Category: Securities Law

SEC Proposes Changes to Market Data Plans

On January 8, the Securities and Exchange Commission (SEC) released a proposed order to improve the governance of National Market System (NMS) data plans that produce consolidated equity market data and disseminate trade and quote data. Currently, the equities exchanges and the Financial Industry Regulatory Authority (the Participants) together collect, consolidate and disseminate information regarding trades and quotes in NMS stocks pursuant to three separate national market system plans. According to the press release, “the current governance structure of these plans perpetuates disincentives to enhance consolidated equity market data feeds, which are often slower and contain less information than the proprietary market data feeds offered by the participants that control much of the voting power for the NMS plans.” The proposed order would direct the Participants to create a single equity data plan that would address these conflicts of interests between the exchanges’ commercial interests and their regulatory obligations to produce and provide consolidated market data.

The SEC also published for comment amendments to the existing NMS data plans to require mandatory disclosure policies with respect to conflicts of interest and to institute a confidentiality policy for certain data and information. Comments on the proposals must be submitted on or before 45 days from publication in the Federal Register.

The SEC’s press release regarding the proposed order is available here. The proposed order is available here.

©2020 Katten Muchin Rosenman LLP

More SEC regulation updates via the National Law Review SEC & Securities law page.

Cryptocurrency is At The Center of Multi-Million Dollar Investment Security and Commodities Fraud

The Criminal Division of the IRS arrested Swedish businessman Roger Nils-Jonas Karlsson, for allegedly operating a fraudulent pension plan using cryptocurrency. Karlsson allegedly used fake websites “registered to a fictitious person” to advertise shares of a “Pre-Funded Reversed Pension Plan” (PFRPP). The criminal complaint states that Karlsson allegedly invited potential investors to buy shares of this plan at $98 per share. In exchange, Karlsson promised to eventually return 1.15 kilograms of gold per share to the shareholder as return on investment. In early 2019, 1.15 kilograms of gold was worth $45,000, making investors in the plan a 460 percent return for each share owned. The plan’s investors made payments using virtual currencies, also known as cryptocurrency. Bitcoin, Ethereum, and Litecoin prominent cryptocurrencies and were allegedly used to pay Karlsson. With the assistance of his company, Eastern Metal Securities, Karlsson allegedly defrauded victims into losing more than $11 million.

The U.S. Securities and Exchange Commission does not regulate cryptocurrencies, which are considered risky. The lack of regulation makes it sometimes impossible to get cryptocurrency refunded from fraudulent transactions because banks or government organizations do not guarantee these currencies. In cases where a company or individual commits securities or commodities fraud against the government, private citizens often play an essential role by acting as whistleblowers.

© 2019 by Tycko & Zavareei LLP

More on cryptocurrency enforcement actions via the National Law Review Criminal Law & Business Crimes page.

SEC Proposes Significant Amendments to Investment Adviser Advertising Rule

The Securities and Exchange Commission (the “Commission” or the “SEC”), on November 4, approved the publication of a substantial release (the “Release” 1 proposing significant amendments to the rules under the Investment Advisers Act of 1940 (the “Advisers Act”) that govern advertising by investment advisers and the solicitation of advisory and fund investments, as well as related recordkeeping and SEC Form ADV disclosure requirements. This memorandum provides a summary of the proposed amendments to the advertising rule and related recordkeeping requirements; a separate memorandum addresses the proposed amendments to the solicitation rule.2

The Advisers Act advertising rule, Rule 206(4)-1, has not been amended significantly since it was first adopted in 1961. 3 The changes now proposed by the SEC are largely motivated by the SEC’s desire to modernize the rule and create a more “principles-based” approach to advertising regulation.

I.  Overview of the Amendments

  • Broadened Definition of “Advertisement”: The proposed amendments to Rule 206(4)-1 would broaden the definition of “advertisement” to cover all communications that promote an investment adviser’s services, even if sent to a single person, subject to specific exemptions.
  • Advertising Standards: The amendments would replace the current list of prohibited forms of advertisement with general prohibitions on misleading advertising practices. The proposed amendments would also adopt new requirements for advertisements that include gross, past, extracted, related or hypothetical performance.
  • Administrative Provisions: Advisers would have to designate specific employees to review and approve advertisements before distribution. Advisers would also be required to report certain of their advertising practices on Form ADV, and would be subject to new recordkeeping obligations under Rule 204-2 intended to require advisers to demonstrate their compliance with the new obligations under Rule 206(4)-1.
  • Comment Period: The comment period will end 60 days after the Release is published in the Federal Register.
  • Compliance Date: Compliance with the amended rules would be required one year after the effective date.

II.  Broadened Definition of “Advertisement”

A.  Overview

Rule 206(4)-1 currently defines “advertisement” to mean “any notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television [emphasis added].”

Under Proposed Rule 206(4)-1(e), “advertisement” would be defined to mean “any communication, disseminated by any means, by or on behalf of an investment adviser, that offers or promotes the investment adviser’s investment advisory services or that seeks to obtain or retain one or more investment advisory clients or investors in any pooled investment vehicle advised by the investment adviser [emphasis added].” The proposed rule would expand the definition of “advertisement” to apply to any communication that promotes an investment adviser’s services, regardless of the form of the communication or the manner in which it is distributed (e.g., in writing, electronically, in audio or video files, blogs or social media), and even if sent to a single person.

Certain communications would nonetheless be excluded from the proposed expanded definition of “advertisement”: (i) live oral communications not broadcast on electronic media; 4 (ii) responses to unsolicited requests for information about an adviser’s services, except for (a) communications about performance results to Retail Persons and (b) all communications about Hypothetical Performance; 5 (iii) communications about registered investment companies (“RICs”) or business development companies (“BDCs”);6 and (iv) disclosures required by statute or regulation (e.g., information required by Part 2 of Form ADV or Form CRS).

B.  Key Terms

Certain of the terms used in the proposed definition of “advertisement” are further explained or defined in the Release or in the proposed amendments. The key terms are as follows:

  • Disseminated by any means. This phrase would replace the current limitation to written communications or announcements made over radio or television. The Release emphasized that the focus of the amended rule is “on the goal of the communication, and not its method of delivery.”
  • By or on behalf of an investment adviser. The proposed rule would apply to material disseminated by an adviser’s agents, such as consultants and solicitors, 7 or by an investment adviser’s affiliates, and may apply, depending on the facts and circumstances, to material disseminated by unaffiliated third parties. 8 The determination of whether material distributed by a third party is considered an “advertisement” of the adviser will depend on the adviser’s involvement in the content or production of the material (g., whether the investment adviser assists in preparing the content, influences or controls the substance of the content or pays for the distribution). Advisers should thus implement appropriate procedures to monitor materials distributed on their behalf to assure compliance with the requirement of any newly adopted rules.
  • Offers or promotes the investment adviser’s investment advisory services. Material providing a client with general account information in the regular course of business or disseminating general educational materials about investing and markets would not be considered advertisements. However, the Commission may consider an adviser’s market commentary to be an advertisement if the commentary offers or promotes the adviser’s services. 9
  • Investors in any pooled investment vehicle. This provision treats investors in a pooled investment vehicle, other than investors in a RIC or a BDC,10 as clients of the adviser. This provision would provide additional protections for investors in pooled investment vehicles beyond those already provided under Rule 206(4)-8 (prohibiting fraudulent practices with respect to pooled investment vehicles).

