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

The Dodd-Frank Act requires or authorizes various federal agencies to issue hundreds of rules to implement reforms intended to strengthen the financial services industry. As amended by Public Law No. 112-10, the act also mandates that the Government Accountability Office, or GAO, annually study financial services regulations. GAO has issued a report that examines:

  • the regulatory analyses agencies conducted in their Dodd-Frank rulemakings;
  • interagency coordination on such rulemakings and by CFPB in its supervision activities; and
  • the possible impact of selected Dodd-Frank provisions and related rules and agency plans to assess Dodd-Frank Act rules retrospectively.

In the report GAO recommends that the Office of Management and Budget, or OMB, issue guidance to help standardize Congressional Review Act, or CRA, processes. OMB disagreed such guidance is needed, in part because GAO did not identify inconsistencies in major rule designations. GAO maintains that the identified process inconsistencies could lead to differing designations under CRA, and its recommendation helps ensure consistency in designating major rules.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

 

The U.S. Department of the Treasury’s Federal Insurance Office, or FIO, has submitted to Congress and released a report on how to modernize and improve the system of insurance regulation in the United States.  Given the significance of the insurance sector in the U.S. economy, and the globally active nature of U.S. insurance firms, the report concludes that in some circumstances, policy goals of uniformity, efficiency, and consumer protection make continued federal involvement necessary to improve insurance regulation. However, the report concludes that insurance regulation in the United States is best viewed in terms of a hybrid model, where state and federal oversight play complementary roles and where the roles are defined in terms of the strengths and opportunities that each brings to improving solvency and market conduct regulation.

The report, mandated under Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act, makes recommendations in the areas of insurance sector solvency and marketplace regulation.  The recommendations outline near-term reforms that states should undertake regarding capital adequacy, safety and soundness, reform of insurer resolution practices, and marketplace regulation.  In addition, the report outlines areas for federal involvement in insurance regulation.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC charged a London-based hedge fund adviser and its former U.S.-based holding company with internal controls failures that led to the overvaluation of a fund’s assets and inflated fee revenue for the firms.  The case arose from the SEC’s Aberrational Performance Inquiry, an initiative by the Enforcement Division’s Asset Management Unit that uses proprietary risk analytics to identify hedge funds with suspicious returns. Performance that is flagged as inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny.

According to the SEC’s order instituting settled administrative proceedings, from November 2008 to November 2010, the firms’ internal control failures caused the overvaluation of the fund’s 25 percent private equity stake in an emerging market coal mining company.  The overvaluation resulted in inflated fees to the firms and the overstatement of assets under management in the holding company’s filings with the SEC.

According to the SEC’s order, asset valuation policies required the valuation of the coal company’s position to be determined monthly by an independent pricing committee.  On a number of occasions, the firms’ employees received information calling into question the $425 million valuation for the coal company position.  But there were inadequate policies and procedures to ensure that such relevant information was provided to the independent pricing committee in a timely manner or even at all.  There was confusion among the fund managers, middle-office accounting personnel, and senior management about who was responsible for elevating valuation issues to the independent pricing committee.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The so-called Volcker Rule, as required to be implemented by the Dodd-Frank Act, generally prohibits any banking entity from engaging in proprietary trading.  The final rule has been adopted by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, or the Agencies. The final rule includes exemptions from the prohibition on proprietary trading in several areas, including for underwriting, market-making and hedging.  Each of those three exemptions has restrictions on certain compensation arrangements.

Underwriting Exemption

Similar to the proposed rule, the underwriting exemption in the final rule requires that the compensation arrangements of persons performing the banking entity’s underwriting activities, as described in the exemption, be designed not to reward or incentivize prohibited proprietary trading.   The Agencies do not intend to preclude an employee of an underwriting desk from being compensated for successful underwriting, which involves some risk-taking.

