Category: finance

CFPB Takes Aim at Data Brokers in Proposed Rule Amending FCRA

On December 3, the CFPB announced a proposed rule to enhance oversight of data brokers that handle consumers’ sensitive personal and financial information. The proposed rule would amend Regulation V, which implements the Fair Credit Reporting Act (FCRA), to require data brokers to comply with credit bureau-style regulations under FCRA if they sell income data or certain other financial information on consumers, regardless of its end use.

Should this rule be finalized, the CFPB would be empowered to enforce the FCRA’s privacy protections and consumer safeguards in connection with data brokers who leverage emerging technologies that became prevalent after FCRA’s enactment.

What are some of the implications of the new rule?

  • Data Brokers are Now Considered CRAs. The proposed rule defines the circumstances under which companies handling consumer data would be considered CRAs by clarifying the definition of “consumer reports.” The rule specifies that data brokers selling any of four types of consumer information—credit history, credit score, debt payments, or income/financial tier data—would generally be considered to be selling a consumer report.
  • Assembling Information About Consumers Means You are a CRA. Under the rule, an entity is a CRA if it assembles or evaluates information about consumers, including by collecting, gathering, or retaining; assessing, verifying, validating; or contributing to or altering the content of such information. This view is in step with the Bureau’s recent Circular on AI-based background dossiers of employees. (See our prior discussion here.)
  • Header Information is Now a Consumer Report. Under the proposed rule, communications from consumer reporting agencies of certain personal identifiers that they collect—such as name, addresses, date of birth, Social Security numbers, and phone numbers—would be consumer reports. This would mean that consumer reporting agencies could only sell such information (typically referred to as “credit header” data) if the user had a permissible purpose under the FCRA.
  • Marketing is Not a Legitimate Business Need. The proposed rule emphasizes that marketing is not a “legitimate business need” under the FCRA. Accordingly, CRAs could not use consumer reports to decide for an advertiser which consumers should receive ads and would not be able to send ads to consumers on an advertiser’s behalf.
  • Enhanced Disclosure and Consent Requirements. Under the FCRA, consumers can give their consent to share data. Under the proposed rule, the Bureau clarified that consumers must be provided a clear and conspicuous disclosure stating how their consumer report will be used. It would also require data brokers to acknowledge a consumer’s right to revoke their consent. Finally, the proposed rule requires a new and separate consumer authorization for each product or service authorized by the consumer. The Bureau is focused on instances where a customer signs up for a specific product or service, such as credit monitoring, but then receives targeted marketing for a completely different product.

Comments on the rule must be received on or before March 3, 2025.

Putting It Into Practice: With the release of the rule so close to the end of Director Chopra’s term, it will be interesting to see what a new administration does with it. We expect a new CFPB director to scale back and rescind much of the informal regulatory guidance that was issued by the Biden administration. However, some aspects of the data broker rule have bipartisan support so we may see parts of it finalized in 2025.

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Copyright © 2024, Sheppard Mullin Richter & Hampton LLP.
For more on the CFPB, visit the NLR Financial Institutions Banking section

Proposed Disregarded Payment Loss Rules Create Traps for the Unwary

Be wary: The US Department of the Treasury’s proposed disregarded payment loss (DPL) regulations lay surprising new traps for multinational taxpayers – and those ensnared are unlikely to see what’s coming.

Under the proposed regulations, disregarded payments from a foreign disregarded entity to its domestic corporate parent can give rise to a US income inclusion without any offsetting deduction.[1] This phantom income can be substantial and because the inclusion results from payments that are disregarded as a matter of US tax law, it is sure to be an unwelcome surprise for some taxpayers.

Multinational taxpayers with US corporate entities that hold or acquire interests in foreign disregarded entities should understand the proposed regulations, determine their potential exposure, and consider steps to mitigate potential tax liabilities. This article provides a high-level overview of the proposed regulations and reviews the questions that multinational companies should ask themselves before the traps are sprung.

In Depth

The DPL rules are included in proposed regulations that were published on August 7, 2024.[2] The proposed regulations address, among other topics, how the Section 1503(d) dual consolidated loss (DCL) rules apply in the context of Pillar Two taxes. Though the proposed regulations include both DCL and DPL rules and the DPL rules use similar timing and concepts as the DCL rules, the DPL rules operate separately and apply to a different set of circumstances.[3]

While the DCL rules prevent taxpayers from deducting the same loss twice (once in the United States and once in a foreign jurisdiction), the DPL rules target “deduction/no inclusion” (D/NI) outcomes. In a D/NI scenario, a domestic corporation owns a foreign disregarded entity that makes payments to its domestic corporate parent. The payments are regarded for foreign tax purposes and may give rise to a foreign deduction or loss but are disregarded for US tax purposes, so there is no corresponding US income inclusion. Under foreign tax law, the foreign deduction or loss can be used to offset other foreign income and reduce foreign tax.[4]

To prevent D/NI outcomes, the proposed DPL rules identify certain foreign tax losses attributable to disregarded payments and then require the domestic corporate parent to include a corresponding amount of income for US tax purposes. However, the rules are extremely broad and may require US income inclusions where there is no D/NI outcome or potentially when the foreign disregarded entity is not actually in a loss position from a foreign tax perspective.[5]

As explained below, the rules (1) apply only to domestic corporations that are deemed to consent to their application, (2) may require domestic corporations to include a substantial “DPL inclusion amount” as ordinary income with no offsetting deduction, and (3) will require such inclusion whenever one of two triggering events occur, namely, a “foreign use” of the DPL or a failure to satisfy the rules’ certification requirements.

DEEMED CONSENT

The DPL rules apply only to consenting domestic corporations but set a low bar for what this “consent” requires. Essentially, a domestic corporation consents to the rules if it owns a foreign disregarded entity, with the applicability date depending on when the domestic corporation acquired or checked the box on the foreign disregarded entity.

First, a domestic corporation consents to the DPL rules if it directly or indirectly owns interests in a “specified eligible entity”[6] that makes a check-the-box election on or after August 6, 2024, to be a disregarded entity.[7]

Second, a domestic corporate owner is deemed to consent to the DPL rules if, as of August 6, 2025, the entity directly or indirectly owns interests in a disregarded entity and has not otherwise consented to the rules. To avoid such deemed consent with respect to a disregarded entity, the disregarded entity may instead elect to be treated as a corporation prior to August 6, 2025. Of course, the related consequences of such an election can be significant.[8]

THE DPL INCLUSION AMOUNT

Domestic corporations that consent to the rules may be required to include a DPL inclusion amount as income. For a specified eligible entity or foreign branch of a consenting domestic corporation (such specified eligible entity or foreign branch is referred to as a “disregarded payment entity”), the DPL for a given tax year is the disregarded payment entity’s net loss for foreign tax purposes that is composed of certain items of income and deduction that are disregarded for US tax purposes.[9] The notice of proposed rulemaking (NPRM) provides the following example:

[I]f for a foreign taxable year a disregarded payment entity’s only items are a $100x interest deduction and $70x of royalty income, and if each item were disregarded for U.S. tax purposes as a payment between a disregarded entity and its tax owner (but taken into account under foreign law), then the entity would have a $30x disregarded payment loss for the taxable year.

