Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

A recent $100,000 settlement between the Commodity Futures Trading Commission (CFTC) and an accounting firm highlights — for accounting firms auditing Futures Commission Merchants (FCM) — the importance of closely following audit rules or risk being fined. See United States Commodity Futures Trading Commission v. Tunney & Associates, P.C. & Michael Tunney

The Linn Group (TLG) is a registered CFTC FCM and as such is required to conduct yearly audits in which they certify their financial statements. In 2007, TLG terminated their previous accounting firm and went looking for a new firm. An accounting firm, Tunney & Associates and its sole owner, Michael Tunney, wanted the business but it had never provided audit services to an FCM or an entity required to hold segregated accounts for customers, and it had no understanding of the CFTC regulations related to customer secured and segregated funds or the net capital requirements or net capital computations for an FCM.

Tunney knew Mr. Y, however, and Mr. Y, while not a certified public accountant (CPA), had previously worked with TLG and TLG’s previous auditor. Tunney and Mr. Y joined forces and got the TLG auditing business. From 2007 through 2010, Mr. Y performed the vast majority of the work, but Mr. Y died in 2011 and Tunney did the audit.

Not surprisingly, given that Mr. Y was not a CPA and Tunney lacked CFTC experience, the CFTC found numerous deficiencies with the Tunney audits.

  • Tunney did not contact TLG’s previous auditor as required by Generally Accepted Auditing Standards.
  • Tunney did not have the requisite technical training and proficiency to audit an FCM as required by GAAS General Standard No. 1.
  • Tunney failed to obtain a sufficient understanding of TLG’s business, risks and internal controls to assess the risk of material misstatement of the financial statements as required by Standard of Fieldwork No. 2.
  • Tunney did not exercise due professional care as required by GAAS General Standard No. 3. Specifically, Tunney did not possess the level of knowledge, skill and ability necessary to evaluate the audit evidence obtained by Mr. Y as related to material, critical audit areas such as the computation of minimum capital requirements and customer segregation requirements. Tunney also did not conduct any planning procedures or material fieldwork, and he did not review Mr. Y’s work to any meaningful degree as required by GAAS General Standard No. 3 and GAAS Standard of Fieldwork No. 1 for the 2007 through 2010 audits.
  • Tunney failed to obtain sufficient appropriate audit evidence and to maintain work-papers and audit documentation as required by Standard of Fieldwork No. 3.

These audit failures had real-world consequences. For example, TLG deposited and held non-customer and proprietary funds in a customer omnibus trading account from 2007 to 2011 in violation of the regulations and failed to timely obtain customer segregation and secured acknowledgement letters from banks for at least nine bank accounts containing TLG’s customers’ funds between November 2007 and June 2012 as CFTC regulations require. Tunney’s audits, however, failed to include audit procedures that would have tested for TLG’s procedures for safeguarding customer and firm assets.

On April 28, 2014, the CFTC settled with Tunney for $100,000 and ,as part of that settlement, Tunney was permanently prohibited from practicing before the CFTC.

NAM et al have filed an emergency motion for stay with the Court of Appeals in the conflict minerals case.  As predicted, it is largely a replay of the arguments made when NAM asked the SEC for a stay.  In brief, the rule can no longer function without the “unconstitutional confession” which is now sometimes referred to as the “scarlet letter.”

NAM et al do their best to try and convince the Court that the District Court will have no choice but to vacate the rules and therefore irreparable harm will occur if the stay is not granted.

NAM et al also infer that the Division of Corporation Finance’s “ad hoc” statement on the rule is defective because it was issued without notice and comment.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

 

Norm Champ, Director, SEC Division of Investment Management, recently gave a speech where he reminded investment advisers to review compliance policies annually as required by SEC rules. He said “As you are no doubt aware, Rule 206(4)-7 requires advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and also requires that advisers designate a chief compliance officer. The rule, which was adopted against the backdrop of the late trading and market timing scandals, stresses the importance of strong compliance programs in preventing violations of law as well as the important role that compliance professionals play in ensuring a strong culture of compliance.”

Perhaps more importantly, Mr. Champ warned the audience about failure to implement adequate policies: “Compliance policies and procedures must be specifically tailored to your firm’s advisory business, and a few recent enforcement cases confirm this point . . . just last month, the Commission charged an investment adviser with issuing false and misleading advertisements. The Commission noted that the firm’s policies and procedures only parroted the Commission’s rule, and were not specifically tailored to prevent advertisements from violating the advertising rules.”