III.  Advertising Standards

A.  General Prohibitions

The current rule contains a general prohibition on false or misleading statements, and additionally prohibits four specific types of communications in advertisements: (i) testimonials; (ii) past specific recommendations; (iii) representations that a chart or graph alone can be relied upon to make investment decisions; and (iv) misrepresentations about the cost of services. The proposed amendments replace these specific prohibitions by instead creating General Prohibitions that largely incorporate principles developed through the Commission’s prior no-action letters and are consistent with other anti-fraud provisions in the Federal securities laws.11

Under Proposed Rule 206(4)-1, advisers would be prohibited from making untrue or misleading statements or omissions, making material claims that are unsubstantiated,12 failing to “clearly and prominently” disclose potential risks, or referencing performance results and specific investment advice in a way that is not fair and balanced.13 A finding of negligence would be sufficient to establish a violation of the General Prohibitions.14

B.  Specific Investment Advice

The SEC proposes to replace the prescriptive requirements currently applicable to advertisements that include discussions of “past specific recommendations” with a principles-based approach that would permit material that discusses “specific investment advice” as long as it is “fair and balanced.”15 The Release notes that the following current guidance may be helpful to advisers in satisfying the “fair and balanced” requirement:

  1. referring to the information that must currently be included when presenting a list of all past specific recommendations made by the adviser within the past year;16
  2. using objective, non-performance based criteria to select the securities discussed in advertisements;17 and
  3. considering “the facts and circumstances of the advertisement, including the nature and sophistication of the audience.”

While reference to current guidance may be useful, the proposed rule would provide advisers with greater flexibility to include discussions of specific investment advice in advertising material, provided that the discussion is fair and reasonable, and includes sufficient information and context to enable recipients to evaluate the discussion.18 Advisers would, however, be subject to the specific requirements applicable to performance information discussed in Section D below.

C.  Testimonials, Endorsements, and Third-Party Ratings

The proposed amendments establish conditions that, if followed, allow for the use of testimonials, endorsements and third-party ratings in advertisements.19

  • Advisers using Testimonials20 or Endorsements21 in advertisements must “clearly and prominently disclose”: (i) that the testimonial was given by a client or investor, and the endorsement was given by a person who is not a client or investor; and (ii) whether the adviser, or anyone acting on its behalf, provided (cash or non-cash) compensation for the testimonial or endorsement.22
  • Third-Party Ratings23 may be used if: (i) the adviser “reasonably believes”24 that the questionnaires used to produce the ratings were designed to produce unbiased results; and (ii) the adviser or third party clearly and prominently discloses information including the rating date, time period on which the rating was based, the identity of the third party that produced the rating and whether the adviser, or anyone acting on its behalf, provided compensation, in the form of cash or otherwise.

D.  Performance Advertising

The current rule does not address the appropriate presentation of an adviser’s performance results. Guidance on performance advertising has been developed through SEC no-action letters.25 The proposed rule would establish explicit requirements as to the use of performance results, setting different standards depending on whether the advertisement is a Retail or Non-Retail Advertisement, as defined below.

  • Non-Retail Advertisements would mean advertisements directed at Non-Retail Persons, defined for this purpose as “qualified purchasers” or “knowledgeable employees,”26 as defined in the Investment Company Act.27 For such advertisements, an adviser would be required to implement “policies and procedures reasonably designed to ensure that the advertisement is disseminated solely to qualified purchasers and knowledgeable employees.”
  • Retail Advertisements would mean advertisements directed at Retail Persons, meaning anyone other than a Non-Retail Person.

Under the SEC proposal, performance information would be subject to the following requirements:

  • All Portfolio28 performance results included in Retail Advertisements must be presented in 1-, 5-, and 10-year periods, “each presented with equal prominence and ending on the most practicable date.”29
  • To use Gross Performance30 in a Retail Advertisement, the advertisement must: (i) present Net Performance31 results “with at least equal prominence,” in a format designed to facilitate comparison with the Gross Performance, using the same calculation methods and calculated over the same prescribed time periods;32 and (ii) provide, or offer to provide promptly, a percentage schedule of the fees and expenses deducted to calculate Net Performance.33
  • To use Gross Performance in a Non-Retail Advertisement, an adviser must provide or offer to provide promptly, a percentage schedule of the fees and expenses deducted to calculate Net Performance. The Non-Retail Advertisement would not, however, be required to include Net Performance results.34
  • An advertisement may include Related Performance35 only if it includes the performance of all Related Portfolios,36 unless (a) the performance results advertised are no higher than they would have been if no Related Portfolios were excluded, and (b) for Retail Advertisements, the performance results must be presented for the required time periods noted above, notwithstanding the exclusion of some Related Portfolios.37
  • Extracted Performance38 may be used only “if the advertisement provides, or offers to provide promptly, the performance results of all investments in the Portfolio from which the performance was extracted.”
  • To use Hypothetical Performance,39 an adviser would be required to:
    1. adopt policies and procedures “reasonably designed to ensure that the Hypothetical Performance is relevant to the financial situation and investment objectives” of the recipient. The purpose of this requirement is to ensure that an adviser only provides hypothetical performance “where the recipient has the financial and analytical resources to assess the hypothetical performance and that the hypothetical performance would be relevant to the recipient’s investment objective”;40
    2. provide, in both Retail and Non-Retail Advertisements, “calculation information” that is tailored to the audience receiving it, to enable recipients to understand the criteria and assumptions used in calculating Hypothetical Performance; and
    3. provide in Retail Advertisements, or offer to provide promptly in Non-Retail Advertisements, “risk information” tailored to the audience receiving it, to enable recipients to understand the risks and limitations of using the Hypothetical Performance in making investment decisions.