The DPL inclusion amount is the DPL amount reduced by the positive balance of the “DPL cumulative register.” The DPL cumulative register reflects the cumulative amount of disregarded payment income attributable to the disregarded payment entity across multiple years. The NPRM also provides the following example:

[I]f a disregarded payment entity incurs a $100x disregarded payment loss in year 1 and has $80x of disregarded payment income in year 2, only $20x of the disregarded payment loss is likely available under the foreign tax law to be put to a foreign use. As such, if a triggering event occurs at the end of year 2, then the specified domestic owner must include in gross income $20x (rather than the entire $100x of the disregarded payment loss).

Taxpayers who expect to benefit from the DPL cumulative register should keep in mind that the register only reflects disregarded payments that would be interest, royalties, or structured payments if regarded for US tax purposes. It reflects no other disregarded payments, and it reflects no regarded payments of any sort.

Notably, disregarded payment entities “for which the relevant foreign tax law is the same” are generally combined and treated as a single disregarded payment entity for purposes of the DPL rules. As a result, disregarded payments between entities formed in the same foreign jurisdiction generally should not give rise to DPL inclusions. However, this rule applies only where the entities have the same foreign tax year and are owned by the same consenting domestic corporation or by consenting domestic corporations that are members of the same consolidated group. Further, to ensure the items of foreign income and deduction net against one another within the combined disregarded payment entity, taxpayers should analyze the applicable foreign tax rules to confirm that these items accrue in the same foreign taxable year.

THE TRIGGERING EVENTS

Consenting domestic corporations will be forced to include the DPL inclusion amount as ordinary income if one of two triggering events occurs within a certification period. A certification period includes the foreign tax year in which the DPL is incurred, any prior foreign tax year, and the subsequent 60-month period. These certification periods and triggering events are somewhat similar to the ones used in the DCL rules. In the case of the DPL rules, however, there is no ability to make a domestic use election, as for US tax purposes there is no regarded loss that can be used to offset US tax.

The first triggering event is a “foreign use” of the DPL. A foreign use is determined under the principles of the DCL rules. Thus, a foreign use generally occurs when any portion of a deduction taken into account in computing the DPL is made available to offset or reduce income under foreign tax law that is considered under US tax law to be income of a related foreign corporation (and certain other entities in limited circumstances).

The second triggering event occurs if the domestic corporation fails to comply with certification requirements. Specifically, where a consenting domestic corporation’s disregarded entity has incurred a DPL, the domestic corporation must certify annually throughout the certification period that no foreign use of the DPL has occurred.

HYBRID MISMATCH RULES AND PILLAR TWO

The DPL rules provide that if a relevant foreign tax law denies a deduction for an item to prevent a D/NI outcome, the item is not taken into account for purposes of computing DPL or disregarded payment income. These so-called “hybrid mismatch rules” go some way toward softening the headache the DPL rules are likely to cause taxpayers.

However, foreign countries’ adoption of Pillar Two rules will exacerbate their impact. The rules make clear that for purposes of a qualified domestic minimum top-up tax (QDMTT) or income inclusion rule (IIR) top-up tax, foreign use is considered to occur where a portion of the deductions or losses that comprise a DPL is taken into account in determining net Global Anti-Base Erosion Rules income for a QDMTT or IIR or in determining qualification for the Transitional Country-by-Country Safe Harbor.[10] There is also a transition rule providing that, for this purpose, QDMTTs and IIRs are not taken into account for taxable years beginning before August 6, 2024.[11] This means that calendar year taxpayers who have not consented early to the DPL rules generally should not have a DPL inclusion amount in 2024 solely as a result of Pillar Two taxes, but, depending on their facts, could have an inclusion next year if proactive measures are not taken.

NEXT STEPS

Now is the time for multinational taxpayers to evaluate their risk under the DPL rules. Taxpayers with a domestic corporation in their structure should think carefully before making check-the-box elections to treat foreign entities as disregarded entities.[12] Moreover, taxpayers should determine whether their domestic corporations own any foreign disregarded entities or other specified entities that will cause them to be deemed to consent to the rules as of August 6, 2025.

Multinational taxpayers also should determine whether they have disregarded interest payments, structured payments, or royalties that fall under the purview of the rules. If so, they should consider whether they will be able to avoid future triggering events or if “foreign uses” of DPLs will be unavoidable. One should pay particular attention to Pillar Two, including the Transitional Country-by-Country Safe Harbor, when considering whether there could be a foreign use.

Taxpayers who cannot avoid triggering events should consider whether, and when, to take some defensive measures. Such actions might include winding up foreign disregarded entities that could be subject to the rules, eliminating disregarded payments that would result in DPL income inclusions,[13] or taking other restructuring steps (e.g., electing to treat certain foreign disregarded entities as associations, as the Treasury suggests). When determining whether to take defensive actions, taxpayers should consider the impact that DPL inclusions could have on their overall tax profile, including sourcing issues, foreign tax credits, and the Section 163(j) limitation on business interest deductions. In terms of timing, taxpayers also should consider whether they have until August 5, 2025, to unwind any arrangements subject to the DPL rules or whether it may be prudent to unwind any such arrangements before the end of the year.

Finally, taxpayers concerned about these rules should watch for news about whether they will be issued in final form. The results of the 2024 US presidential election call into question whether the proposed rules will be finalized or, conceivably, shelved.[14] These considerations further complicate the question of whether and when multinational taxpayers should act in response to the rules, particularly as the clock continues to tick toward the deemed consent date of August 6, 2025.

Endnotes

[1] The proposed regulations also can apply to payments made by a foreign disregarded entity to other foreign disregarded entities owned by the same domestic corporate parent.

[2] REG-105128-23.

[3] Although not analyzed in detail here, the proposed changes to the DCL rules are also significant and taxpayers should consider their impact.

[4] For example, the foreign deduction or loss can be used through a loss surrender or consolidation regime.

[5] For example, this may occur when a foreign disregarded entity makes a payment that is included in another foreign disregarded entity payee’s income for foreign tax purposes.

[6] A specified eligible entity is an eligible entity that is a foreign tax resident or owned by a domestic corporation that has a foreign branch.

[7] The rules also can apply to an entity that is formed or acquired after August 6, 2024, and classified without an election as a disregarded entity.

[8] For example, Section 367 may apply to a deemed contribution to the newly regarded foreign corporation.

[9] Generally, these are items of income and deduction from certain disregarded interest, royalties, and “structured payments” within the meaning of the Section 267A regulations.

[10] A limited exception is available in certain cases where the Pillar Two duplicate loss arrangement rule applies.

[11] This favorable transition rule is subject to an anti-abuse provision that can prevent it from applying.

[12] Taxpayers also should give careful thought to any internal restructurings involving foreign disregarded entities.

[13] Eliminating these payments may, of course, result in a corresponding increase in foreign tax liability.

[14] Commentators to the proposed regulations also have raised substantive invalidity arguments under the Loper Bright framework.

© 2024 McDermott Will & Emery
For more on the Treasury, visit the NLR Tax section

How to Prepare for the Upcoming Filing Deadline Under the Corporate Transparency Act (CTA)

The January 1, 2025 filing deadline under the CTA for filing beneficial ownership information reports (BOI reports) for reporting companies formed prior to January 1, 2024 is rapidly approaching.

January 1, 2025 Filing Deadline

The CTA became effective on January 1, 2024. If you have filed a BOI report in the last 11 months, it may have been in connection with BOI reporting requirements for entities formed in 2024, because any reporting company formed on or after January 1, 2024 is required to submit its initial BOI report within 90 days of the filing of formation documents. However, the CTA’s BOI report requirements also apply to entities formed before 2024 (as well as to entities formed in 2025 and beyond), and the deadline for filing BOI reports for these entities is fast approaching. BOI reports for entities formed before 2024 must be filed by January 1, 2025, and as further discussed below, BOI reports for entities formed on or after January 1, 2025 must be filed within 30 days of the filing of formation documents.

