Tag: Finance

Three Ways Litigation Finance Can Help Corporate Legal Departments

Corporate legal departments are generally measured by their ability to control legal costs, manage risk, and deputize external litigation resources, especially when their company is involved in litigation. Although a common feature of modern business, litigation is an increasingly costly proposition that is fraught with risk. In recent years, commercial litigation finance has emerged as an effective means of shouldering case costs and redistributing risk. While the number of law firms that have seized the advantages of this type of financing has grown exponentially, general counsels (“GCs”) and corporate legal departments have been slower to recognize the many benefits that it can offer, which has handicapped their companies by keeping a potent tool needlessly out of reach. Here are three things every GC should know about litigation finance.

Litigation Finance Offsets Risk

Litigation costs and other financial risks inherent to the legal process pose a daunting challenge to GCs. As a result, companies often forgo bringing lawsuits due to their impact on financial performance. Yet even when legal departments decide to forge ahead with legal claims, their outcome is often far from certain. The decision to bring a lawsuit, therefore, has the power to make or break entire companies. This risk is even more acute for smaller companies and those facing financial headwinds. A victory could revive a company’s fortunes, while a poorly conceived effort might precipitate the firm’s demise. Litigation finance mitigates that risk through funding “without recourse,” which allows a company to shift costs to a third party and only share an agreed-upon portion of proceeds with the funder at the successful conclusion of the claim. If a case is lost and no proceeds are recovered, the company is under no obligation to repay the funding amount.

Consider the following example: Suppose a small tech startup sues an industry giant for theft of its trade secrets relating to a revolutionary new product. The startup’s case against its unscrupulous competitor is seemingly strong as the brazen theft greatly damaged the fledgling company. Unfortunately, the lawsuit comes with a steep price tag, forcing the startup to spend more than $100,000 each month on attorneys’ fees and associated costs. Small and vulnerable, the startup is quickly exhausting its cash reserves as its better-capitalized opponent employs a panoply of defensive tactics designed to delay and frustrate plaintiff’s efforts at all stages of litigation. As legal bills continue to mount, the startup may need to abandon its lawsuit or accept a paltry settlement far below the actual value of its claim.

Faced with an existential threat, what the startup really needs is a cash injection from a litigation finance provider to pay for the escalating litigation costs while also providing a much-needed insurance policy against unforeseen financial difficulties that can result from litigation. The startup’s GC is surprised to learn that this type of funding is an increasingly common financing option that is available to companies large and small. In a typical transaction, a third-party funder can finance most, or all of the legal expenses associated with the lawsuit in return for a portion of any recovery. The funds may be used to hire top legal talent or procure additional expert resources. Essentially a corporate finance transaction, this type of funding can even be used to supplement the company’s working capital or clean up arrears to legal service providers.

The example above is just one of the ways that litigation finance can be used to hedge litigation risk. More creative GCs have been able to offset their institution’s litigation costs entirely by using a portfolio-based approach to finance all of their legal claims.  This type of structure typically provides a much larger financing commitment but requires cross-collateralization of several litigation matters. Where portfolio financing is utilized, it may provide a greater degree of certainty about long-term future litigation spend.  If the funding amount is substantial enough, GCs may no longer need to allocate for litigation budgets on an annual basis and take a longer-term approach instead.

Litigation Finance Can Transform Legal Departments into Profit Centers Through Balance Sheet Management

Under GAAP, litigation costs are reflected as expenses, which can negatively impact a company’s financials and quarterly performance. This is especially troublesome for public companies that are valued on earnings or cash flow or require certain financial criteria to be met to comply with credit covenants. For such companies, litigation costs paid from company funds must be recorded as expenses immediately when incurred, thereby diminishing reportable earnings. Worse yet, recoveries from successful legal matters may not offset the adverse impact of lawsuit-related costs because such recoveries are generally treated as below-the-line items that do not increase earnings. Moreover, some actions may result in favorable judgments which then take months or years to enforce, leaving a temporary hole in a company’s cash flows despite a successful ruling.