All performance advertisements must comply with the General Prohibitions. Though the Commission declined to require specific disclosures, the Release noted that examples of disclosures currently used by advisers in performance advertisements include: “(1) the material conditions, objectives, and investment strategies used to obtain the results portrayed; (2) whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings; (3) the effect of material market or economic conditions on the results portrayed; (4) the possibility of loss; and (5) the material facts relevant to any comparison made to the results of an index or other.”41 In line with its principles-based approach, advisers would be required to include appropriate disclosures to reflect the assumptions and factors relevant to the calculation of performance information.42

E.  Portability

The Commission has issued a number of no-action letters on when investment advisers may advertise performance results from the firm’s predecessor entities or from entities at which the firm’s employees were previously employed.43 Neither the current rule nor the proposed amendments set explicit standards for portability; the determination is subject to analysis under whether the porting of the prior results would be misleading. However, the Release does summarize and discuss the Commission’s considerations as to when portability is appropriate:

“(i) the person responsible for such results is still the adviser;

(ii) the prior account and the present account are similar enough that the performance results would provide relevant information;

(iii) all prior accounts that are being managed in a substantially similar fashion to the present account are being factored into the calculation; and

(iv) the advertisement includes all relevant disclosures.”44

The Release stated that the portability of testimonials, endorsements, and third-party ratings would be governed by the same considerations as predecessor performance results.

IV.  Administrative Provisions

A.  Internal Review and Approval of Advertisements

Proposed Rule 206(4)-1(d) creates a new requirement that investment advisers designate an employee to review and approve all advertisements before they are disseminated. The only exceptions to this rule are for (1) communications to only a single person, household, or investor in a pooled investment vehicle and (2) live oral communications broadcast on electronic media. The SEC did not propose an exemption from pre-distribution reviews for Non-Retail Advertisements.45

B.  Amendments to Form ADV

The proposed rule would amend Item 5 of Part 1A of Form ADV to add a subsection “L. Advertising Activities” to help SEC staff prepare for on-site examinations. This five-question subsection would ask advisers to respond yes or no to the following questions:

(1) Whether any of the adviser’s advertisements contain performance results;

(2) If so, whether all of those performance results were verified or reviewed by a person who is not a “related person” (i.e., an entity unaffiliated with the adviser);

(3) Whether any of the adviser’s advertisements include testimonials, endorsements, or third-party ratings, and if so, whether the adviser provides direct or indirect compensation in connection with their use; and

(4) Whether any of the adviser’s advertisements includes a reference to specific investment advice provided.

C.  Amendments to the Books and Records Rule

First, the recordkeeping requirements of Rule 204-2(a)(11) would be expanded to require advisers to keep copies of all advertisements disseminated, whereas the rule currently requires that advisers only keep records of written communications disseminated to 10 or more people. This provision would require that advisers retain records of the risk and calculation information for Hypothetical Performance that they are required to provide under amended Rule 206(4)-1(c)(1)(v) because the Commission views such additional information as part of the advertisement itself.46

Second, the amended recordkeeping rule would require investment advisers make and keep originals of: (1) written communications sent or received relating to the performance or rate of return of any or all Portfolios and (2) supporting records regarding the calculation of the performance or rate of return of any or all Portfolios.

Third, advisers would be required to retain records of any questionnaires and surveys used to obtain third-party ratings for advertisement purposes.

Finally, advisers would be required to maintain records of the written approvals for all advertisements.

V.  Summary and Policy Considerations

The SEC has issued a thoughtful proposal that would adopt a technology-neutral, principles-based approach to investment adviser advertising. The Release includes extensive questions on all aspects of the proposal, and industry participants should carefully consider whether to submit responses.

One issue that is not specifically addressed in the Release is the degree to which the amended rules should be harmonized more closely with equivalent FINRA standards for broker-dealer communications and NFA standards for promotional material distributed by CFTC-registered firms. These considerations are particularly relevant to SEC-registered investment advisers that are also registered with the CFTC as CPOs or CTAs, which are subject to both SEC and NFA requirements, and advisers who market interests in funds they advise through broker-dealers, in which case the sales material would be subject to both the SEC and FINRA requirements. Finally, we note that the Release contains a wealth of material on current requirements for investment adviser advertising, which firms may consult to confirm that their current advertising practices conform to applicable SEC standards.

1   Commission Release No. IA-5407 (Nov. 4, 2019).

2  See Cadwalader Clients and Friends Memo titled SEC Proposes Significant Amendments to Investment Adviser Solicitation Rule, dated December 3, 2019 (the “Cadwalader Investment Adviser Solicitation Proposal Memo”).

3   Any reference to Rules in this memorandum shall mean rules promulgated under the Advisers Act, unless otherwise specified.

4   The Release differentiates between “live” oral communications, which are not “advertisements” if not broadcast widely on electronic media, and pre-recorded communications, which could be considered advertisements. Additionally, any written materials (e.g., slides, storyboards, or scripts) prepared in advance for use during a live oral communication could be considered advertisements. See Release, pp. 41-42.

5   See Section III.D., infra, for definitions.

6  Specifically, the exclusion would apply to sales material about RICs and BDCs complying with the advertising requirements of rules 156 and 482 under the Securities Act of 1933 (the “Securities Act”).

7   Persons who promote an investment adviser’s services through testimonials or endorsements may be considered solicitors and thus subject to the requirements of both Rule 206(4)-1 (the advertising rule) and Rule 206(4)-3 (the solicitation rule). See Cadwalader Investment Adviser Solicitation Proposal Memo, Section III.A at nn.16-17 and accompanying text.

8  The Release discusses the circumstances in which online material may be deemed to be an investment adviser’s advertising as a result of linkages between the investment adviser’s website or social media site and third-party sites. See Release, pp. 25-28.

9   See Release, p. 33 (citing Investment Counsel Association of America, Inc., SEC Staff No-Action Letter (Mar. 1, 2004)).

10 The Release reasons that investors in RICs and BDCs are adequately protected by provisions of the Securities Act and Investment Company Act of 1940 (the “Investment Company Act”). See Release, pp. 36-40.

11 See, e.g., Release, pp. 67-68 (delineating criteria that would help advisers comply with the proposed rule (citing Franklin Management, Inc., SEC Staff No-Action Letter (Dec. 10, 1998))).

12 Put differently, an adviser would have to be able to substantiate every material claim contained in its advertisements.

13 This would prohibit, for example, cherry-picking favorable results or time periods. The “fair and balanced” standard mirrors FINRA Rule 2210(d)(1)(A), which requires broker-dealer communications to be “fair and balanced.”

14 See Release, p. 54 at n.109 and accompanying text.

15 The SEC proposes to replace the current Rule’s reference to “past specific recommendations” with “specific investment advice” to clarify that the Rule applies to current advice, and investments in a discretionary account. See Release, pp. 68-69.

16 Rule 206(4)-1(a)(2) currently requires that advisers advertising their past specific recommendations disclose a list of all recommendations they made in the last year, including: the name of each security, the date and nature of the recommendation (e.g., buy, sell, hold), the market price of the security at the time of the recommendation and as of the most recent date, the price at which the recommendation was to be acted upon and a warning that “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.”

17 See the TCW Group, SEC Staff No-Action Letter (Nov. 7, 2008) (declining to recommend enforcement action when a chart contained in an advertisement was clear, consistent, and included both the account’s best and worst performance during the period).