Compliance with the Corporate Transparency Act

Below are several initial steps to take to prepare for this upcoming deadline:

1. Exemptions. Assuming your entity was formed by the filing of a document with a secretary of state or any similar office under the law of a State or Indian Tribe, your entity may be a reporting company subject to the CTA. If so, review the 23 exemptions to being a reporting company and confirm if any of these exemptions apply to any of your entities.

  • An entity formed as noted above that qualifies for any of these 23 exemptions is not required to submit a BOI report to the Financial Crimes Enforcement Network (FinCEN).
  • An entity formed as noted above that does not qualify for any exemption is referred to as a “reporting company” and will be required to submit a BOI report to FinCEN.

2. Entity Records. Review the entity records for each reporting company and confirm that these records reflect accurate, up to date information with respect to the ownership percentages, management, etc. of each entity within the structure.

3. Determine Beneficial Owners. There are two types of reporting company beneficial owners: (i) any individual (natural person) who directly or indirectly owns 25% or more of a reporting company, and (ii) any individual (including any individual who owns 25% or more of the reporting company) who directly or indirectly exercises substantial control over the reporting company. FinCEN expects that every reporting company will be substantially controlled by at least one individual, and therefore will have at least one beneficial owner. There is no maximum number of beneficial owners who must be reported.

4. FinCEN Identifiers. Once the individual(s) who qualify as beneficial owners of any of your reporting companies have been identified, you may obtain FinCEN identifiers for these individuals. Although this step is not required, obtaining a FinCEN identifier will allow you to report an individual’s FinCEN identifier number in lieu of his or her personal beneficial ownership information in the BOI report filed for the reporting company in which he or she has been determined to be a beneficial owner. If/when any beneficial ownership information changes for that individual, the individual will be required to update the beneficial ownership information associated with his or her FinCEN identifier, but each reporting company which this individual is a beneficial owner of will not be required to file a corresponding update (unless an update is required for a separate reason).

5. Prepare to File BOI Reports Sooner Rather than Later. With the January 1, 2025 filing deadline fast approaching and over 32 million entities expected to be impacted by the CTA, we recommend taking the steps to prepare and file BOI reports for your reporting companies as soon as possible. While awareness of the CTA and its requirements continues to grow, people still have questions and concerns regarding how their personal information will be handled, and it can take time to collect the necessary information. Accordingly, identifying any beneficial owners and requesting their beneficial ownership information as soon as possible will help to avoid any last-minute scrambles to prepare and file your reporting companies’ BOI reports. Some have questioned whether BOI reports are subject to disclosure under the Freedom of Information Act (FOIA). FinCEN has pointed out that these reports are exempt from disclosure under FOIA.

6. Reach Out With Questions. We have a team of attorneys, paralegals and support staff that would be happy to help guide you through this process.

The Corporate Transparency Act in 2025 and Beyond

In addition to reporting requirements for reporting companies formed before 2024 and during 2024 as outlined above, all entities formed in 2025 and beyond that qualify as reporting companies will be required to submit BOI reports within 30 days of the filing of formation documents. This is a significantly shorter filing window than what was imposed on entities formed before and during 2024. Accordingly, moving forward, for entities formed in 2025 and beyond, the CTA should be viewed as an additional step in the entity formation process.

The CTA also imposes requirements for updating BOI reports following any changes to the beneficial ownership information reported on a BOI report. Any changes to the beneficial ownership information must be reflected in an updated BOI reports filed with FinCEN no later than 30 days after the date on which the change occurred (note, the same 30-day timeline applies to changes in information submitted by an individual in order to obtain a FinCEN identifier).

© 2010-2024 Allen Matkins Leck Gamble Mallory & Natsis LLP
For more on the CTA, visit the NLR Corporate Business Organizations section.

CFPB Imposes $95 Million Fine on Large Credit Union for Overdraft Fee Practices

On November 7, 2024, the CFPB ordered one of the largest credit unions in the nation to pay over $95 million for its practices related to the imposition of overdraft fees. The enforcement action addresses practices from 2017 to 2022 where the credit union charged overdraft fees on transactions that appeared to have sufficient funds, affecting consumers including those in the military community, in violation of the CFPA’s prohibition on unfair, deceptive, and abusive acts or practices.

The Bureau alleges that the credit union’s practices, particularly in connection with its overdraft service, resulted in nearly $1 billion in revenue from overdraft fees over the course of five years. According to the Bureau, the credit union unfairly charged overdraft fees in two ways. First, it charged overdraft fees on transactions where the consumer had a sufficient balance at the time the credit union authorized the transaction, but then later settled with an insufficient balance. The Bureau noted that these authorize-positive/settle-negative violations have been a focus of federal regulators since 2015, and were the subject of a CFPB circular in October 2022. Second, when customers received money though peer-to-peer payment networks, the credit union’s systems showed the money as immediately available to spend. However, the credit union failed to disclose that payments received after a certain time of the day would not post until the next business day. Customers who tried to use this apparently available money were then charged overdraft fees

In addition to monetary fines, the CFPB’s order prohibits the credit union from imposing overdraft fees for authorize-positive, settle negative transactions, and also in cases where there was a delayed crediting of funds from peer-to-peer payment platforms.

The monetary penalties the consent order imposes consist of $80 million in consumer refunds for wrongfully charged overdraft fees and a $15 million civil penalty to be paid to the CFPB’s victims relief fund.

Putting It Into Practice: This order aligns with federal and state regulators’ recent focus on overdraft fees in a broader initiative to eliminate allegedly illegal “junk fees” (a trend we previously discussed here, here, and here). For companies operating in the financial sector or providing peer-to-peer payment services, this enforcement action serves as a critical reminder of the need for transparency and adherence to consumer financial protection laws. Regular audits of fee practices and disclosures can help identify and rectify potential compliance issues before they escalate. Companies aiming to impose overdraft or other types of fees should review agency guidance enforcements to ensure their internal policies and business practices do not land them in hot water.

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Copyright © 2024, Sheppard Mullin Richter & Hampton LLP.
For more on the CFPB, visit the NLR Financial Institutions Banking section.

Lawsuit Challenges CFPB’s ‘Buy Now, Pay Later’ Rule

On Oct. 18, 2024, fintech trade group Financial Technology Association (FTA) filed a lawsuit challenging the Consumer Financial Protection Bureau’s (CFPB) final interpretative rule on “Buy Now, Pay Later” (BNPL) products. Released in May 2024, the CFPB’s interpretative rule classifies BNPL products as “credit cards” and their providers as “card issuers” and “creditors” for purposes of the Truth in Lending Act (TILA) and Regulation Z.

The FTA filed its lawsuit challenging the CFPB’s interpretative rule in the U.S. District Court for the District of Columbia. The FTA alleges that the CFPB violated the Administrative Procedure Act’s (APA) notice-and-comment requirements by imposing new obligations on BNPL providers under the label of an “interpretive rule.” The FTA also alleges that the CFPB violated the APA’s requirement that agencies act within their statutory authority by ignoring TILA’s effective-date requirement for new disclosure requirements and imposing obligations beyond those permitted by TILA. The FTA also contends that the CFPB’s interpretive rule is arbitrary and capricious because it is “a poor fit for BNPL products,” grants “insufficient time for BNPL providers to come into compliance with the new obligations” imposed by the rule, and neglects “the serious reliance interests that [the CFPB’s] prior policy on BNPL products engendered.”