It is no surprise then that corporate legal departments are frequently perceived by management as cost centers, necessary to put out fires or navigate the laws applicable to a particular industry, but not as potential revenue generators. Traditionally, GCs who have identified a roster of affirmative litigation likely to yield significant recoveries will still need to convince their c-suite to take on the risk and immediate financial burden of funding lawsuits from the company’s own balance sheet. Enter litigation finance. When both the risk and burden are shifted to litigation finance providers in exchange for a portion of any recoveries, a company’s legal department can focus on unlocking the hidden value of its legal matters without the risk of negatively impacting its financials, becoming a potential profit generator for the company.

An Experienced Litigation Funder Can Help Optimize Litigation Outcomes

The quality and breadth of resources that litigants are able to deploy can greatly impact outcomes in legal disputes.  For example, the skill of the legal team, the quality of expert witnesses and other litigation consultants are important drivers of how courts and juries perceive the merits of legal claims. With litigation financing mitigating the burden of paying for legal costs, GCs have greater flexibility in assembling a first-rate litigation team. A legal department buttressed by litigation finance can focus on the skill and effectiveness of its team without worrying about negotiating for the lowest possible fees. Access to the support of top-quality counsel and litigation consultants can improve a company’s overall likelihood of success and the magnitude of any recovery.

Experienced litigation funders can provide access to these top litigation support channels by leveraging their network.  In addition, they can provide an invaluable outside perspective on the merits of a case during the due diligence process and throughout the pendency of the claim. When choosing a litigation funder, consider the expertise of the funder’s team and if there are any practice areas which they target in their investment strategy.

A trusted litigation finance firm should demonstrate the highest professionalism, abide by the explicit understanding that a third-party funder should have no involvement in the litigation or strategy, and should protect attorney-client privilege and confidentiality at all times.  When these essential confidences are met, engaging with a third-party funder can be enormously helpful in assessing the merits and risk of a case, budgeting litigation spend, and providing access to first-rate litigation support.

Conclusion

As litigation finance continues to gain popularity among law firms, GCs should also take notice. As businesses continuously seek to gain a competitive advantage over their peers, the ability to mitigate the risks associated with litigation should be an important consideration, especially since poorly conceived strategies can often carry existential consequences.  GCs, therefore, should recognize litigation finance as an indispensable asset that has the potential to offset the risk of litigation, provide effective balance sheet management while unlocking the hidden value of prospective legal claims, and improve outcomes for meritorious cases.

 

© 2019 LexShares, Inc. All rights reserved.

ARTICLE BY Matthew Oxman of LexShares.

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.

Japan’s New Crypto Regulation – 2019 Amendments to Payment Services Act and Financial Instruments and Exchange Act of Japan

Japan will fundamentally change its crypto asset regulations effective in spring of 2020.

In May, 2019, the National Diet, the Japanese national legislature, passed an amendment bill to the Payment Services Act (the “PSA”) and the Financial Instruments and Exchange Act (the “FIEA”), which was promulgated on June 7, 2019 (the “2019 Amendment”).  The 2019 Amendment will become effective within one year from promulgation, following further rulemaking by the Japan Financial Services Agency (the “JFSA”) to implement the 2019 Amendment, which is anticipated sometime soon and includes public comment process.

Key Takeaways of the 2019 Amendment

The 2019 Amendment, coming into force within one year of the promulgation, will bring certain significant and fundamental changes to how crypto assets are regulated in Japan.  Key takeaways are:

  • Crypto asset margin trading and other crypto asset derivative transactions will become subject to Japanese regulations on derivative transactions generally.  Broker-dealers and exchanges will likely need to revisit and update their registration status and policies and procedures.  While it may be possible to rely on a limited grandfathering provision for 6 months after the effective date, a notification must be submitted to a relevant local Finance Bureau within two weeks after the effective date of the 2019 Amendment.
  • Certain crypto assets distributed through distributed ledger technologies (such as blockchain) will be expressly regulated as Type I securities.  Consequently, solicitation and offering of such crypto assets, including Initial Coin Offerings, to Japanese investors will require careful review and structuring to avoid any regulatory pitfalls.
  • Crypto asset-related custodial activities will be subject to licensing.
  • Crypto asset trading activities will be subject to various prohibitions on unfair trading and practices.
  • A detailed rulemaking process will follow and involve opportunities to submit comments during the public consultation process.