18 See Release, pp. 64-65.

19 FINRA permits broker-dealers to include testimonials in sales material, but requires additional disclosures when they are used in retail communications. See FINRA Rule 2210(d)(6).

20 “Testimonial” would be defined in Proposed Rule 206(4)-1(e) as “any statement of a client’s or investor’s experience with the investment adviser or its advisory affiliates.” The proposed rule defines “advisory affiliate” by reference to the definition in Form ADV, which includes, among others, entities “directly or indirectly controlling or controlled by” the investment adviser. This would thus include entities in the ownership chain of the adviser, but not entities under common control (i.e., sister companies). See Release, pp. 78-79 at n.152 and accompanying text.

21 “Endorsement” would mean “any statement by a person other than a client or investor indicating approval, support, or recommendation of the investment adviser or its advisory affiliates.”

22 Examples of non-cash compensation could include reduced-fee or no-fee advisory services, or the adviser referring its clients or investors to the third-party’s business. See Release, p. 90.

23 “Third-party rating” would mean “a rating or ranking of an investment adviser provided by a person who is not a related person and such person provides such ratings or rankings in the ordinary course of its business.” The proposed rule uses the Form ADV definition of “related person”: “[a]ny advisory affiliate and any person that is under common control with your firm.” A third-party rating is thus a rating produced by an entity that is not a parent, subsidiary, or entity in a common control relationship with the adviser. The Release notes that “The requirement that the provider not be an adviser’s related person would avoid the risk that certain affiliations could result in a biased rating.” See Release, p. 81.

24 The Release provides no definition for “reasonable belief,” and instead suggests that advisers be responsible for creating internal policies and procedures to implement the “reasonable belief” provisions.

25 See, e.g., Clover Capital Mgmt., Inc., SEC Staff No-Action Letter (Oct. 28, 1986) (discussing when an advertisement using Hypothetical Performance might be false or misleading); Anametrics Investment Management, SEC Staff No-Action Letter (Apr. 5, 1977) (stating that advertising account performance without disclosing that the market significantly outperformed the account over the same time period was misleading); Bradford Hall, SEC Staff No-Action Letter (Jul. 19, 1991) (stating that the presentation of gross performance not reflecting a deduction for advisory fees would be misleading).

26 A “knowledgeable employee” would be a Non-Retail Person solely with respect to a fund falling within the exclusion from the definition of an “investment company” in Section 3(c)(7) of the Investment Company Act, advised by the investment adviser. See Release, pp. 114-15.

27 The Commission decided against treating other categories of investors as Non-Retail Persons, such as Regulation D accredited investors, and Rule 205-3(d)(1) qualified clients. See Release, p. 114. We note the following regarding the treatment of retail vs. non-retail advertisements by the National Futures Association (“NFA”) and the Financial Industry Regulatory Authority (“FINRA”):

– The NFA governs communications by firms registered with the Commodity Futures Trading Commission (“CFTC”), including commodity pool operators and commodity trading advisors (“CPOs” and “CTAs”). The NFA imposes somewhat more lenient requirements on promotional material directed at “qualified eligible persons” (“QEPs”) as defined in CFTC Rule 4.7. See, e.g., NFA Compliance Rule 2-29(c). QEPs include, but are not limited to, “qualified purchasers” and “knowledgeable employees.” An SEC-registered investment adviser that is also registered with the CFTC as CPO or CTA would thus have to determine whether it is sending sales material to (i) a Retail or Non-Retail Person under the SEC’s proposed rule, and (ii) a QEP or non-QEP under CFTC Rule 4.7.

– FINRA Rule 2210, governing broker-dealer communications, distinguishes between “retail communications” and “institutional communications.” For this purpose, an “institutional communication” is a communication sent exclusively to “institutional investors,” which are defined as certain categories of regulated entity, and other entities or individuals that have total assets of at least $50 million. See FINRA Rule 2210(a)(4) incorporating the definition of “institutional account” in FINRA Rule 4512(c). This is a higher asset test than that used in the “qualified purchaser” definition, which requires individuals to own at least $5 million in investments, and institutions to own and invest at least $25 million in investments. This means that where an investment adviser directly markets interests in a fund operated under Section 3(c)(7) of the Investment Company Act to “qualified purchasers” and “knowledgeable employees,” it may treat those investors as “Non-Retail Persons,” whereas if interests in the fund are sold through a broker-dealer, the broker-dealer would be required to treat those investors as “retail investors” for purposes of complying with the communications requirements of FINRA Rule 2210.

28 “Portfolio” would mean a group of investments managed by the investment adviser, including an account or a “pooled investment vehicle” as defined in Rule 206(4)-8(b) (i.e., an “investment company” as defined in Section 3(a) of the Investment Company Act, or a fund falling within the exclusion from the definition of an “investment company” in Section 3(c)(1) or 3(c)(7) of the Investment Company Act). Proposed Rule 206(4)-1(e)(10).

29 If the relevant Portfolio did not exist for a particular prescribed period, then the life of the Portfolio must be submitted for that period.

30 “Gross Performance” would mean “the performance results of a Portfolio before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s investment advisory services to the relevant Portfolio.” Proposed Rule 206(4)-1(e)(4).

31 “Net Performance” would mean “the performance results of a Portfolio after the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s investment advisory services to the relevant Portfolio, including, if applicable, advisory fees, advisory fees paid to underlying investment vehicles, and payments by the investment adviser for which the client or investor reimburses the investment adviser.” Proposed Rule 206(4)-1(e)(6).

32 The Release does not prescribe a specific calculation of Gross and Net Performance; the Commission seeks comment on what additional guidance it should provide for such calculations.

33 See Release, p. 128 (noting that “Where an adviser presents net performance, whether because net performance is required under the proposed rule or because the adviser otherwise chooses to present it, the schedule should show the fees and expenses actually applied in calculating the net performance that is presented.”).

34 We note that the NFA recently amended NFA Compliance Rule 2-29(b)(5) to include a specific requirement that past performance be presented on a net basis, regardless of whether the recipient is a QEP (and thus a Non-Retail Person). See NFA Notice to Members I-19-26 (Nov. 13, 2019). This reflects existing requirements under the CFTC and NFA rules that require CPOs and CTAs to calculate rate of return information on a net basis regardless of whether the investor is a QEP. See NFA Compliance Rule 2-29(b)(5)(ii).

35 “Related Performance” would mean “the performance results of one or more related Portfolios, either on a Portfolio-by-Portfolio basis or as one or more composite aggregations of all Portfolios falling within stated criteria.” Proposed Rule 206(4)-1(e)(11).

36 “Related Portfolio” would mean a “Portfolio with substantially similar investment policies, objectives, and strategies as those of the services being offered or promoted in the advertisement,” including, but not limited to, Portfolios for the account of the investment adviser or its advisory affiliate. Proposed Rule 206(4)-1(e)(12).