Consistent with the proposal, activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of securities underwritten by the banking entity are inconsistent with the underwriting exemption. A banking entity may, however, take into account revenues resulting from movements in the price of securities that the banking entity underwrites to the extent that such revenues reflect the effectiveness with which personnel have managed underwriting risk. The banking entity should provide compensation incentives that primarily reward client revenues and effective client services, not prohibited proprietary trading. For example, a compensation plan based purely on net profit and loss with no consideration for inventory control or risk undertaken to achieve those profits would not be consistent with the underwriting exemption.

The Agencies did not adopt an approach that prevents an employee from receiving any compensation related to profits arising from an unsold allotment, because the Agencies believe the final rule already includes sufficient controls to prevent a trading desk from intentionally retaining an unsold allotment to make a speculative profit when such allotment could be sold to customers.  The Agencies also did not require compensation to be vested for a period of time.

Market-Making Exemption

Similar to the proposed rule, the market-making exemption requires that the compensation arrangements of persons performing the banking entity’s market making-related activities, as described in the exemption, are designed not to reward or incentivize prohibited proprietary trading.  The language of the final compensation requirement has been modified in response to comments expressing concern about the proposed language regarding “proprietary risk-taking.”  The Agencies note that the Agencies do not intend to preclude an employee of a market-making desk from being compensated for successful market making, which involves some risk-taking.

The Agencies continue to hold the view that activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of a position held in inventory, rather than use of that inventory to successfully provide effective and timely intermediation and liquidity services to customers, are inconsistent with permitted market making-related activities. Although a banking entity relying on the market-making exemption may appropriately take into account revenues resulting from movements in the price of principal positions to the extent that such revenues reflect the effectiveness with which personnel have managed retained principal risk, a banking entity relying on the market-making exemption should provide compensation incentives that primarily reward customer revenues and effective customer service, not prohibited proprietary trading.  For example, a compensation plan based purely on net profit and loss with no consideration for inventory control or risk undertaken to achieve those profits would not be consistent with the market-making exemption.

Hedging Exemption

The proposed rule required that the compensation arrangements of persons performing risk-mitigating hedging activities be designed not to reward proprietary risk-taking.  In the proposal, the Agencies stated that hedging activities for which a banking entity has established a compensation incentive structure that rewards speculation in, and appreciation of, the market value of a covered financial position, rather than success in reducing risk, are inconsistent with permitted risk-mitigating hedging activities.

The final rule substantially retains the proposed requirement that the compensation arrangements of persons performing risk-mitigating hedging activities be designed not to reward prohibited proprietary trading. The final rule was also modified to make clear that rewarding or incentivizing profit making from prohibited proprietary trading is not permitted.

The Agencies recognize that compensation, especially incentive compensation, may be both an important motivator for employees as well as a useful indicator of the type of activity that an employee or trading desk is engaged in. For instance, an incentive compensation plan that rewards an employee engaged in activities under the hedging exemption based primarily on whether that employee’s positions appreciate in value instead of whether such positions reduce or mitigate risk would appear to be designed to reward prohibited proprietary trading rather than risk-reducing hedging activities. Similarly, a compensation arrangement that is designed to incentivize an employee to exceed the potential losses associated with the risks of the underlying position rather than reduce risks of underlying positions would appear to reward prohibited proprietary trading rather than risk-mitigating hedging activities. The Agencies believe banking entities should review its compensation arrangements in light of the guidance and rules imposed by the appropriate Federal supervisor for the entity regarding compensation.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The SEC has granted the first bad actor waiver under Rule 506 to RBS Securities.  RBS pointed out the following to the SEC:

  • The disqualifying judgment arose out of a single offering of residential mortgage-backed securities in 2007.
  • The conduct did not pertain to offerings under Regulation A or D.
  • RBS Securities has taken steps to address the conduct alleged in the complaint. RBS Securities also has taken and will be taking actions reasonably designed to prevent potential violations of Section 17(a)(2) and (3) in connection with disclosures related to, and offer and sale of, residential mortgage-backed securities.
  • The disqualification of RBS Securities and its affiliates from relying on the exemptions available under Regulation A and Rules 505 and 506 of Regulation D would be unduly and disproportionately severe.
  • For a period of five years from the date of the final judgment, RBS Securities will furnish (or cause to be furnished) to each purchaser in a Rule 506 offering that would otherwise be subject to the disqualification under Rule 506(d)( l) as a result of the final judgment, a description in writing of the Final Judgment a reasonable time prior to sale.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