Copyright 2019 K & L Gates

ARTICLE BY Tsuguhito Omagari of K&L Gates.
More on cyprocurrency regulation on the National Law Review Financial Institutions & Banking law page.

Federal Court Temporarily Blocks Health Insurance Requirement for Immigrant Visa Applicants

On November 2, 2019, the U.S. District Court for the District of Oregon issued a temporary restraining order, blocking the Trump administration from enforcing a recent presidential proclamation requiring health insurance for immigrant visa applicants. The proclamation, which had been scheduled to take effect on November 3, 2019, would have required certain immigrant visa applicants to prove that within 30 days of their entering the United States they would have approved health insurance or that they otherwise possessed the “financial resources” to cover “reasonably foreseeable medical costs.”

The restraining order will remain in effect for 28 days. In the meantime, the court will hear arguments on November 22, 2019, to determine if the proclamation warrants a preliminary injunction.

© 2019, Ogletree, Deakins, Nash, Smoak & Stewart, P.C., All Rights Reserved.

More on immigration on the Immigration Law page of the National Law Review.

London–IBOR’s Falling Down, Falling Down

The IRS has released proposed regulations that provide a fluid transition to the use of references rates other than the interbank offered rates, such as the London Interbank Offered Rate (LIBOR), in debt instruments and financial products. In July 2017, the UK Financial Conduct Authority announced that the LIBOR might be phased out after 2021. The announcement came amid concerns of manipulation, a decline in the volume of funding from which the LIBOR is calculated, and recommendations for the development of a reference rate based on transactions in a more robust market. The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed, recommended the Secured Overnight Financing Rate (SOFR) as a replacement to the LIBOR, and petitioned the IRS for guidance on the tax consequences of the transition from the LIBOR to the SOFR.

In an effort to “minimize potential market disruption and . . . facilitate an orderly transition in connection with the phase-out” of the LIBOR and other similar reference rates, the IRS issued flexible proposed regulations based on the ARRC’s recommendations. The regulations address seven key areas of the Internal Revenue Code and Treasury Regulations impacted by the change in reference rates. These areas include: (1) the potential gain recognized on modification of debt instruments to change the reference rate; (2) the dissolution of integrated instruments as a result of termination or legging out of an integrated hedge; (3) the source and character of one-time payments used as an alternative to an adjustment to the spread between the LIBOR and SOFR; (4) the conversion of grandfathered debt instruments to registration-required obligations; (5) whether debt-instruments referencing the SOFR will qualify as variable rate debt instruments; (6) the preclusion of “regular interest” classification in a real estate mortgage investment conduit; and (7) foreign bank corporations’ use of the SOFR to calculate interest expense allocable to excess US-connected liabilities.

The regulations generally allow the SOFR to be a replacement for the LIBOR and provide guidance that ensures the tax impacts of the transition from LIBOR to SOFR will be minimal. For example, the parties may generally modify debt instruments to change the reference rate without triggering potential gain or loss that may normally result from material changes to the interest rate of a debt instrument under the significant modification rules.

Taxpayers may rely on these proposed regulations for changes made to debt instruments on or after October 9, 2019.

© 2019 Jones Walker LLP

Important Differences Between Federal and Private Student Loans

Student loan borrowers commonly wonder whether they should refinance federal loans into private loans. There are many factors to consider in the case of federal loans, such as interest subsidies and possible forgiveness (but often with income tax consequences) paired with interest rates that are often lower in the case of private loans. Knowing the differences between federal and private student loans is imperative when making this decision.

Most notably, federal student loans are generally forgiven upon death whereas private lenders will pursue an estate for amounts owed by deceased borrowers.

Before refinancing your federal student loans into private ones, consider the cost of the extra life insurance you will need to purchase to cover the debt and, if you have already refinanced, be sure that your insurance coverage is adequate so that amounts intended for your family do not instead pay back creditors. When planning for federal student loan forgiveness, do not forget to account for any associated cancellation of debt income and purchase adequate insurance to cover the anticipated tax burden. The income tax on cancellation of debt income regarding federal student loans forgiven due to death was eliminated by the 2017 Tax Cuts and Jobs Act but this change is set to expire at the end of 2025 unless extended by Congress.