In a press release announcing its lawsuit, the FTA said the BNPL industry would welcome regulations that fit the unique characteristics of BNPL products, but that the CFPB’s interpretive rule is a poor fit that risks creating confusion for consumers. “Unfortunately, the CFPB’s rushed interpretive rule falls short on multiple counts, oversteps legal bounds, and risks creating confusion for consumers,” FTA President and CEO Penny Lee said. “The CFPB is seeking to fundamentally change the regulatory treatment of pay-in-four BNPL products without adhering to required rulemaking procedures, in excess of its statutory authority, and in an unreasonable manner.”

The FTA’s pending lawsuit notwithstanding, BNPL providers may wish to consult with legal counsel regarding compliance with the CFPB’s interpretive rule. Retailers marketing BNPL products should also consider working with legal counsel to implement third-party vendor oversight policies to enhance BNPL-partner compliance with the rule.

©2024 Greenberg Traurig, LLP. All rights reserved.
For more on the CFPB, visit the NLR Financial Institutions Banking section.

Rytr or Wrong: Is the FTC’s Operation AI Comply a Prudent Defense Against Deception or an Assault on Innovation and Constitutional Free Speech?

In today’s rapidly evolving digital economy, new artificial intelligence tools promise to transform every industry. Sometimes, those promises are overblown or outright deceptive. So, as the AI hype cycle continues, regulators are left with the unenviable role of determining their duties to shape the impact of these developing tools on businesses and the public. Although the EEOC, SEC, DOJ and several State Attorneys General are issuing warnings and increasingly investigating the risks of AI, this tension is on full display with the Federal Trade Commission’s recent enforcement actions announced as part of its “Operation AI Comply,” which marks the beginning of its “new law enforcement sweep” against companies that are relying on AI “as a way to supercharge deceptive or unfair conduct that harms consumers.”1

Although many of the initial targets of Operation AI Comply were accused of conduct that plausibly violated Section 5, the FTC’s charges against an AI writing assistant, Rytr, drew strong dissents from two of the FTC Commissioners who accused their fellow commissioners of effectively strangling AI innovation in the crib. There are several important takeaways from Operation AI Comply, particularly if the dissenting commissioners have correctly identified that the FTC is pushing the boundaries of its authority in pursuit of AI.

The FTC and its Role in AI Regulation.

The FTC plays a critical role in protecting consumers from unfair or deceptive practices, and it has long been warning developers about how their algorithms and AI tools might violate one of its broadest sources of statutory authority: Section 5 of the FTC Act.2

In many respects, the FTC’s September 25, 2024, announcement of its “Crackdown on Deceptive AI Claims and Schemes” should not have come as a surprise, as most of the enforcement actions related to overhyping AI.3 For example, the FTC’s Complaint and proposed settlement with DoNotPay – which made bold claims about being “the world’s first robot lawyer” and that it could “generate perfectly valid legal documents in no time,” replacing “the $200-billion-dollar legal industry with artificial intelligence”4– turned on relatively straightforward false or unsubstantiated performance claims in violation of Section 5 of the FTC Act.5 Similarly, the FTC’s charges against Ascend Ecom,6 Ecommerce Empire Builders,7 and FBA Machine8 all relate to allegations of e-commerce business opportunity schemes that generally engaged in AI-washing – i.e., a tactic of exaggerating or falsely representing that a product uses AI in an effort to make the product or company appear more cutting edge than it actually is.9 Each of these four cases was unanimously supported by the Commission, receiving 5-0 votes, and is consistent with other actions brought by the FTC to combat unfair, deceptive, or discriminatory impacts of AI.10

However, with a 3-2 split among its commissioners, the FTC’s complaint against Rytr is a different story.11 Historically, unanimous decisions were more typical; however, split decisions are becoming more common as the FTC pursues more aggressive enforcement actions and reflect a broader ideological conflict about the role of regulation and market intervention.

Rytr: Creative Assistant or Assistant to Fraud?

Rytr is a generative AI writing assistant that produces unlimited written content for subscribers for over 43 use cases.12 At the core of the FTC’s complaint against Rytr is the risk that one of its use cases – a “Testimonial & Review” feature – can be used to create customer reviews that may be false or misleading.13

Based on limited user input, users can generate “genuine-sounding, detailed reviews quickly and with little user effort,” which the FTC believes “would almost certainly be false for users who copy the generated content and publish it online.”14 The FTC gives one example where a user provided minimal inputs of “this product” and “dog shampoo” to generate a detailed paragraph boasting how the dog shampoo smelled great, reduced shedding, improved the shine of their dog’s coat, and recommended the product.15 Based on example inputs and outputs like this, the FTC concluded that Rytr’s services “causes or is likely to cause substantial harm to consumers” and “its likely only use is to facilitate subscribers posting fake reviews with which to deceive consumers.”16 As such, the FTC’s complaint argues that Rytr – by offering a tool that could be readily used to generate false reviews — provided the “means and instrumentalities for deception” and engaged in unfair acts or practices in violation of Section 5 of the FTC Act.17

In other words, the majority of the FTC Commissioners were concerned about an infinite potential for inaccurate or deceptive product reviews by Rytr’s subscribers and did not recognize countervailing reasons to allow this use of technology. Without admitting or denying the allegations in the Complaint, Rytr agreed to a proposed settlement with the FTC by which Rytr would stop offering the Testimonial & Review use case at issue in this case18 – a pragmatic solution to avoid litigation with the government.

Dissents from the FTC’s Direction.

Commissioners Melissa Holyoak and Andrew Ferguson submitted two dissenting statements, criticizing the complaint against Rytr as an aggressive expansion of the FTC’s authority under Section 5 and cautioned against its chilling effect on a nascent industry.19

Commissioner Ferguson framed the internal conflict well: “Treating as categorically illegal a generative AI tool merely because of the possibility that someone might use it for fraud is inconsistent with our precedents and common sense. And it threatens to turn honest innovators into lawbreakers and risks strangling a potentially revolutionary technology in its cradle.”20 The dissenting statements identified three broad objections to the Rytr complaint.

First, as a threshold matter, the complaint failed to identify any evidence of actual harmful or deceptive acts stemming from Rytr’s product – a clear requirement under Section 5 of the FTC Act.21 Both dissents criticized the complaint for effectively treating draft outputs from Rytr as the final reviews published by users; however, “the Commission does not allege a single example of a Rytr-generated review being used to deceive consumers in violation of Section 5 [.]22 Both dissents criticized the complaint for ignoring the obvious benefits of generative AI in this context. Namely, that “much of the promise of AI stems from its remarkable ability to provide such benefits to consumers using AI tools. . . . If Rytr’s tool helped users draft reviews about their experiences that they would not have posted without the benefit of a drafting aid, consumers seeing their reviews benefitted, too.”23

Second, the dissenters rejected the complaint as “a dramatic extension of means-and-instrumentalities liability,”24 particularly in a case “where there is no allegation that Rytr itself made misrepresentations.”25 The complaint focused on the fact that Rytr “has furnished its users and subscribers with the means to generate written content for consumer reviews that is false and deceptive[,]” thus providing “the means and instrumentalities for the commissions of deceptive acts and practices.”26 However, the dissenters note that the “critical element for primary liability is the existence of a representation, either by statement or omission, made by the defendant.”27 The theory advanced against Rytr could be “true of an almost unlimited number of products and services: pencils, paper, printers, computers, smartphones, word processors, . . . etc.”28 Accordingly, both dissenting commissioners rejected this expansion of means-and-instrumentalities liability because a “knowledge requirement avoids treating innocent and productive conduct as illegal merely because of the subsequent acts of independent third parties.”29