On November 25, 2013, the Commodity Futures Trading Commission (CFTC) settled with Daniel Shak and SHK Management LLC (collectively Respondents) for violating the Commodity Exchange Act (CEA). Read about the case here. Specifically, the CFTC found that Shak and SHK attempted to manipulate the price of light sweet crude oil (WTI) futures contracts by “banging the close” on two days in 2008. Further in pursuing its “bang of the close” strategy, Respondents exceeded the NYMEX position limits for this contract, thereby also violating the CEA. Finally, the CFTC found Shak liable for SHK’s violations of the CEA.

This is the second recent CFTC ‘banging the close” case (read about previous case here). This time, Respondents established substantial short positions by selling Trading At Settlement (TAS) contacts, priced at the daily settlement price. Immediately prior to the close, Respondents offset some of their TAS positions by buying outright futures contracts at a rapid pace to start driving the price of the contracts higher.  Then, Respondents bought at a rapid pace during the close, in the end accounting for 52.56% of the prompt month open interest during the close on one day and 63.55% on the other day.

Further in “banging the close,” Respondents violated the CEA by exceeding positions limits on the Light Sweet Crude Oil Futures Contract.  The CEA “unambiguously imposes liability for violations of contract market position limit rules.”  Order at 7.  In this case, Respondents exceeded the NYMEX-imposed 3,000 contract limit by approximately 500 the first day and 1,000 the second day.

Finally, the CFTC found Shak liable for the violations of SHK. Because Shak was the only principal of SHK, controlled the day-to-day operation of SHK and was responsible for (1) trading the pool account and (2) the employment of any SHK personnel or agents, the CFTC said that Shak possessed the requisite degree of control. Moreover, the CFTC said Shak either (1) knowingly induced, directly or indirectly, the acts constituting the violation or (2) failed to act in good faith.

To settle these violations, Shak and SMK agreed to, among other things, (1) a $400,000 fine, (2) a permanent ban on trading financial instruments in crude oil and (3) a two-year ban on trading any financial instrument during a closing period.

As in most market manipulative cases, there were “red flags” waving around, one of which in this case was that the Respondents’ trading was uneconomic and they made uneconomic trades in one market to benefit a position in another market. As the CFTC said, “[t]ypically, traders want to buy at low prices and sell at higher ones,” but here “Respondents bought at higher prices in order to ultimately benefit from pushing prices higher during the Close.  Since the settlement price of WTI futures contracts is based on the volume weighted average price of trades executed during the Close, Respondents would profit if the value of their substantial short TAS position in WTI futures contracts, which is based on the settlement price, was greater than the average value of their long position in WTI futures contracts.”  Order at 4.

Whistleblowers covered by one of 22 statutes (including Sarbanes-Oxley and Dodd-Frank) administered by the U.S. Department of Labor’s Occupational Safety and Health Administration will now be able to file complaints online.  Currently, workers can make complaints to OSHA by filing a written complaint or by calling certain telephone numbers.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The Public Company Accounting Oversight Board has reproposed for public comment amendments to PCAOB auditing standards that would provide greater transparency into audits of public companies, brokers, and dealers about the engagement partner and certain other participants in the audit.

The reproposed amendments would require disclosure in the auditor’s report of:

  • the name of the engagement partner who led the audit for the most recent period, and
  • the names, locations, and extent of participation (as a percentage of the total audit hours) of other public accounting firms that took part in the audit, and the locations and extent of participation of other persons (whether an individual or a company) not employed by the auditor who performed procedures on the audit.

In October 2011, the Board issued a proposal that, among other things, would have required disclosure of the name of the engagement partner without requiring a signature, as well as disclosure of other participants in the audit.