37 Under FINRA guidance, a broker-dealer may only include related performance information in sales materials distributed to (i) “institutional investors,” as defined in FINRA Rule 2210(a)(4), or (ii) qualified purchasers with respect to their investment in funds falling within Section 3(c)(7) of the Investment Company Act. See, e.g., FINRA Interpretive Letter to Stradley Ronon Stevens & Young, dated April 16, 2018; see also FINRA Interpretive Letter to Davis Polk & Wardwell, dated Dec. 30, 2003. The Release notes FINRA’s more restrictive approach, and comments that: “We believe that the utility of related performance in demonstrating the adviser’s experience in managing portfolios having specified criteria, together with the provisions designed to prevent cherry-picking and the provisions of paragraph (a) [imposing prohibitions on false or misleading advertisements], support not prohibiting related performance in advisers’ Retail Advertisements.” See Release, p. 151.

38 “Extracted Performance” would mean “the performance results of a subset of investments extracted from a Portfolio.”

39 “Hypothetical Performance” would mean “performance results that were not actually achieved by any Portfolio of any client of the investment adviser.” Under this definition, results achieved by proprietary accounts of the adviser would be “hypothetical” as they would not be achieved by a client of the adviser. Examples of Hypothetical Performance that an adviser may use include Backtested Performance, Representative Performance (including performance of “model” portfolios), and Targets and Projections. See Proposed Rule 206(4)-1(e)(5) and Release, pp. 162-67, for definitions and discussions of these subsets of Hypothetical Performance.

40 See Release, p. 171. The Release further notes that in determining whether hypothetical performance is relevant to a Retail Person, a firm’s policies should include “parameters that address whether the Retail Person has the resources to analyze the underlying assumptions and qualifications of the hypothetical performance to assess the adviser’s investment strategy or processes, as well as the investment objectives for which such performance would be applicable.” In light of this requirement, the Release concludes that investment advisers would not be permitted to include hypothetical performance in advertisements that are distributed generally to Retail Persons regardless of their financial situation or investment objectives. See Release, p. 174.

FINRA and the NFA take differing approaches to hypothetical performance information:

– FINRA only permits broker-dealers to include hypothetical (backtested) performance information in certain communications with “institutional investors” as defined in FINRA Rule 2210(a)(4). See, e.g., FINRA Interpretive Letter to Foreside, dated Jan. 31, 2019.

– The NFA prohibits CFTC-registered firms from including hypothetical performance in promotional material sent to non-QEPs (i.e., Retail Persons) with respect to any trading program for which the firm has three months of actual trading results. Further, to the extent hypothetical performance information is permitted in retail promotional material, NFA requires a CFTC-registered firm to include comparable information regarding actual past performance of all customer accounts directed by the firm for the last five years (or the entire performance history, if less than five years). These restrictions do not, however, apply to hypothetical performance included in promotional material sent exclusively to QEPs (i.e., Non-Retail Persons). See NFA Compliance Rule 2-29(c)(3), (4) and (6).

41 See Release, pp. 103-05.

42 See Release, p. 105

43 The Commission also recently extended these guidelines to a case in which an investment adviser desired to use performance results of its predecessor entity after an internal restructuring. See South State Bank SEC Staff No-Action Letter (May 8, 2018) (not recommending enforcement action when the successor entity would operate in the same manner and under the same brand name as the predecessor).

44 See Horizon Asset Management, LLC, SEC Staff No-Action Letter (Sept. 13, 1996).

45 By contrast, FINRA Rule 2210(b)(3) permits post-distribution reviews of broker-dealer communications to “institutional investors” as defined in FINRA Rule 2210(a)(4) provided the firm trains personnel in the firm’s procedures governing institutional communications, and implements follow-up procedures to confirm that the procedures have been followed.

46 This information includes the criteria, assumptions, and methodology used in calculations, and the risks and limitations of the calculations. See Release, pp. 176-77, 287-88.

© Copyright 2019 Cadwalader, Wickersham & Taft LLP

For more Securities and Exchange Commission regulations, see the National Law Review Securities Law section.

Maintaining Attorney-Client Privilege Over Communications with Consultants Involved in Internal Investigations

When a company retains outside counsel to conduct an internal investigation of alleged wrongdoing, attorney investigators sometimes need or require the assistance of outside consultants, such as forensic accountants or technology specialists, to effectively represent and communicate with their client. While the extension of the attorney-client privilege to communications between counsel and such outside consultants has been recognized, the consultant must be integral to counsel’s ability to perform the investigation and convey and discuss the results to the client, and privileged communications with the consultant should be narrowly restricted.

In a recent case, SEC v. Navellier & Assocs., Civil Action No. 17-11633-DJC (D. Mass. Jan. 22, 2019), the court held that the attorney-client privilege did not extend to an outside consultant hired as part of an internal company review to assist counsel in advising clients regarding possible future litigation with the Securities and Exchange Commission regarding exchange traded funds. According to the court, the third party “must be ‘necessary, or at least highly useful, for the effective consultation between the client and the lawyer which the privilege is designed to permit.’” The court emphasized that the third-party consultant’s involvement must be nearly indispensable or serve some specialized purpose in facilitating the attorney-client communications. The court found that the consultant’s role in that case, while helpful in assisting counsel, did not rise to the required level of necessity; thus, communications between counsel and consultant were not privileged. The Navellier decision serves as a reminder to both companies and counsel to analyze as a threshold matter whether the consultant is truly necessary or merely helpful or convenient, and tailor communications with the consultant accordingly.

©2019 Epstein Becker & Green, P.C. All rights reserved.

See more on attorney-client responsibilities on the National Law Review Law Office Management page.

Cardholders Seek to Capital-ize on Madden

Last week, three Capital One cardholders filed a putative class action in the Eastern District of New York, Cohen v. Capital One Funding, LLC,1 alleging that the rates of interest they paid to a securitization trust unlawfully exceed the sixteen percent threshold in New York’s usury statutes.  The Plaintiffs seek to recoup the allegedly excessive interest payments and an injunction to cap the interest rates going forward.

The Plaintiffs seek to leverage the Second Circuit’s decision in Madden v. Midland Funding, LLC.2  There are factual differences between the current lawsuit and Madden.  In Madden, the loan in question was a nonperforming credit card account that Bank of America’s Delaware-based credit card bank had assigned to Midland Funding, which sought to enforce the past-due loan.  In Cohen, the loans involve credit card receivables from otherwise performing loans that have been deposited into securitization trusts.  Another distinction is that Cohen, unlike Madden, is a putative class action.  The legal theory in both cases, however, is the same:  the Plaintiffs argue that the holders—here, securitization vehicles—do not have the originating national bank’s right to collect interest at rates above the limits of New York’s usury laws.  And any usurious interest collected, the Plaintiffs argue, must be disgorged.