Finally, the dissenters offered several reasons why the FTC’s complaint was not in the public’s interest. Both dissenters expressed concerns that this case was too aggressive and would undermine innovation in the AI industry.30 Commissioner Ferguson went further to note that the complaint could violate important First Amendment interests, noting that the complaint “holds a company liable under Section 5 for a product that helps people speak, quite literally.”31 He criticized the theory behind the complaint; “[y]et because the technology in question is new and unfamiliar, I fear we are giving short shrift to common sense and to fundamental constitutional values.”32

Conclusion

It bears repeating that the FTC Commissioners unanimously approved almost every case listed in Operation AI Comply; “[w]hen people use generative AI technology to lie, cheat, and steal, the law should punish them no differently than if they use quill and parchment.”33 So, the FTC’s warnings about marketing AI systems for professional services, using AI to engage in misleading marketing, or overstating a product’s AI integration should be heeded, especially with the FTC’s statements that this is only the beginning of its enforcement activity.34 In prepared remarks, Chair Lina Khan has stated that the FTC is “making clear that there is no AI exemption from the laws on the books[,]35 so companies should take care to protect against whether their AI and other automated tools are being used for unfair or deceptive purposes or have biased or discriminatory impacts. Just because a technology is new does not mean that it can ignore existing laws – and we’ve seen similar sentiments and disputes in other areas of emerging technology enforcement, such as the SEC’s view that, with respect to U.S. securities laws, “[t]here’s no reason to treat the crypto market differently just because different technology is used.”36

However, the Rytr case could be an indicator that the majority intends to pursue a broader theory of liability under Section 5 of the FTC Act to include tools that merely could be misused – without proof of actual harm or intent. If that continues to be the case, developers should be vigilant in identifying how their products and platforms could be misused for fraudulent purposes, as well-intentioned developers may become the target of investigations or other inquiries by the FTC. The FTC is accepting public comments on the proposed consent agreement with Rytr through November 4, 2024,37 which could develop the FTC’s position further.

1) FTC Announces Crackdown on Deceptive AI Claims and Schemes, Press Release, Federal Trade Commission (Sept. 25, 2024), available at https://www.ftc.gov/news-events/news/press-releases/2024/09/ftc-announces-crackdown-deceptive-ai-claims-schemes.

2) See, e.g., Aiming for truth, fairness, and equity in your company’s use of AI, Elisa Johnson, Federal Trade Commission (April 19, 2021), available at https://www.ftc.gov/business-guidance/blog/2021/04/aiming-truth-fairness-equity-your-companys-use-ai.

3) Operation AI Comply: Detecting AI-infused frauds and deceptions, Alvaro Puig, Federal Trade Commission (Sept. 25, 2024), available at https://consumer.ftc.gov/consumer-alerts/2024/09/operation-ai-comply-detecting-ai-infused-frauds-and-deceptions.

4) See, e.g., id.

5) In re DoNotPay, Inc., FTC Matter No. 2323042, Complaint available at https://www.ftc.gov/system/files/ftc_gov/pdf/DoNotPayInc-Complaint.pdf.

6) FTC v. Ascend Capventures, Inc., et al., C.D. Ca. Case No. 2:24-CV-07660-SPG-JPR (Filed Sept. 9, 2024).

7) FTC v. Empire Holdings Group LLC, et al., E.D. Pa. Case No. 2:24-CV-04949 (Filed Sept. 18, 2024).

8) FTC v. TheFBAMachine Inc., et al., D. N.J. Case No. 2:24-CV-06635-JXN-LDW (Filed June 3, 2024).

9) See generally, FTC Announces Crackdown on Deceptive AI Claims and Schemes, supra.

10) The FTC aggregated several summaries for its recent cases related to AI and other automated tools, which can be found here: https://www.ftc.gov/business-guidance/blog/2024/09/operation-ai-comply-continuing-crackdown-overpromises-ai-related-lies#:~:text=These%20cases%20are,CRI%20Genetics.

11) See generally Cases and Proceedings: Rytr, FTC Matter No. 2323052 (last updated Sept. 25, 2024), available at https://www.ftc.gov/legal-library/browse/cases-proceedings/rytr.

12) See, e.g., In re Rytr LLC, FTC Matter No. 2323052, Complaint ¶ 2, available at https://www.ftc.gov/system/files/ftc_gov/pdf/2323052rytrcomplaint.pdf.

13) Id. ¶ 6.

14) Id. ¶¶ 6-8.

15)  Id. ¶ 10.

16) Id. ¶ 14.

17) Id. ¶¶ 15-18.

18)  See In re Rytr LLC, Agreement Containing Consent Order, available at https://www.ftc.gov/system/files/ftc_gov/pdf/2323052rytracco.pdf.

19) See, e.g., Dissenting Statement of Commissioner Melissa Holyoak, Joined by Commissioner Andrew N. Ferguson, In re Rytr LLC, FTC Matter No. 2323052 at p.1 (cautioning against settlements to “advance claims or obtain orders that a court is highly unlikely to credit or grant in litigation,” as it may encourage the use of “questionable or misguided theories or cases.”) [hereinafter, “Holyoak Dissent”].

20) Dissenting Statement of Commissioner Andrew N. Ferguson, Joined by Commissioner Melissa Holyoak, In re Rytr LLC, FTC Matter No. 2323052 at p.1 [hereinafter, “Ferguson Dissent”].

21) See 15 U.S.C. § 45(n) (prohibiting the FTC from declaring an act or practice unfair unless it “causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.”).

22) Ferguson Dissent at p.6; see also Holyoak Dissent at p.2.

23) Holyoak Dissent at p.3; see also Ferguson Dissent at p.7 (noting the challenges of writing a thoughtful review and that “a tool that produces a well-written first draft of a review based on some keyword inputs can make the task more accessible.”).

24) Ferguson Dissent at p.5.

25) Holyoak Dissent at p.4 (emphasis original).

26) Complaint ¶¶ 15-16.

27) Holyoak Dissent at p.4 (emphasis original) (cleaned up with citations omitted); see also Ferguson Dissent at pp.3-5 (discussing the circumstances in which means-and-instrumentalities liability arises).

28) Ferguson Dissent at p.5.

29) Ferguson Dissent at p.7; see also Holyoak Dissent at p.5 (“Section 5 does not categorically prohibit a product or service merely because someone might use it to deceive someone else.”).

30)  Holyoak Dissent at p.5 (“Today’s misguided complaint and its erroneous application of Section 5 will likely undermine innovation in the AI space.”); Ferguson Dissent at p.10 (“But we should not bend the law to get at AI. And we certainly should not chill innovation by threatening to hold AI companies liable for whatever illegal use some clever fraudster might find for their technology.”).

31) Ferguson Dissent at p.10.

32) Id.

33) Id. at p.9 (citing Concurring and Dissenting Statement of Commissioner Andrew N. Ferguson, A Look Behind the Screens: Examining the Data Practices of Social Media and Video Streaming Services, at pp.10-11 (Sept. 19, 2024)).

34) Operation AI Comply: Detecting AI-infused frauds and deceptions, supra.

35) A few key principles: An excerpt from Chair Khan’s Remarks at the January Tech Summit on AI, FTC (Feb. 8, 2024), available at https://www.ftc.gov/policy/advocacy-research/tech-at-ftc/2024/02/few-key-principles-excerpt-chair-khans-remarks-january-tech-summit-ai.