The Board is reproposing the amendments to seek additional comment on matters such as the usefulness of the information that would be required to be disclosed, the potential costs the reproposed amendments might impose, whether the reproposed amendments would have any effect on competition, and any other aspects of the reproposal. The Board has also made technical changes to the originally proposed requirement that the auditor disclose information about other participants in the audit, such as changing the threshold for disclosure, and seeks commenters’ views on those revisions. Finally, the Board is soliciting commenters’ views regarding whether the reproposed amendments should apply to audits of emerging growth companies, as that term is defined in the Jumpstart Our Business Startups Act of 2012.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

On December 4, 2013, the SEC released a new batch of FAQs regarding new Rules 506(d) and 506(e). Before diving in to the clarifications provided and the new uncertainties raised by the SEC in the new FAQs, you might want to take a quick look back at our prior post explaining the rules.  Broadly speaking, Rule 506(d) disqualifies an issuer from relying on Rule 506 in a private offering if a person subject to the rule (a “covered person”) has committed any of a number of enumerated prohibited acts (“bad acts”) with various look-back periods.  Rule 506(e) requires issuers to disclose to purchasers past bad acts by covered persons that do not lead to disqualification, but would have led to disqualification at the time of the offering if Rule 506(d) had been applicable to the offering.

Some of the answers provided by the SEC in the new FAQs are straightforward.  For example:

  • Bad acts under the laws of non-U.S. jurisdictions (and orders, judgments, etc. of authorities in non-U.S. jurisdictions) don’t count for purposes of Rule 506(d)
  • If the body that enters the relevant order, judgment, or decree advises in writing that the order, judgment, or decree should not result in a violation of Rule 506(d)(1) (as described in Rule 506(d)(2)(iii)), then a separate waiver from the SEC is not necessary (in other words, Rule 506(d)(2)(iii) is self-executing)
  • Compensated solicitors (discussed below) are not limited to registered brokers and their associated persons
  • The term “affiliated issuer” means only an affiliate (per Rule 501(b)) that is issuing securities in the same offering, including offerings subject to integration
  • There are no waivers for the requirement to disclose bad acts that would have led to disqualification at the time of the offering if Rule 506(d) had then been applicable
  • If a past bad act was outside of the applicable look back period at the time of the offering, then disclosure under Rule 506(e) is not required
  • In an offering with multiple placement agents, disclosure of the bad acts of the covered persons of all placement agents then involved in the offering to all purchasers is required – the disclosure obligation to a particular purchaser is not limited to the placement agent that actually solicits such purchaser
  • In a continuous offering, Rule 506(e) disclosures need not be made for all covered persons who have ever been involved in the offering; rather, disclosure must be made a reasonable time prior to a particular sale with respect to covered persons then involved in the offering

A few of the FAQs, however, are less clear and in some cases raise additional questions:

When must an issuer bring down or freshen its bad actor inquiry?

The bad actor determination must be made any time an issuer is offering or selling securities.  The SEC’s position is that an issuer “may reasonably rely” on a covered person’s undertaking to provide notice of a disqualifying event pursuant to contractual or bylaw requirements or an undertaking in a questionnaire.  However, a covered person’s current certification and undertaking to provide notice of any future bad acts goes stale at some point and requires freshening via a bring-down certification or other means.  The SEC is not clear on when a bring down would be necessary, stating only that “if an offering is continuous, delayed, or long-lived, the issuer must update its factual inquiry periodically.”  What is a “long-lived” offering?  What does “periodically” mean?  Would an issuer that uses an annual questionnaire with an undertaking to provide notice of any subsequent bad acts need to obtain bring-downs of the bad actor reps for an offering conducted nine months after the date of the last questionnaire?  How about six months?  These are just a few of the questions raised by this attempted clarification by the SEC.

When does the “I couldn’t have known” exception apply?

Rule 506(d)(2)(iv) provides an exception to the disqualification provisions in Rule 506(d)(1) if the issuer establishes that it did not, and in the exercise of reasonable care could not, know about the bad act.  Reasonable care requires that the issuer at least make inquiry of the covered persons, but the specific steps that constitute reasonable care in a given instance will depend on the facts and circumstances.  This exception applies not only to bad acts (i.e., the issuer has correctly identified the covered persons but fails to discover a bad act), but also to matters of the identity of covered persons (i.e., the issuer fails to identify all covered persons or mistakenly excludes from inquiry a covered person).