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC has denied NAM’s motion for a full stay of the conflict minerals rules.  As I indicated, it was somewhat of a hail Mary, but maybe a precondition to asking the court for relief.  Expect NAM et al to head for court soon as threatened.

The SEC did issue a partial stay, but there is no news here.  Basically it just implements Corporation Finance’s previously issued guidance.

Given that the court previously didn’t seem enamored with NAM and the other petitioners’ arguments, I’d say it’s an uphill battle for NAM et al.  But who knows, maybe Commissioners Gallagher and Piwowar will release a Second Joint Statement on the Conflict Minerals Decision or file an amicus brief or something.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

 

When Commissioners Daniel M. Gallagher and Michael S. Piwowar released this Joint Statement on the Conflict Minerals Decision on April 28, 2014, I wondered where it would go. The answer is it went in this motion for a stay of the conflicts minerals rules filed by the National Association of Manufacturers, or NAM, and the other petitioners, with the SEC on April 29, 2014.

The part of the motion I like best is:

“Indeed, the entire purpose of the rule and statute was to try to effect social change by publicly shaming companies through forcing them to label certain products as not “DRC conflict free.” Now that the shaming mechanism has been struck down on First Amendment grounds, the remainder of the rule has questionable benefits. The Commission must therefore re-assess whether the rule complies with the requirements of 15 U.S.C. § 78w(a)(2), which bars “any rule,.. which would impose a burden on competition not necessary or appropriate,” and 15 U.S.C. §78c(f), which requires the Commission to “consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation.” At a minimum, the Commission should preserve the status quo while it reconsiders whether to require billions of dollars in expenditures for a purported benefit that no longer exists.”

I put it in the “Hail Mary” category because SEC Chair Mary Jo White, per TheCorporateCounsel.net, told a Congressional committee that the SEC will continue to implement the bulk of its conflict minerals rule despite the recent ruling by the US Court of Appeals for the DC Circuit, and Keith Higgins of Corporation Finance has issued his edict to issuers to file.

But a Hail Mary is sometimes successful, as it was when the Business Roundtable, also a petitioner in the conflicts minerals case, petitioned the SEC for a stay of the proxy access rules.

And a Hail Mary isn’t necessarily a waste of time.  The NAM petition asks for action on the motion by May 1, 2014 (which I am assuming didn’t happen because of the lack of  public announcement) so that the petitioners may promptly proceed to court to seek appropriate relief if a stay is not granted.  About all the petitioners have to do is change the caption on the motion and reformat it a little bit to file as threatened.

So far no indication in the dockets (as near as I can tell) of NAM proceeding or the SEC filing for an en banc hearing.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

 

The below article by Sean Colligan was featured in the April issue of Stinson Leonard Street’s Business Torts Update, which focuses on recent developments affecting litigation of securities law, whistleblower, trade secret and non-compete claims.

Two recent U.S. District Court decisions hold that whistleblower claims under the Dodd-Frank Act are subject to arbitration under an appropriate pre-dispute arbitration agreement. In addition, the first of these decisions highlights several important distinctions between Dodd-Frank and Sarbanes-Oxley Act (SOX) whistleblower protection provisions, and the second decision held that internal reporting is sufficient to trigger Dodd-Frank whistleblower protection.

Murray v. UBS Securities, LLC

In this case, a federal district judge in Manhattan rejected a plaintiff’s argument that his whistleblower claim could not be arbitrated under a SOX provision that invalidates agreements to arbitrate SOX whistleblower claims.

Plaintiff was a Commercial Mortgage-Backed Security (CMBS) analyst with UBS Securities. He alleged that he was terminated for complaining to his supervisors about pressure to skew his research in ways that would support UBS Securities’ ongoing CMBS trading and loan origination activities.

Following his termination, plaintiff filed both this lawsuit under the Dodd-Frank whistleblower protection statute, and an administrative claim with OSHA under the SOX whistleblower protection statute. The SOX claim was still pending at OSHA when the district court issued its decision on whether the federal court claim was arbitrable.