36) Prepared Remarks of Gary Gensler on Crypto Markets at Penn Law Capital Markets Association Annual Conference, Chair Gary Gensler, SEC (April 4, 2022), available at https://www.sec.gov/newsroom/speeches-statements/gensler-remarks-crypto-markets-040422.

37) Rytr LLC; Analysis of Proposed Consent Order To Aid Public Comment, Federal Register, available at https://www.federalregister.gov/documents/2024/10/03/2024-22767/rytr-llc-analysis-of-proposed-consent-order-to-aid-public-comment.

Copyright ©2024 Nelson Mullins Riley & Scarborough LLP

The Corporate Transparency Act Requires Reporting of Beneficial Owners

The Corporate Transparency Act (the “CTA”) became effective on January 1, 2024, requiring many corporations, limited liability companies, limited partnerships, and other entities to register with and report certain information to the Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Department of Treasury (“Treasury”). The CTA marks a substantial increase in the reporting obligations for many U.S. companies, as well as for non-U.S. companies doing business in the United States.

IN SHORT:
Most corporate entities are now required to file a beneficial ownership information report (“BOI Report”) with FinCEN disclosing certain information about the entity and those persons who are “beneficial owners” or who have “substantial control.” BOI Reports for companies owned by trusts and estates may require significant analysis to determine beneficial ownership and substantial control.

The CTA imposes potential penalties on entities that fail to file BOI Reports with FinCEN by the prescribed deadline. For entities formed prior to January 1, 2024, a BOI Report must be filed by January 1, 2025. For entities formed on or after January 1, 2024, but prior to January 1, 2025, a BOI Report must be filed within 90 days of the entity’s formation. For entities formed on or after January 1, 2025, a BOI Report must be filed within 30 days of the entity’s formation.

Entities formed after January 1, 2024, must also report information regarding “company applicants” to FinCEN. If certain information within a BOI Report changes, entities are required to file a supplemental BOI Report within 30 days of such change.

While Winstead’s Wealth Preservation Practice Group will not be directly filing BOI Reports with FinCEN, our attorneys and staff will be available this year, by appointment, to answer questions regarding reporting requirements if scheduled by Friday, November 22, 2024. We strongly recommend that company owners begin analyzing what reporting obligations they may have under the CTA and schedule appointments with their professional advisors now to ensure availability.

BACKGROUND:
Congress passed the CTA in an effort to combat money laundering, fraud, and other illicit activities accomplished through anonymous shell companies. To achieve this objective, most entities operating in the United States will now be required to file BOI Reports with FinCEN.

The CTA applies to U.S. companies and non-U.S. companies registered to operate in the United States that fall within the definition of a “reporting company.” There are certain exceptions specifically enumerated in the CTA, which generally cover entities that are already subject to anti-money laundering requirements, entities registered with the Securities and Exchange Commission or other federal regulatory bodies, and entities that pose a low risk of the illicit activities targeted by the CTA.

REPORTING OBLIGATIONS:
Entity Information. Each reporting company is required to provide FinCEN with the following information:

  1. the legal name of the reporting company;
  2. the mailing address of the reporting company;
  3. the state of formation (or foreign country in which the entity was formed, if applicable) of the reporting company; and
  4. the employer identification number of the reporting company.

Beneficial Owner and Applicant Information. Absent an exemption, each reporting company is also required to provide FinCEN with the following information regarding each beneficial owner and each company applicant:

  1. full legal name;
  2. date of birth;
  3. current residential or business address; and
  4. unique identifying number from a U.S. passport or U.S. state identification (e.g., state-issued driver’s license), a foreign passport, or a FinCEN identifier (i.e., the unique number issued by FinCEN to an individual).

DEFINITIONS:
Reporting Company. A “reporting company” is defined as any corporation, limited liability company, or any other entity created by the filing of a document with a secretary of state or any similar office under the law of a State. Certain entities are exempt from these filing requirements, including, but not limited to:

  1. financial institutions and regulated investment entities;
  2. utility companies;
  3. entities that are described in Section 501(c) of the Internal Revenue Code;
  4. inactive, non-foreign owned entities with no assets; and
  5. sizeable operating companies that employ more than 20 full-time employees in the United States that have filed a United States federal income tax return in the previous year demonstrating more than $5,000,000 in gross receipts or sales.

A reporting company that is not exempt must register with and report all required information to FinCEN by the applicable deadline.

Beneficial Owner. A “beneficial owner” is defined as any individual who, directly or indirectly, (i) exercises substantial control over such reporting company or (ii) owns or controls at least 25% of the ownership interests of such reporting company.

Substantial Control. An individual exercises “substantial control” over a reporting company if the individual (i) serves as a senior officer of the reporting company, (ii) has authority over the appointment or removal of any senior officer or a majority of the board of directors (or the similar body governing such reporting company), or (iii) directs, determines, or has substantial influence over important decisions made by the reporting company, including by reason of such individual’s representation on the board (or other governing body of the reporting company) or control of a majority of the reporting company’s voting power.

Company Applicant. A “company applicant” is any individual who (i) files an application to form the reporting company under U.S. law or (ii) registers or files an application to register the reporting company under the laws of a foreign country to do business in the United States by filing a document with the secretary of state or similar office under U.S. law.

DEADLINES:
Entities Formed Before January 1, 2024. A reporting company that was formed prior to the effective date of the CTA (January 1, 2024) is required to register with FinCEN and file its initial BOI Report by January 1, 2025.

Entities Formed After January 1, 2024, but Before January 1, 2025. A reporting company that was formed after the effective date of the CTA (January 1, 2024), but before January 1, 2025, must register with FinCEN and file its initial BOI Report within 90 calendar days of formation.
Entities Formed After January 1, 2025. A reporting company formed after January 1, 2025, will be required to register with FinCEN and file its initial BOI Report within 30 calendar days of formation.

Supplemental BOI Reports. If any information included in a BOI Report changes, a reporting company must file a supplemental report with FinCEN within 30 days of such change. This includes minor changes, such as an address change or an updated driver’s license for a beneficial owner or someone who has substantial control over the reporting company.

PENALTIES FOR NON-COMPLIANCE:
The CTA and Treasury regulations impose potential civil and criminal liability on reporting companies and company applicants that fail to comply with the CTA’s reporting requirements. Civil penalties for reporting violations include a monetary fine of up to $500 per day that the violation continues unresolved, adjusted for inflation. Criminal penalties include a fine of up to $10,000 and/or two years in prison.

REPORTING REQUIREMENTS RELATED TO TRUSTS AND ESTATES:
When a trust or estate owns at least 25% of a reporting company or exercises substantial control over the reporting company, the BOI Report must generally include (i) the fiduciaries of the trust or estate (i.e., the trustee or executor), (ii) certain individual beneficiaries, and (iii) the settlor or creator of the trust. If the trust agreement gives other individuals certain rights and powers, however, such as a distribution advisor, trust protector, or trust committee member, the reporting company may also be required to disclose such individuals’ information in the BOI Report. Similarly, if a corporate trustee or executor is serving, the BOI Report must contain the names and information of the employees who actually administer the trust or estate on behalf of the corporation. Due to these nuances, it is often necessary to engage in additional analysis when a trust or estate is a beneficial owner of or has substantial control over a reporting company.