As we discussed in our prior C&F Memorandum, “It’s a Mad, Mad, Madden World” (June 29, 2016), the Second Circuit’s Madden ruling is unsound.  Under the Second Circuit’s Madden theory, the usury rate applicable to a given loan—and thus its enforceability—turns on the identity of the loan’s holder.  The notion that the enforceability of a loan originated by a national bank turns on who holds the loan from time-to-time conflicts with the well-settled valid-when-made doctrine—a doctrine that provides that whether a loan is usurious is determined at the loan’s inception.   This approach was abandoned in Madden.  As a result, under Madden, bank-originated consumer loans can be less valuable if sold, thus devaluing the loans on the books of the originating bank.  Banks, then, are discouraged from originating such loans or, once originated, from selling them.  The net result is—at least in theory—a tightened consumer credit market.

In many corners, Madden is viewed to be “bad law.”  Even so, the Office of the Comptroller of the Currency recommended against petitioning the Supreme Court for a writ of certiorari in Madden.  Nor did Congress produce a legislative fix, despite such a bill being introduced in 2018.  Both the OCC and Congress faced political headwinds over the practice by some marketplace and payday lenders that originate high-rate consumer loans through banks under the so-called bank origination model; the concern was that reversing Madden could enshrine such practices and could be potentially harmful to consumers.  (For a discussion of the bank origination model, see our prior C&F Memorandum, “Marketplace Lending Update:  Who’s My Lender?” (Mar. 14, 2018).)  But that concern is not present in Cohen, where the Plaintiffs rely on Madden to attack traditional, currently performing credit card receivables that were originated by a national bank—a structure unrelated to the bank-origination model used by some marketplace lenders.

Cohen is the second Madden-related lawsuit brought against securitization trusts; the first is proceeding in Colorado against marketplace-lending receivables originated by Avant and Marlette.  See “Marketplace Lending #5:  The Very Long Arm of Colorado Law” (Apr. 24, 2019).  Until Madden is reversed, we continue to recommend that clients exercise caution when acquiring, securitizing, or accepting as collateral consumer loans (or asset-backed securities backed by such loans), when the loans were originated to residents of a state in the Second Circuit (New York, Connecticut, and Vermont) and carry a rate above the applicable general usury rate (generally, sixteen percent in New York, twelve percent in Connecticut, and eighteen percent in Vermont).

1   No. 1:19-cv-03479-KAM-RLM (E.D.N.Y. filed June 12, 2019), https://www.cadwalader.com/uploads/media/CapitalOneCase.pdf.

2   786 F.3d 246 (2d Cir. 2015), cert. denied, __ U.S. __, 136 S. Ct. 2505, 195 L. Ed. 2d 839 (2016).

 

© Copyright 2019 Cadwalader, Wickersham & Taft LLP
More on financial issues on the National Law Review Financial Institutions & Banking page.

SEC Adopts FAST Act Disclosure Simplification and Modernization Amendments

On March 20, 2019, the U.S. Securities and Exchange Commission (SEC) adopted amendments to modernize and simplify Regulation S-K’s disclosure requirements and related rules and forms, as required by the Fixing America’s Surface Transportation (FAST) Act. The amendments were proposed by the SEC in October 2017. The SEC adopted most of the amendments as proposed and some of the amendments with modifications, and elected not to adopt certain proposed amendments at all.

The SEC intends for the amendments to improve the readability and navigability of company disclosures and to discourage repetition and disclosure of immaterial information. These amendments complement other recent amendments adopted by the SEC to simplify disclosure, such as in the Disclosure Update and Simplification Final Rule that became effective in November 2018.

Below are brief summaries of some of the more significant amendments:

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) 

(Regulation S-K, Item 303 and Form 20-F). Registrants may omit discussion of the earliest of three years in the MD&A if they already discussed that year in any of their prior EDGAR filings that required such discussion. Registrants who elect not to include a discussion of the earliest year must include a statement that identifies the location in the prior filing where the omitted discussion may be found.

Description of Property (Regulation S-K, Item 102)

Registrants must provide disclosure about physical property only to the extent that the property is material to the registrant’s business.

Risk Factors (Regulation S-K, Item 503(c) (moved to new Item 105))

The examples are deleted from the risk factors item to emphasize the principles-based nature of this disclosure requirement.

Material Contracts Two-Year Look Back (Regulation S-K, Item 601(b)(10))

Only “newly reporting registrants” are required to file fully performed material contracts that the registrant has entered into within two years of the applicable registration statement or report.

Redaction of Confidential Information in Material Contracts (Regulation S-K, Items 601(b)(10) and 601(b)(2) and investment company registration forms)

Registrants may omit or redact confidential information from their filed material contracts without submitting a confidential treatment request to the SEC if the confidential information (i) is not material and (ii) would likely cause competitive harm to the registrant if publicly disclosed. This amendment is effective upon the rule’s publication in the Federal Register.

New Form 10-K Exhibit (new Regulation S-K, Item 6(b)(4)(iv)).

Registrants are required to file an additional Exhibit to Form 10-K containing the description of the registrant’s securities required under Regulation S-K, Item 202(a)-(d) and (f).

Schedules and Attachments as Exhibits (Regulation S-K, Item 601(a)(5) and investment company forms).

Registrants are no longer required to file attachments to their material agreements if such attachments do not contain material information or were not otherwise disclosed.

Hyperlinks (Securities Act Rule 411(b)(4); Exchange Act Rules 12b-23(a)(3) and 12b-32; Investment Company Act Rule 0-4; and Regulation S-T Rules 102 and 105).

Registrants are no longer required to file as an exhibit any document that is incorporated by reference in the filing, but instead registrants must provide a hyperlink to such document.

Financial Statements: Incorporation by Reference and Cross-Reference (Forms 8-K, 10-Q, 10-K, 20-F, and 40F).

Financial statements are prohibited from incorporating by reference, or cross-referencing to, information outside the financial statements (including in other parts of the same filing), unless otherwise specifically permitted by the SEC’s rules, U.S. Generally Accepted Accounting Principles, or International Financing Reporting Standards, as applicable.

Cover Page (Forms 8-K, 10-Q, 10-K, 20-F, and 40F).

Registrants are required to disclose on the form cover page the national exchange or principal U.S. market for their securities, the trading symbol, and the title of each class of securities. Additionally, registrants are required to tag all cover page information using Inline XBRL. This cover page Inline XBRL requirement has a three-year phase-in compliance period identical to the phase-in compliance period for the SEC’s Inline XBRL rules adopted in 2018, with large accelerated filers required to comply beginning with fiscal periods ending on or after June 15, 2019.

Section 16 Disclosure (Regulation S-K, Item 405 and Form 10-K).