Arbitrability

Plaintiff’s employment agreement contained an arbitration clause covering disputes arising out of or relating to his employment relationship or the termination of that relationship. The arbitration clause excluded claims arising under SOX. The SOX whistleblower protection statute states that “[n]o predispute arbitration agreement shall be valid or enforceable, if the agreement requires arbitration of a dispute arising under this section.” The Dodd-Frank whistleblower statute contains no analogous prohibition on arbitration of Dodd-Frank whistleblower claims.

In resisting UBS Securities’ motion to compel arbitration of his federal court claim, plaintiff argued that his termination violated the Dodd-Frank whistleblower statute because his complaints to his supervisors were protected by SOX, and therefore that his claims arose under SOX. UBS argued that plaintiff had stated a claim in federal court only under Dodd-Frank, and could not avoid arbitration on the grounds that his Dodd-Frank claim was allegedly premised upon protected SOX activity. The court agreed with UBS that the SOX ban on arbitration did not apply.

Differences Between SOX and Dodd-Frank Whistleblower Claims

The Court noted that a SOX claim is subject to administrative exhaustion requirements at OSHA, and plaintiff had not submitted the instant claim to OSHA in the first instance, but directly to the court.

In addition to the differing exhaustion requirements for SOX and Dodd-Frank whistleblower claims, the court noted that the statutes provide different remedies for successful claimants. While SOX whistleblowers are limited to reinstatement and back pay with interest, Dodd-Frank whistleblowers are entitled to twice the amount of back pay with interest, as well as bounties of 10-30% on recoveries over $1 million in a government enforcement action that relies on information provided by the whistleblower.

In light of these statutory differences, the court refused to allow plaintiff to recharacterize his Dodd-Frank claim as a SOX claim. Because Dodd-Frank whistleblower claims are not statutorily exempt from arbitration, plaintiff’s claim had to be resolved by arbitration.

Khazan v. TD Ameritrade Holding Corp. (D.N.J. March 11, 2014)

In this case, the plaintiff had been an investment oversight officer with defendants. Plaintiff alleged that he was terminated in retaliation for reporting to his supervisors that certain of defendants’ financial products failed to comply with securities regulations.

Plaintiff reported the violations to the U.S. Securities and Exchange Commission (SEC) only after he was terminated. One of the primary issues in the case was whether plaintiff qualified for Dodd-Frank whistleblower protections, given that his only pre-termination reports were made to internal supervisors, and not to the SEC.

The Court noted a split of authority on the question whether purely internal reporting qualifies a plaintiff for Dodd-Frank whistleblower protections. An SEC regulation construing the statute says that internal reporting is sufficient to trigger Dodd-Frank protections. The Fifth Circuit U.S. Court of Appeals (covering Texas, Louisiana and Mississippi) and federal courts in the District of Colorado and the Northern District of California have held that the SEC’s regulation is not entitled to deference and that under the clear language of the statute, its protection applies only to whistleblowers who have reported their concerns to the SEC. But most federal district courts defer to the SEC’s interpretation that internal reporting is sufficient to qualify for the protection. The Khazan court sided with this majority.

Having determined that the Dodd-Frank whistleblower protection applied to plaintiff’s claims, the court turned to the question whether his claim was arbitrable under the arbitration clause in his employment agreement, or whether the statute invalidating arbitration of SOX whistleblower claims precluded arbitration.

The court addressed this question from an entirely different perspective than the court in Murray did, though it reached the same conclusion and required arbitration of the Dodd-Frank claim. Instead of examining whether the anti-arbitration provision applied to Dodd-Frank whistleblower claims or only to SOX whistleblower claims, the court found that the anti-arbitration provision passed in 2010 could not be applied retroactively to invalidate the parties’ arbitration agreement reached in 2006. Therefore, regardless of the scope of the anti-arbitration statute, the court found that it did not apply to the instant case, and that the claim must be submitted to arbitration.