Similarly, consider any federal interest subsidies that may be available before refinancing. In some cases, the offset of the federal interest subsidy combined with the cost of the additional life insurance needed to cover the private loan debt makes refinancing a disadvantageous move.

In all cases, be sure to discuss the extent and type of your student loan debt and your repayment plan with your estate planning attorney. Planning for federal student loans is notoriously difficult because they are a moving target. The rules surrounding forgiveness, associated income tax consequences, repayment plans and interest subsidies can be changed at any time by any administration. Until a borrower’s loans are actually forgiven or paid off, the rules may be changed in the middle of the game which can make planning very dynamic. It is imperative to monitor the laws surrounding student loans and how they may affect repayment options, forgiveness options and associated income tax consequences.

© 2019 Varnum LLP

ARTICLE BY Rebecca K. Wrock of Varnum LLP.

CFPB Decision on “GSE Patch” Revives Debate About Prudent Underwriting

The Consumer Financial Protection Bureau (CFPB) recently announced that it will allow the so-called “GSE patch” to expire in January 2021.[1] This patch permits Government-Sponsored Entities Fannie Mae and Freddie Mac to buy loans even though the borrower’s debt-to-income (“DTI”) ratio exceeds the standard limit of 43%.[2]

The CFPB’s decision revives a long-standing debate about what constitutes a creditworthy loan. By eliminating the patch, the DTI ratio of 43% will become an absolute rule, making any loans with higher DTI’s ineligible for GSE funding.[3]

This type of bright-line rule—focused on a single component of a loan—has already drawn criticism as myopic.[4] Some have pointed out that, based on recent studies, DTI alone is a poor predictor for default of prime and near-prime loans.[5] For example, in each year since 2011, the 90-day delinquency rate for loans with DTI ratios over 45% has actually been lower than that for loans with DTI ratios between 30% and 45%.[6]

In fact, some studies indicate that adequate compensating factors can completely offset any minimal increase in risk associated with a higher DTI.[7] Yet, under this new rule, a borrower with a 44% DTI cannot qualify for a GSE loan, notwithstanding any number of other positive factors in the loan file.

It is entirely possible that this new decision could harm consumers, contrary to the CFPB’s mandate to protect them. Barring “high” DTI borrowers from accessing GSE loans could, at best, force such borrowers to obtain more expensive and riskier products, and at worst, preclude such borrowers from qualifying for any product at all.[8] Over the last six years, more than 10% of GSE-backed loans have relied on the patch.[9] Eliminating the patch is also likely to have a disproportionately adverse effect on minorities and others living in underserved communities.[10]

The creditworthiness of a loan, we firmly believe, must be evaluated by considering the loan as a whole. Simply isolating one aspect of the loan file such as DTI does not necessarily provide a thorough understanding of the risk profile. Instead, one typically must consider many characteristics beyond DTI–such as credit score and history, LTV and CLTV, asset and cash reserves, type and length of employment, and many more–to assess whether a loan should qualify for credit.[11]

Simply put, a loan typically cannot be considered a “bad” loan simply because of one feature. Instead, as some lawyers and courts have colorfully put it, each loan is a “snowflake” that must be considered independently and holistically on its own merits.

[1] See, for example.

[2] The other criteria for a Qualifying Mortgage (QM) include: (1) a lack of negative amortization, interest-only, or balloon features; (2) fully-documented income verification; (3) a total of points and fees less than 3 percent of the loan amount; and (4) a fully amortized payment schedule no longer than 30 years, with a fixed rate for at least five years, and all principal, interest, taxes, insurance, and other assessments included. See “Qualified Mortgage Definition for HUD-Insured and Guaranteed Single-Family Mortgages,” 78 Fed. Reg., 75215 (December 11, 2013); “Loan Guaranty: Ability-to-Repay Standards and Qualified Mortgage Definition under the Truth in Lending Act,” 79 Fed. Reg., 26620 (May 9, 2014); “Single-Family Housing Guaranteed Loan Program,” 81 Fed. Reg., 26461 (May 3, 2016).