CONCLUDING REMARKS:
The CTA and its BOI Report filing requirement are still relatively new, and although FinCEN continues to publish additional guidance, many open questions remain. All companies formed or operating in the United States should carefully review whether they are required to file an initial BOI Report in accordance with the CTA, and take further steps to identify all individuals who must be included in such BOI Report.

© 2024 Winstead PC.
For more news on Corporate Transparency Act Reporting Requirements, visit the NLR Financial Institutions Banking section.

SEC Revises Tick Size, Access Fees and Round-Lot Definition and Takes Steps to Disseminate Odd-Lot and Other Better Priced Orders

On September 18, the Securities and Exchange Commission (SEC or the Commission) adopted amendments to Rule 612 (Tick Sizes) and Rule 610 (Access Fees) under Regulation NMS under the Securities Exchange Act of 1934, as amended (Regulation NMS).1 The SEC also added and amended definitions and other rules under Regulation NMS to address round-lot and odd-lot sizing and dissemination. We address each category of revisions below and highlight at the outset that the SEC did not adopt the controversial provision that would have prevented market centers from executing orders at prices less than the current or revised tick sizes. That is, the minimum tick size continues to address only the minimum price increment at which a market center can publish a quotation for a security. This is significant, as adopting such a prohibition would have prevented broker-dealers and other market centers from providing price improvement at prices finer than the quotation tick sizes.

The SEC also took a measured approach to other aspects of the rule. As explained more fully below, the Commission adopted only one additional minimum quotation size (rather than the three proposed), narrowed the scope of securities that might be subject to the smaller minimum quotation size, reduced the frequency with which primary listing exchanges must calculate tick sizes and round-lot sizes, and expanded the amount of data to be evaluated for these calculations from one month’s worth to three months’ worth.

Tick Sizes/Minimum Pricing Increments

Rule 612 of Regulation NMS regulates the price increments (that is, the “tick size”) at which a market center can display a quotation and at which a broker-dealer can accept, rank, or display orders or indications of interest in NMS stocks. Currently, for NMS stocks priced at or above $1.00 per share, broker-dealers and market centers can accept orders or quote in one-penny ($0.01) price increments and at a much smaller increment ($0.0001) for NMS stocks priced less than $1.00 per share.

The SEC and other market participants had observed that many stocks were “tick constrained” — that is, bids, offers, and other orders in those stocks might regularly allow for quotation spreads narrower than $0.01, but the penny spread requirement of Rule 612 constrained such narrower quoting. Determining the “right” quote size for a security can be complicated: on the one hand, a narrower spread reduces transaction costs for investors. On the other hand, too narrow a quotation spread allows other market participants to “step ahead” of a quotation — that is, obtain better priority — by entering an order that is priced only slightly better. Obtaining priority by quoting for an economically insignificantly better price disincentivizes those offering liquidity or price improvement to the market. Stated simply, a market participant has little incentive to expose its order to the market if another participant can easily get better priority over that order at an insignificant cost. Accordingly, the Commission sought to balance the two competing concerns of spread size and fear of stepping ahead.

Tick sizes are also relevant in the competition between exchange and non-exchange trading venues. Due to their market structure, exchanges generally execute orders at the prices they quote, but cannot execute at prices within the quoted spread. Narrower spreads provide better opportunities for exchanges to execute at the higher bids or lower offers represented by those narrower spreads. In short, narrower spreads allow exchange venues to be more competitive with off-exchange venues.

In December 2022, the SEC proposed to add three minimum tick sizes for NMS stocks priced $1.00 or more: one-tenth of a cent ($0.001), two-tenths of a cent ($0.002), and five-tenths (or one-half) of a cent ($0.005). Public comment suggested that this proposal was too complicated and the smaller price increment of $0.001 might also have been too small, thereby facilitating stepping ahead.

The adopted rule provides for only one new tick size for certain NMS stocks priced at or above $1.00 per share: $0.005. This half-penny minimum quotation size will apply for those NMS stocks priced at or above $1 that have a “time-weighted average quoted spread” (a metric defined in the rule) of $0.015 during a three-month Evaluation Period (as described in the table below) occurring twice a year.[1] “Time-weighted average quoted spread” seeks to estimate tick constraint and identify those securities that are quoted on average at close to a one-cent spread. Specifically, under the revised rule, primary listing exchanges must calculate the time-weighted average spread over the months of January, February, and March and July, August, and September. The results of the first (Q1) calculation determines which securities are subject to the half-penny tick size for the business days between May 1 and October 31 of that year. The results of the second (Q3) calculation determines which securities are subject to the half-penny tick size for the business days between November 1 of that year and April 30 of the following year.

The following chart shows the applicable tick sizes and calculations:

The SEC’s policy rationale for adopting these amendments is that they relax existing restrictions on tick sizes, which should reduce transaction costs and provide for better price discovery for certain NMS stocks. Additionally, smaller tick sizes for NMS stocks that merit them should improve liquidity, competition, and price efficiency.

Access Fees

Securities exchanges generally charge access fees to those who take liquidity and rebate a portion of that access fee to those who provide liquidity. As the SEC explains, “the predominant exchange fee structure is maker-taker, in which an exchange charges a fee to liquidity takers and pays a rebate to liquidity providers, and the rebate is typically funded through the access fee.”3 Rule 610(c) of Regulation NMS limits the fee that an exchange can charge for accessing protected quotations4 pursuant to Rule 611 of Regulation NMS. Currently, the access fee is capped at 30 cents per 100 shares (or “30 mils” per share) for NMS securities priced at or above $1. The access fee is capped at 0.3% of the quotation price for NMS stocks priced below $1.

With a smaller minimum quotation size, the SEC took the opportunity to revise the access fee cap, which some market participants believed had been set too high. Like the tick size changes, the access fee amendment ultimately adopted was modified from what was originally proposed. Originally, the SEC proposed to reduce access fee caps (a) from 30 mils to 10 mils per share for NMS stocks priced at or over $1 that would have been assigned a tick size larger than $0.001 and (b) to 5 mils per share for NMS stocks priced at or over $1 that would have been assigned a $0.001 tick size. For protected quotations in NMS stocks priced under $1.00 per share, the Commission originally proposed to reduce the 0.3% fee cap to 0.05% of the quotation price.

Ultimately, the Commission adopted a more simplified reduction in access fee caps. Because it added only one tick size to Rule 612, the SEC adopted only one reduction in access fee caps, from 30 mils to 10 mils per share for protected quotations in NMS stocks priced $1.00 or more. For such quotations priced less than $1.00, the Commission reduced the access fee cap from 0.3% to 0.1% of the quotation price per share. In addition, the SEC adopted (as proposed) new Rule 612(d), requiring all exchange fees charged and all rebates paid for order execution to be determinable at the time of execution. Currently, such exchange fees are subject to complex fee schedules that apply tiered and other discounts at month-end. As a result, market participants would not necessarily know intra-month whether their broker might access a higher tier later in the month, which would adjust the fee charged for the subject order. The new rule ends this uncertainty.

