restatement” to coincide with existing positions and should refine the definition of “executive officer” to avoid covering officers with little or no actual control over the preparation of financial statements. The SEC should also take steps to avoid applying the proposed rule retroactively and should provide an economic analysis concerning whether the proposed changes will promote capital formation and competition, the CCMC concluded.

Tuesday, September 15, 2015

Hedge Fund Adviser’s Cert Petition Cites Federal-State Conflicts on Fiduciary Duty, Seller Liability

By Amanda Maine, J.D.

A hedge fund adviser has filed a petition for a writ of certiorari to the U.S. Supreme Court, urging the reversal of Massachusetts state court holdings finding him liable for securities fraud. The adviser argued that those holdings created conflicts between state and federal laws regarding the fiduciary duty owed to investors in hedge funds and regarding the imposition of seller liability (Ellrich v. Hays, September 8, 2015).

Background. Molly Hays sued Morgan Financial Advisors, Inc. (MFA) and its sole owner and officer, David J. Ellrich, alleging violations of the antifraud provisions of the Massachusetts Uniform Securities Act (MUSA). Hays had worked with Ellrich as her investment adviser since 1993, investing mostly in registered mutual funds. In September 2000, MFA agreed to become an investment adviser to a private hedge fund called Convergent and signed an agreement with Convergent’s General Partner, Emerging Health Capital Partners, LLC (EHCP). Hays, acting on advice from Ellrich, transferred 75 percent of her retirement savings to Convergent. In 2003, Convergent became insolvent due to overstatements by Convergent’s qualified custodian, and Hays lost nearly all of her investment.

The trial judge found in favor of Hays. On appeal, the Massachusetts Supreme Judicial Court rejected Ellrich’s arguments, finding that: (1) Ellrich met MUSA’s definition of a “seller” of securities because he was motivated in part by the potential for personal financial gain, despite not receiving direct financial compensation; and (2) Hays’s claims were not barred by the statute of limitations.

Fiduciary duty. In his petition for a writ of certiorari to the U.S. Supreme Court, Ellrich argued that the Massachusetts court rulings imposed a fiduciary duty on federally-registered investment advisers that conflicts with their fiduciary duties under federal law. Specifically, Ellrich pointed out that the Investment Advisers Act requires that federally-registered investment advisers owe a fiduciary duty only to the hedge fund itself, and not individual shareholders, limited partners, or members of the fund. Ellrich also noted that federal law actually prohibits Ellrich and MFA from owing a fiduciary duty to Hays, observing that an adviser to a hedge fund could give conflicting advice to the fund and to the client. Advice to a fund about to go bankrupt would include taking all efforts to remain solvent, while advice to an investor in that fund would likely be to sell, he explained, citing Goldstein v. SEC (D.C. Cir. 2006).

According to Ellrich, the Massachusetts courts have created an “impossible, catch-22 type of situation” because federally-registered investment advisers now owe simultaneous undivided fiduciary duties to both their hedge fund clients and investors in those hedge funds, which is both legally impermissible and a duty with which the advisers cannot comply. He also claimed the decision was dangerous by setting a precedent where federally-registered advisers who have complied with federal requirements may still be liable for violations of state common law, which is contrary to the intent of Congress and the SEC.

Seller liability. Ellrich’s petition also contended that the Massachusetts courts erroneously imposed seller liability on him in conflict with federal law. Under Investment Advisers Act Section 206(3), an investment adviser will not be deemed to be acting as a broker (seller) when the adviser receives no compensation, other than its advisory fee, for effecting a particular transaction. Ellrich pointed out that he did not receive direct financial compensation as a result of Hays’s decision to invest in Convergent—EHCP solicited the sales of limited partner interests in Convergent, and neither Ellrich nor MFA had any control over EHCP. Without “direct compensation,” Ellrich is not a seller under federal law, he argued. By imposing seller liability on investment advisers who did not receive direct compensation, the Massachusetts courts created a new avenue of seller liability for individuals who “merely assist or participate in” a general partner’s solicitation of investments in a hedge fun, according to Ellrich.

The case is No. 15-300.