[3] This rigid model stands in stark contrast to the FHA, VA, and USDA, which have no maximum DTI requirement. See, at page 2.

[4] See, for example.

[5] Id. at page 1; see also, e.g., Richard Green, “The Trouble with DTI as an Underwriting Variable—and as an Overlay,” Richard’s Real Estate and Urban Economics Blog, December 7, 2016.

[6] See(see Table 2).

[7] See page 10 and footnote 33.

[8] Id. at page 7.

[9] Mortgage Rule (see Table 1).

[10] Mortgage GSE Patch.

[11] (see Table 2) (noting that credit scores and LTV ratios might predict default more accurately than DTI ratios).

© 2019 Bilzin Sumberg Baena Price & Axelrod LLP
This article was written by Kenneth Duvall and Philip R. Stein of Bilzin Sumberg.
For more CFPB regulation updates, see the National Law Review Financial Institutions & Banking Law page.

House Financial Services Committee Passes Credit Reporting Bills

Four bills dealing with credit reporting were passed last Thursday by the House Financial Services Committee.  While there has been bipartisan support for credit reporting reform, none of the bills received any Republican votes.

The bills, which are listed below, would make various amendments to the FCRA (Fair Credit Reporting Act), including those described below:

  • The “Improving Credit Reporting for All Consumers Act” would impose new requirements for conducting reinvestigations of consumer disputes and related standards, require consumer reporting agencies to create a webpage providing information about consumer dispute rights, require furnishers to retain records necessary to substantiate the accuracy and completeness of furnished information, create a right for consumers to appeal the results of a reinvestigation, prohibit automatic renewals of consumer reporting and credit scoring products and services, and require a credit scoring model to treat multiple inquiries for a credit report or credit score made in connection with certain consumer credit products within a 120-period as a single inquiry.
  • The “Restoring Unfairly Impaired Credit and Protecting Consumers Act” would shorten the time period during which adverse information can stay on a consumer report, require the expedited removal of fully paid or settled debts from consumer reports, impose restrictions on the reporting of information about medical debts, require a consumer reporting agency to remove adverse information relating to a private student loan where the CFPB has certified that the borrower has a valid “defraudment claim” with respect to the educational institution or career education program, allow victims of financial abuse to obtain a court order requiring the removal of adverse information, and prohibit a credit scoring model from taking into account in an adverse manner the consumer’s participation in certain credit restoration or rehabilitation programs or the absence of payment history for an existing account resulting from such participation.
  • The “Free Credit Scores for Consumers Act of 2019” would expand the information that must be given to consumers about credit scores, require nationwide consumer reporting agencies to provide a free credit score when providing a free annual consumer report requested by the consumer, and require free consumer reports and credit scores to be provided under certain circumstances.
  • The “Restricting Use of Credit Checks for Employment Decisions Act” would prohibit the use of consumer reports for most employment decisions other than where the person using the report is required by federal, state, or local law to obtain the report or the report is used in connection with a national security investigation.

The House Financial Services Committee is scheduled to mark up more bills dealing with credit reporting today.

 

Copyright © by Ballard Spahr LLP
For more financial legislation, please see the Financial Institutions & Banking page of the National Law Review.

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.

Wyoming Cements Position as Leading U.S. Jurisdiction for Blockchain with Sweeping New Legislation

In its most recent legislative sessions, Wyoming has undertaken substantial efforts to build on the momentum created by its 2018 enactment of legislation friendly to the blockchain and digital assets industries. In the months that followed that enactment, industry participants and legislators alike ascertained that further reforms and legislation were needed to cement Wyoming’s position as the leading jurisdiction in the sector. Through the public comment and legislative meeting protocols unique to Wyoming, eight blockchain-related bills made it to the floor of the legislature for a vote, all of which were passed and are now poised to become law.

Wyoming’s latest wave of blockchain legislation is, in sum, intended to facilitate the creation of blockchain ventures within the state and to further cement Wyoming’s status as the leading corporate jurisdiction in the United States for blockchain-related ventures.