Setting the revised access fee cap at 10 mils per share was somewhat controversial, with Commissioners Peirce and Uyeda questioning the manner in which 10 mils was determined, whether another rate should have been used (15 mils? 5 mils? 12 mils?) and whether the Commission should be in the rate-setting business at all. The Commissioners ultimately voted in favor of the proposal based upon a pledge (discussed below) that the SEC staff will, by May 2029, “conduct a review and study the effects of the amendments in the national market system.”5

Required Staff Review and Study

The Adopting Release requires that the Commission staff conduct a “review and study” by May 2029 of the effects of the amendments on the national market system. The details of such study are not clearly defined, but the Adopting Release provides that:

[s]uch a review and study might include, but would not be limited to, an investigation of: (i) general market quality and trading activity in reaction to the implementation of the variable tick size, (ii) the reaction of quoted spreads to the implementation of the amended access fee cap, and (iii) changes to where market participants direct order flow, e.g., to exchange versus off-exchange venues, following the implementation of the amendments.6

Compliance Dates and Timelines

The amendments described above become effective 60 days after the publication of the SEC’s Adopting Release in the Federal Register. The date by which exchanges, broker-dealers, and other market participants must comply with the rule amendments is generally in November 2025 but, in some instances, in May 2026, as described more fully below. Specifically, the Compliance Date:

  • for the tick size amendments (half-penny quoting for “tick-constrained” stocks) of Rule 612 is “the first business day of November 2025,” or November 3, 2025.
  • for the 10 mils per share access fee cap amendment of Rule 610 and the new requirement under Rule 612(d) that exchange fees be known at time of execution in each case, is also November 3, 2025.
  • for the new round-lot definition (100 shares, 40 shares, 10 shares, or 1 share) is November 3, 2025.
  • for the dissemination of “odd-lot information,” including the new BOLO data element, is six months later, to allow broker-dealers and others to program systems accordingly. These changes will take effect on “the first business day of May 2026,” or May 1, 2026.

Closing Thoughts

The tick size and access fee amendments, and the other provisions adopted, appear to reflect negotiated concessions and a reasonable approach to addressing tick-constrained securities while avoiding the complex framework originally proposed. The decision not to prevent executions at prices within the minimum quotation size is appropriate and preserves the ability of market participants to provide price improvement to investors. While there can be some lingering debate about the appropriate level to which to reduce the access fee cap and whether 10 mils is an appropriate level, the net cumulative effect of these amendments appears reasonable. The planned “review and study” of the effect of the amendments may come too late if conducted towards the outer limit of “by May 2029,” but the overall effect of the amendments should serve to narrow spreads and increase quotation transparency through sub-penny quoting, reduced round-lot sizes, and the inclusion of odd-lot information.

1 Release No. 34-101070, Regulation NMS: Minimum Pricing Increments, Access Fees, and Transparency of Better Priced Orders, U.S. Sec. Exch. Comm’n (Sept. 18, 2024), https://www.sec.gov/files/rules/final/2024/34-101070.pdf (the “Adopting Release”).
2 The SEC modified of these requirements in the final rule. For example, the SEC had originally proposed smaller tick sizes for stocks with a time-weighted average quoted spread of $0.04 (rather than $0.015). The proposal also sought to evaluate tick-sizes 4 times per year rather than twice a year and based on monthly data rather than quarterly data.
3 Adopting Release at 15.
4 A protected quotation is defined in Rule 600(b)(82) of Regulation NMS as “a protected bid or protected offer.” 17 C.F.R. § 242.600(b)(82). A protected bid or protected offer is defined as “a quotation in an NMS stock that: (i) is displayed by an automated trading center; (ii) is disseminated pursuant to an effective national market system plan; and (iii) is an automated quotation that is the best bid or best offer of a national securities exchange, or the best bid or best offer of a national securities association.” 17 C.F.R. § 242.600(b)(81)
5 Adopting Release at 288.
6 Id. (emphasis added).
©2024 Katten Muchin Rosenman LLP
For more news on Rule 612 and Rule 610 of Securities Exchange Act of 1934, visit the NLR Securities SEC section.

End of Summer Pool Party: CFTC Approves Final Rule Amending 4.7 Regulatory Relief for CPOs and CTAs

On 12 September 2024, the Commodity Futures Trading Commission (CFTC) published a Final Rule impacting registered commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on the regulatory relief provided under CFTC Regulation 4.7. “Registration light,” as Regulation 4.7 is sometimes known, provides reduced disclosure, reporting and recordkeeping obligations for CPOs and CTAs that limit sales activities to “qualified eligible persons” (QEPs).

The Final Rule amends Regulation 4.7 by:

  • Updating the QEP definition by increasing the financial thresholds in the “Portfolio Requirement” to account for inflation; and
  • Codifying certain CFTC no-action letters allowing CPOs of Funds of Funds to opt to deliver monthly account statements within 45 days of month-end.

For most asset managers, however, the most significant update is that the CFTC declined to adopt the proposed minimum disclosure requirements. Under existing Regulation 4.7, CPOs and CTAs are exempt from certain disclosure requirements when offering pools solely to QEPs. Without those exemptions, dually-registered managers would be burdened with duplicate or conflicting disclosure requirements under the Securities and Exchange Commission’s (SEC) rules. The Proposed Rule would have rescinded or narrowed certain of these exemptions. Commenters almost unanimously opposed the disclosure-related amendments, and the CFTC ultimately decided to take additional time to consider the concerns and potential alternatives.

The Final Rule doubled the Portfolio Requirement for the Securities Portfolio Test and the Initial Margin and Premium test to US$4,000,000 and US$400,000, respectively. Despite the increased suitability standards for QEPs, the Final Rule will not impact most private funds relying on Rule 506 of Regulation D, as those amounts are still less than the “Qualified Purchaser” threshold under the SEC’s rules.

Copyright 2024 K & L Gates
For more news on CFTC Final Rule, visit the NLR Antitrust Trade Regulation section.

FTC Staff Issue Report on Multi-Level Marketing Income Disclosure Statements

Staff reviewed income disclosure statements in February 2023 that were publicly available on the websites of a wide array of MLMs, from large household names to smaller, less well-known companies, according to FTC attorneys. “These statements are sometimes provided to consumers who are considering joining MLMs, and often purport to show information about income that recruits could expect to receive.”

According to the report, FTC staff found a number of issues with the statements they reviewed, including that most omit key information when calculating the earnings amounts they present. Specifically, the report notes that most of the reviewed statements do not include participants with low or no earnings in their display of earnings amounts and also don’t account for the expenses faced by participants, which can outstrip the income they make. The report notes that these omissions are often not plainly disclosed in the income statements.

The report also notes that most statements emphasize the high earnings of a small group of participants, and many entirely omit or only inconspicuously disclose key information about the limited earnings made by most participants. In addition, the staff report notes that most of the disclosure statements staff reviewed present earnings information in a potentially confusing way, “like giving average earnings amounts for groups that could have very different actual incomes, or using annual income figures that aren’t based on what an actual group of participants made for the year.”

The report also notes based on staff’s analysis of data in the income disclosure statements, including information included in fine print, that many participants in those MLMs received no payments from the MLMs, and the vast majority received $1,000 or less per year—that is, less than $84 per month, on average.

“The FTC staff report documents an analysis of 70 publicly available income disclosure statements from a wide range of MLMs — big and well-known to smaller companies. The report found that these income disclosure statements showed most participants made $1,000 or less per year — that’s less than $84 dollars per month. And that may not account for expenses. In at least 17 MLMs, most participants didn’t make any money at all.”

As referenced above, the staff report documents (and provides numerous examples of) how most of the publicly available MLM income disclosure statements used all the following tactics:
  • Emphasizing the high dollar amounts made by a relatively small number of MLM participants.
  • Leaving out or downplaying important facts, like the percentage of participants who made no money.
  • Presenting income data in potentially confusing ways.
  • Ignoring expenses incurred by participants — even though expenses can, and in some MLMs often do, outstrip income.
© 2024 Hinch Newman LLP