The caption for reporting delinquent reporting under Section 16(a) of the Exchange Act is changed from “Section 16(a) Beneficial Ownership Reporting Compliance” to “Delinquent Section 16(a) Reports,” and the checkbox on the cover page of Form 10-K related to such delinquencies is eliminated. Additionally, registrants are allowed to rely on Section 16 reports filed on EDGAR (as opposed to only paper copies of reports).

Investment Companies.

The adopted amendments include parallel amendments to several rules and forms applicable to investment companies and investment advisers, including amendments that require certain investment company filings to include a hyperlink to each exhibit listed in the filings’ exhibit index and that require registrants to submit such filings in HyperText Markup Language (HTML) format. The requirements that all investment company registration statements and Form N-CSR filings be made in HTML format and comply with the hyperlink rule and form amendments applies to all filings made on or after April 1, 2020.

Except as otherwise noted, the amendments will be effective 30 days from publication in the Federal Register.

The above summaries are not comprehensive and provide only highlights of certain amendments. They do not reflect all of the amendments nor all of the rules and forms that are affected by the amendments.

 

© 2019 Schiff Hardin LLP

The Effects Of The SEC Shutdown On The Capital Markets

Although EDGAR continues to accept filings, the government shutdown has now eclipsed its 28th day and the SEC continues to operate with limited staff which is having a crippling effect on the ability of many companies to raise money in the public markets. This is particularly due to the fact that the SEC is unable to perform many of the critical functions during the lapse in appropriations, including the review of new or pending registration statements and/or the declaration of effectiveness of any registration statements.

Although Section 8(a) of the Securities Act of 1933, as amended, creates an avenue whereby a registration statement will automatically become effective 20 calendar days after the filing of the latest pre-effective amendment that does not include “delaying amendment” language, many companies seeking to raise money in the public markets, including through an initial public offering, are reluctant to use this route for the following reasons. First, any pre-effective amendment which removes the “delaying amendment” language must include all information required by the form including pricing information relating to the securities being sold as Rule 430A is not available in the absence of a delaying amendment. This means that companies must commit to pricing terms at least 20 days in advance of the offering which may be difficult due to the volatility in the markets. In the event pricing terms change, companies must file another pre-effective amendment which restarts the 20-day waiting period. Second, companies run the risk that the SEC may, among other things, issue a stop order. Finally, companies may run into issues with FINRA, Nasdaq or the NYSE as these organizations may not agree to list securities on such exchanges without the SEC confirming that they have reviewed and cleared such filing and affirmatively declared the registration statement effective. These risks, among others, associated with using Section 8(a) as a means by which a registration statement can become effective after the 20-day waiting period, seem to outweigh the benefits of pursuing this alternative despite the fact that many companies with a December 31st year end will soon be required to file audited financial statements for the year ended December 31, 2018 pursuant to Rule 3-12 of Regulation S-X which will further delay the process resulting in an increase in both cost and time related to the offering.

Although companies seeking to raise money in the public markets, including through initial public offerings or shelf registration statements, may be reluctant to rely upon Section 8(a), some companies have already chosen to remove the “delaying amendment” language. For example, some companies which appear to have cleared all comments from the SEC prior to the partial government shutdown have elected to remove the “delaying amendment” and proceed with their offerings after the 20-day waiting period. In addition, other companies conducting rights offerings, such as Trans-Lux Corporation and Roadrunner Transportation Systems, Inc., are also relying on Section 8(a) as a means of raising money. Finally, some special purpose acquisition companies (“SPACs”), including Andina Acquisition Corp. III, Gores Metropoulous, Inc., Pivotal Acquisition Corp. and Wealthbridge Acquisition Limited, are among the issuers that are using Section 8(a) as a way to procced with their offerings during this partial government shutdown since SPACs, in particular, are not sensitive to price volatility in the markets because they have no operations.

Companies and underwriters that may be considering filing a pre-effective amendment to a registration statement to take advantage of Section 8(a) of the Securities Act should discuss the effects of removing the “delaying amendment” language with securities counsel before proceeding down such path.

 

Copyright © 2019, Sheppard Mullin Richter & Hampton LLP.
Read more legal news on the Government Shutdown at the National Law Review.

SEC’s Office of Compliance Inspections and Examinations Releases 2019 Examination Priorities

On Dec. 20, 2018, the Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) issued its annual Examination Priorities for 2019 (Exam Priorities), which is available for download here. The Exam Priorities focus around six thematic areas: (1) Retail Investors, including seniors and those saving for retirement; (2) Registrants responsible for critical market infrastructure; (3) FINRA and MSRB; (4) Digital Assets; (5) Cybersecurity; and (6) Anti-Money Laundering (AML) Programs.

As in the past, OCIE notes that their priorities are not exhaustive. The scope of any examination is determined through a risk-based approach that includes analysis of the registrant’s operations and products offered. For example, OCIE typically examines the disclo­sure of services, fees, expenses, conflicts of interest for investment advisers, and trading and execution quality issues for broker-dealers. OCIE is continually evaluating changes in market conditions, industry practices, and investor preferences to assess risks to both investors and the markets.

In connection with OCIE’s priority to protect retail investors, OCIE reviews retail fees and expenses paid by investors, conflicts of interest of industry personnel, treatment of senior investors and the advertising and suitability of retirement products, portfolio management and trading, operations of and the selection of mutual funds and ETFs, procedures of municipal advisors, procedures for broker-dealers entrusted with customer assets, and microcap securities.

OCIE also continues to prioritize critical market registrants impacting the safety and operation of our financial markets, including clearing agencies, entities subject to Regulation SCI, transfer agents, and national securities exchanges.

Finally, OCIE will prioritize examinations of the effectiveness of FINRA and MSRB, which are assigned the responsibility for certain aspects of investor protection. OCIE also will conduct inspections to gather information and evaluate practices affecting digital assets, cybersecurity, and AML programs (especially broker-dealers subject to express obligations and SAR filing obligations).

Overall, OCIE noted that although changes to its priorities may be continual, OCIE’s analytic efforts and examinations remain firmly grounded in its four pillars: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.

 

©2019 Greenberg Traurig, LLP. All rights reserved.
This article was written by Arthur Don and Vincent Lewis of Greenberg Traurig, LLP.

Bitcoin Boom: Are Cryptocurrencies Securities Subject to Regulation by the SEC?

Bitcoin was launched in January 2009 as the world’s first cryptocurrency — a digital asset designed to function as a currency that is created and managed by decentralized computers, using encryption techniques instead of a central bank or other government authority.

Until early 2017, Bitcoin barely registered on the average investor’s radar screen. But beginning in 2017, the price of Bitcoin jumped dramatically from $1,290 in early March to $19,500 in mid-December. With the sharp rise in the price of bitcoin, alternative cryptocurrencies (a/k/a “altcoins”) such as Litecoin and Ethereum saw investor interest spike as well. By May 2018, over 1,800 cryptocurrencies had been created.