HB 74- Special purpose depository institutions

In what is perhaps the most groundbreaking legislation among the bills passed, the Wyoming legislature recognized that blockchain businesses in general have difficulty opening and maintaining traditional banking relationships due to FDIC and OCC inclusion of blockchain ventures in the same buckets as firearms and cannabis. Wyoming now will permit corporate entities to charter “special purpose depository institutions,” which will perform all traditional bank functions except for lending. With the lending exclusion, these institutions will be under the primary supervision of the Wyoming Banking Commission and not the federal government. These banks will be required to maintain at least 100 percent of reserves against deposits as well as (a) $5 million of capital, (b) three years of operating expenses and (c) private insurance against theft, cybercrime and other wrongful acts.

SF 125- Digital assets (UCC & Custody)

Custody of digital assets has been a global challenge for investors and industry participants. Wyoming has addressed this concern by specifically authorizing banks (including special purpose ones under HB 74) to hold digital assets in custody under their charter trust powers and in accordance with Rule 206-4(2) of the Investment Advisers Act of 1940. In addition, Wyoming amended its provisions of the Uniform Commercial Code to facilitate the custody of these assets along with the means by which security interests may be perfected. Wyoming is now the only U.S. state with comprehensive UCC provisions to address digital assets, which makes it a favorable jurisdiction for those lending or securing funds through digital assets.

HB 57- Financial technology sandbox (includes reciprocity for overseas regulators)

Those entrepreneurs in the blockchain industry who may require special treatment or waivers of unclear regulation in Wyoming may now seek to avail themselves of a “regulatory sandbox” much akin to the one enacted in Arizona last year. Use of the “sandbox” will require applications to state agencies that may have interests in the requested waiver, including the Wyoming Banking Commission and the Wyoming Securities Commission. The “sandbox” will provide a two-year period of relief from legislation for those ventures, all of which must be domiciled and operating within Wyoming.

HB 62- Utility token amendments

Wyoming broke ground in 2018 with its widely reported utility token “exemption” for digital assets having a pure utility function and were not created for investment purposes or for trading on exchanges. Amendments to this legislation were made to further clarify the definition of “utility token” and define when parties may properly seek a token utility designation from Wyoming authorities.

HB 70- Commercial filing system

Wyoming has legislatively determined that records maintained by the Wyoming Secretary of State, including corporate formation records, are to be implemented on blockchain media. In combination with the Series LLC legislation enacted in Wyoming last year, this provision will provide the basis for the swift formation of corporate entities and other related corporate records through blockchain.

HB 185- Tokenized corporate stock

In recognition of the migration of the blockchain industry from “initial coin offerings” to “security tokens,” Wyoming enacted legislation authorizing and permitting the creation of digital assets that represent certificated shares of stock. A “certificate token” under this legislation has been defined as “a representation of shares” that is (a) entered into a blockchain or other secure, auditable database, (b) linked to or associated with the certificate token and (c) electronically transmittable to the issuing corporation, the person to whom the certificate token was issued and any transferee.

HB 113- Special electric utility agreements

Given that Wyoming utilities produce some of the cheapest and most abundant electricity in the United States, Wyoming has through HB 113 enabled those utilities to negotiate power rates with blockchain companies (including miners) and others without approval from Wyoming’s Public Utility Commission.

SF 28- Electronic bank records

This legislation enables banking institutions to issue securities and maintain corporate records on blockchain to an extent not permitted by other provisions of Wyoming law. In particular, this provision allows for the creation of non-voting shares of Wyoming banking institutions in tokenized form.

Summary

In short, Wyoming has further honed its regulatory ecosystem to become the most blockchain-friendly jurisdiction in the United States. While all legislation will be effective as of July 1, 2019, it should be noted that many blockchain industry participants are already undertaking significant efforts to take advantage of the opportunities this legislation presents. Blockchain companies in United States and abroad should carefully examine Wyoming’s new blockchain legislation with counsel to ascertain suitable business opportunities.

 

© 2019 Wilson Elser
This post was written by Robert V. Cornish Jr. of Wilson Elser.
Read more news about Blockchain on the National Law Review’s Finance Type of Law Page.