When can an issuer avoid disqualification by terminating the covered person status of a bad actor?

If a placement agent becomes subject to a disqualification while an offering is ongoing, the issuer can continue to rely on Rule 506 as long as it terminates the engagement with the placement agent and pays no compensation to the agent for future sales.  A similar concept applies when only one or a subset of covered persons associated with the placement agent are affected by a disqualification event (i.e., the offering can continue as long as the persons subject to the disqualifying event are terminated by the placement agent or reduced to roles that do not make them “covered persons” for purposes of Rule 506(d)).   It’s unclear when the termination of covered person status must occur in order to allow the issuer to continue to rely on Rule 506.  It makes sense that if the disqualifying event occurs after sale A in the offering, but the bad actor is cut off before Sale B, then the Rule 506 exemption remains available.  But what if there are intervening sales that occur after the disqualifying event occurs but before the bad actor is cut off?  What if a disqualifying event has occurred, but the issuer doesn’t immediately learn about the disqualifying event?  Would the Rule 506(d)(2)(iv) exception be available?  If so, at what point in time would the analysis of the issuer’s factual inquiry focus on?

What constitutes “participating in” an offering?

Covered persons, for purposes of the rule, include “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers” (a “compensated solicitor” for short) in the offering as well as “any director, executive officer, or other officer participating in the offering” of the compensated solicitor. One of the FAQs relates to when an officer of a compensated solicitor is deemed to be “participating in the offering” and therefore is a covered person.  The SEC describes a spectrum of activities a person could engage in with respect to the offering.  On one end of the spectrum, a person who merely sits on the deal committee of a compensated solicitor and approves the involvement of the compensated solicitor in the offering, or who performs only administrative duties like bookkeeping, is not “participating” in the offering.  On the other end of the spectrum are persons who actively solicit investors on behalf of the compensated solicitor, and who clearly are “participating” in the offering.  In the mushy middle are persons who do more than just administration, but less than actual solicitation.  If a person engages in activities such as performing due diligence, preparing offering documents, or communicating with the issuer or prospective investors about the offering, and if those activities are not “transitory or incidental,” then the person will be deemed to be “participating” in the offering.  How will the SEC analyze whether actions are transitory or incidental?  Will the SEC examine a particular person’s role in other offerings?   

How does one recognize a scienter-based anti-fraud provision of the federal securities laws?

One of the bad acts that can lead to disqualification is a covered person being subject to any order of the SEC entered within the last five years that orders the person to cease and desist from committing or causing a violation or future violation of “any scienter-based anti-fraud provision of the federal securities laws.”  There is some ambiguity here as it relates to securities regulations that are promulgated pursuant to provisions of securities laws, where the laws contain scienter elements but the rules do not.  For example, since Section 10(b) of the Exchange Act contains a scienter element, would a cease and desist order relating to violations of any rule promulgated pursuant to Section 10(b) of the Exchange Act qualify as bad acts for purposes of the rule?  The SEC answers no and provides the example of Exchange Act Rule 105, which is promulgated pursuant to Exchange Act Section 10(b) but does not contain a scienter element.  A cease and desist order relating to Rule 105 would not qualify as a bad act for purposes of the rule.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.

The CFPB has issued a rule that allows the CFPB to supervise certain nonbank student loan servicers for the first time.

The CFPB currently oversees student loan servicing at the largest banks. The new rule expands that supervision to any nonbank student loan servicer that handles more than one million borrower accounts, regardless of whether they service federal or private loans. Under the rule, those servicers will be considered “larger participants,” and the CFPB may oversee their activity to ensure they are complying with federal consumer financial laws.

Under the new rule, which was proposed in March, the CFPB estimates that it will have authority to supervise the seven largest student loan servicers. Combined, the CFPB believes those seven service the loans of more than 49 million borrower accounts, representing most of the activity in the student loan servicing market.

Check dodd-frank.com frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.