Cryptocurrency Boom

The cryptocurrency boom (or bubble, as many economists warn) has spawned interest in the blockchain technology that underlies cryptocurrencies. Broadly, blockchain technologies enable the creation of digital ledgers, or lists of records (or “blocks”) that can be used to share information, transfer value, and record transactions in a secure, decentralized environment. For example, several governments are experimenting with blockchain technologies in land registries to reduce the risk of fraud in real property transactions. The ledger of a particular property would contain a verifiable and validated history of transactions concerning the property. Bloomberg reports that law firms are exploring the use of blockchain to generate, execute and authenticate agreements. IMS anticipates that such applications and many others will increase reliance on experts who understand the underlying technologies and can competently testify concerning infringement of any related patents and/or theft or misappropriation of trade secrets.

Of course, as exciting new technologies become commercialized and investors find themselves smitten by the promise of high returns, there is a foreboding a dark side with con artists seeking to capitalize on gullibility. With cryptocurrencies, frauds have frequently taken the form of initial coin offerings (ICO’s) in which entrepreneurs purport to raise capital for a new venture by exchanging digital “tokens” for investor funds.

The Dispute

In one such scam, the U.S. Attorney for the Eastern District of New York secured an indictment for securities fraud against a defendant who had offered tokens in an ICO for REcoin Group, and promised to invest the proceeds in real estate, and then diamonds. U.S. v. Zaslavskiy, 17 CR 00647 (E.D.N.Y). The defendant moved to dismiss the indictment for lack of jurisdiction based on an interesting defense — he argued that the tokens he had peddled were not securities, but currencies, which are exempted by statute from the definition of “securities.” The broad question thus raised was whether a cryptocurrency issued in an allegedly fraudulent ICO qualifies as a security subject to regulation by the SEC.

In a memorandum of law opposing the motion to dismiss, the government argued that while nominally labeled a currency, the tokens were securities in economic substance since the defendant promised purchasers of the tokens that they would receive a return on their investment. In support, the government cited the Supreme Court’s decision SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which defined an “investment contract” as an investment of money in a common enterprise with a reasonable expectation of profits to be derived solely from the entrepreneurial or managerial efforts of others. In analyzing a particular transaction, the Supreme Court stressed that “form [should be] disregarded for substance and the emphasis placed upon economic reality.”

Here, investors in the REcoin ICO pooled their money in a common enterprise through the purchase of tokens with the expectation that REcoin would pay profits based on the defendant’s skill and effort managing real estate or trading diamonds; they were not directly purchasing real estate or diamonds. Thus, the tokens were securities, the government maintained.

The government further argued that the term “currency” is traditionally defined as a “medium of exchange” approved for the payment of debts and purchase of goods. Typically, courts have found that only cash, or a cash substitute qualifies as currency. Here, the tokens sold by defendant could not function as a medium of exchange anywhere in the physical world or any digital realm. Nor did defendant market the tokens as a substitute for cash.

After oral argument, the judge in the case has taken the matter under advisement. In the meantime, in Congressional testimony and public appearances, SEC officials have repeatedly taken the position that where the economic substance of an ICO is the same as a standard securities offering, the tokens qualify as securities. In contrast, where investors purchase tokens because they require the functionality that the token itself provides — for example, to record a deed or execute a contract in a digital ledger that uses blockchain technology — then the token is not a security.

For example, in April 2018 testimony before the Financial Services and General Government Subcommittee of the House Committee on Appropriations, Chairman of the SEC, Jay Clayton distinguished between cryptocurrencies such as Bitcoin, which are a “pure medium of exchange,” and thus not securities, and tokens used to finance new ventures, which are securities. Subsequently, in a June 14, 2018 presentation at a tech conference, the Director of the SEC’s Division of Corporation Finance, William Hinman, reiterated that a cryptocurrency is not a security when it operates principally as a medium of exchange in a network without any central third party upon whose efforts the success of the network depends.

Conclusion

Hinman added, however, that whether a digital token qualifies as a security or not in a specific context can be a close call, and the outcome will depend on a fact-intensive inquiry. He cited a laundry list of factors that the SEC will examine (including the degree of the promoters’ ongoing involvement and control, the expectations and motivations of investors when making their purchases, the independent utility of the token offered for sale, and the breadth and method of the tokens’ distribution), and invited promoters of digital assets and their counsel to help the SEC work through the issues in particular cases before proceeding. IMS’s roster of blockchain experts can assist counsel with navigating these factors and related intellectual property, technical, and regulatory matters with your own clients.

© Copyright 2002-2018 IMS ExpertServices, All Rights Reserved.
This article was written by Joshua Fruchter, IMS ExpertServices

Lack of Presidential Appointment May Invalidate ALJ Decisions

In one of its last opinions of the term, the U.S. Supreme Court held in Lucia v. U.S. Securities and Exchange Commission (SEC) on June 21, 2018, that administrative law judges (ALJs) are officers of the United States, not mere employees, and therefore must be appointed under the Constitution’s Appointments Clause. The decision leaves important questions open for individuals that have faced or are currently facing administrative proceedings before the SEC and other government agencies.

The Constitution’s Appointments Clause requires that “inferior officers” be appointed to their positions by the President, the courts or the Heads of Departments, or agency commissioners. The case at hand, Lucia v. SEC, concerned an administrative proceeding by the SEC against investment broker Raymond Lucia, whom the SEC accused of using misleading marketing practices to deceive prospective clients.

Mr. Lucia appealed the decision of the administrative law judge, who had fined him $300,000 and barred him for life from the investment industry, on the grounds that the presiding judge had been unconstitutionally appointed. The judge that heard Mr. Lucia’s case, along with the four other ALJs at the SEC, was not appointed by Commissioners, but by staff. Shortly after the case was filed, the SEC sought to remedy any potential constitutional violation by having the Commissioners simply appoint the five ALJs. The Court overturned the ruling against Mr. Lucia after the majority concluded that administrative law judges are “officers” of the United States. The Court went on to hold that Mr. Lucia was entitled to have his case heard before a new ALJ, despite the fact that the ALJ that heard his case had subsequently constitutionally appointed.

What remains to be seen is how federal courts will treat appeals by defendants from adverse administrative decisions in cases where an objection was made to the constitutionality of the presiding judge. Did the SEC remedy the issue in these cases completely when the Commissioners appointed the five administrative judges or will new proceedings be required? If so, can the same judge who heard a case before his/her appointment by the Commissioners, then hear the same case a second time? Perhaps most importantly, will litigants succeed in bringing challenges to the constitutionality of presiding ALJs in other governments agencies such as the Social Security Administration, which employs more than 1,400 ALJs who oversee more than 700,000 cases a year? While Lucia involved highly specific facts, the logic of the majority opinion would appear to apply to agencies outside the SEC.

 

© Polsinelli PC, Polsinelli LLP in California
This article was written by Michael M. Besser, Edward F. Novak of Polsinelli PC.