Implications

Dodd-Frank whistleblower claims will often be more attractive to plaintiffs than SOX whistleblower claims due to the absence of exhaustion requirements and the ability to seek more generous remedies. However, Dodd-Frank whistleblower claims are subject to predispute arbitration clauses, such as the clauses that most brokerage firms have with their employees. The susceptibility of Dodd-Frank whistleblower claims to arbitration agreements may be one of the few downsides to plaintiffs of pursuing such a claim, due to the limited discovery available in such actions and the perception that arbitration awards tend be lower than damage awards in litigation.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

The SEC has approved changes to FINRA Rule 5110, which among other things:

  • narrow the scope of the definition of “participation or participating in a public offering;”
  • modify the lock-up restrictions to exclude certain securities acquired or converted to prevent dilution; and
  • clarify that the information requirements apply only to relationships with a “participating” member.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

At the core, the court’s first amendment objection to the conflict minerals rules was that by requiring issuers to state its products have not been found to be “DRC conflict free” it compelled an issuer to “confess blood on its hands,” and that  interfered with that exercise of the freedom of speech under the First Amendment.

So the SEC solution is predictably simple:  File the reports without the confession.

Before continuing, it is probably worth noting that the SEC has not announced any decision as to whether it will seek a rehearing of the decision or otherwise tipped its hand as to its remaining litigation strategy.  I am assuming this is an interim fix.

The SEC guidance came in the form of a statement from Keith Higgins, Director of Corporation Finance.

Interestingly, the SEC noted that the due date for the first round of reports was June 2, 2014, and the mandate from the Court of Appeals would not be effective before June 5, 2014, leaving one to wonder what might happen thereafter when the mandate was effective.

The remainder of the guidance reads as follows:

“Subject to the guidance below and any further action that may be taken either by the Commission or a court, the Division expects companies to file any reports required under Rule 13p-1 on or before the due date. The Form SD, and any related Conflict Minerals Report, should comply with and address those portions of Rule 13p-1 and Form SD that the Court upheld. Thus, companies that do not need to file a Conflict Minerals Report should disclose their reasonable country of origin inquiry and briefly describe the inquiry they undertook. For those companies that are required to file a Conflict Minerals Report, the report should include a description of the due diligence that the company undertook. If the company has products that fall within the scope of Items 1.01(c)(2) or 1.01(c)(2)(i) of Form SD, it would not have to identify the products as “DRC conflict undeterminable” or “not found to be ‘DRC conflict free,’” but should disclose, for those products, the facilities used to produce the conflict minerals, the country of origin of the minerals and the efforts to determine the mine or location of origin.

No company is required to describe its products as “DRC conflict free,” having “not been found to be ‘DRC conflict free,’” or “DRC conflict undeterminable.” If a company voluntarily elects to describe any of its products as “DRC conflict free” in its Conflict Minerals Report, it would be permitted to do so provided it had obtained an independent private sector audit (IPSA) as required by the rule. Pending further action, an IPSA will not be required unless a company voluntarily elects to describe a product as “DRC conflict free” in its Conflict Minerals Report.”

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

Securities lawyers eagerly await the first (or the first few) new filings required by law to learn (and of course copy) from them.  So the first conflict minerals filing to hit Edgar last week was eagerly anticipated, and immediately over analyzed.

Broc Romanek at TheCorporateCounsel.net reported reader reaction ranging from “If this is the baseline, we are looking to be in good shape,” to “Good example of “what not to do”” to “This thing is totally bizarre.”

For the reasons set forth in this blog, we don’t think issuers will follow this as precedent.

So one lesson learned is never be the first to file anything new early.

We are hoping the second filing is more instructive.

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.

In a letter to the SEC Chair, Mary Jo White, Senator Edward J. Markey and a group of other Member of Congress urged the financial oversight agency to implement the rule requiring due diligence and reporting requirements on the sourcing of conflict minerals in the May 31, 2014 report.  According to the letter “With strong court decisions affirming the key components of the rule, no delay is warranted in the implementation of those requirements while any remaining free speech issues are resolved.”

ABOUT STINSON LEONARD STREET

Stinson Leonard Street LLP provides sophisticated transactional and litigation legal services to clients ranging from individuals and privately held enterprises to national and international public companies. As one of the 75 largest firms in the U.S., Stinson Leonard Street has more than 520 attorneys and offices in 14 cities, including Minneapolis, Mankato and St. Cloud, Minn.; Kansas City, St. Louis and Jefferson City, Mo.; Phoenix, Ariz.; Denver, Colo.; Washington, D.C.; Decatur, Ill.; Wichita and Overland Park, Kan.; Omaha, Neb.; and Bismarck, N.D.

The views expressed herein are the views of the blogger and not those of Stinson Leonard Street or any client.