Tag: SEC

Amendments to SEC Rules Regarding Broker Dealer Financial Responsibility and Reporting Requirements

Katten Muchin

The Securities and Exchange Commission adopted amendments to the financial responsibility requirements for broker dealers under the Securities Exchange Act of 1934 (Exchange Act) designed to safeguard customer securities and funds held by broker dealers. Such requirements include Exchange Act Rule 15c3-1 (Net Capital Rule), Rule 15c3-3 (Customer Protection Rule), Rules 17a-3 and 17a-4 (together, Books and Records Rules) and Rule 17a-11 (Notification Rule, and together with the Net Capital Rule, the Customer Protection Rule and the Books and Records Rules, the Financial Responsibility Rules).

The SEC amended the Customer Protection Rule to: (1) require “carrying broker dealers” that maintain customer securities and funds to maintain new segregated reserve accounts for account holders that are broker dealers; (2) place certain restrictions on cash bank deposits for purposes of the requirement to maintain a reserve to protect customer cash, by excluding cash deposits held at affiliated banks and limiting cash held at non-affiliated banks to an amount no greater than 15 percent of the bank’s equity capital, as reported by the bank in its most recent call report; and (3) establish customer disclosure, notice and affirmative consent requirements (for new accounts) for programs where customer cash in a securities account is “swept” to a money market or bank deposit product.

The SEC amended the Net Capital Rule to: (1) require a broker dealer when calculating net capital to include any liabilities that are assumed by a third party if the broker dealer cannot demonstrate that the third party has the resources to pay the liabilities; (2) require a broker dealer to treat as a liability any capital that is contributed under an agreement giving the investor the option to withdraw it; (3) require a broker dealer to treat as a liability any capital contribution that is withdrawn within a year of its contribution unless the broker dealer receives permission for the withdrawal in writing from its designated examining authority; (4) require a broker dealer to deduct from net capital (with regard to fidelity bonding requirements prescribed by a broker dealer’s self-regulatory organization (SRO)) the excess of any deductible amount over the amount permitted by the SRO’s rules; and (5) clarify that any broker dealer that becomes “insolvent” is required to cease conducting a securities business.

The SEC amended the Books and Records Rules to require large broker dealers (i.e., at least $1,000,000 in aggregate credits or $20,000,000 in capital) to document their market, credit and liquidity risk management controls. Under the amended Notification Rule there are new notification requirements for when a broker dealer’s repurchase and securities lending activities exceed 2,500 percent of tentative net capital (or, alternatively, a broker dealer may report monthly its stock loan and repurchase activity to its designated examining authority, in a form acceptable to such authority). In addition, the amended Notification Rule requires insolvent broker dealers to provide notice to regulatory authorities.

In a separate release, the SEC also amended Exchange Act Rule 17a-5 (Reporting Rule). Under the amended Reporting Rule, a broker dealer that has custody of the customers’ assets must file a “compliance report” with the SEC to verify that it is adhering to broker dealer capital requirements, protecting customer assets it holds and periodically sending account statements to customers. The broker dealer also must engage a Public Company Accounting Oversight Board (PCAOB)-registered independent public accountant to prepare a report based on an examination of certain statements in the broker dealer’s compliance report. A broker dealer that does not have custody of its customers’ assets must file an “exemption report” with the SEC citing its exemption from requirements applicable to carrying broker dealers. The broker dealer also must engage a PCAOB-registered independent public accountant to prepare a report based on a review of certain statements in the broker dealer’s exemption report. A broker dealer that is a member of the Securities Investor Protection Corporation (SIPC) also must file its annual reports with SIPC.

The rule amendments also require a broker dealer to file a new quarterly report, called Form Custody, that contains information about whether and how it maintains custody of its customers’ securities and cash. The SEC intends that examiners will use Form Custody as a starting point to focus their custody examinations. In addition, a broker dealer, regardless of whether it has custody of its clients’ assets, must agree to allow SEC or SRO staff to review the work papers of the independent public accountant if it is requested in writing for purposes of an examination of the broker dealer and must allow the accountant to discuss its findings with the examiners.

The effective date for the amendments to the Financial Responsibility Rules is 60 days after publication in the Federal Register. The effective date for the requirement to file Form Custody and the requirement to file annual reports with SIPC is Dec. 31, 2013. The effective date for the requirements relating to broker dealer annual reports is June 1, 2014.

Click here to read SEC Release No. 34-70072 (Financial Responsibility Rules for Broker Dealers).

Click here to read SEC Release No. 34-70073 (Broker Dealer Reports).

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What the SEC’s Elimination of the Prohibition on General Solicitation for Rule 506 Offerings Means to the EB-5 Community

Sheppard Mullin 2012

As we previously reported, on July 10, 2013, the SEC adopted the amendments required under the JOBS Act to Rule 506 that would permit issuers to use broad-based marketing methods such as the Internet, social media, email campaigns, television advertising and seminars open to the general public.  These types of methods are referred to in U.S. securities laws as “general solicitation,” and they have until now been prohibited in most offerings of securities that are not registered with the SEC. This is an important development to the EB-5 community because EB-5 offerings very often rely on Rule 506 as an exemption from offering registration requirements.

In addition, the SEC amended Rule 506 to disqualify felons and other “bad actors” from being able to rely on Rule 506.  This is also an important development for the EB-5 community, which has developed a heightened sensitivity to the potential for fraud in the wake of the Chicago Convention Center project.

Please note that these new rules are not yet effective.  See “When do the new rules become effective?” below.

Overview

Companies intending to raise capital through the sale of securities in or from the United States must either register the securities offering with the SEC or rely on an exemption from registration.   Failure to assure an available exemption for unregistered securities can result in civil and criminal penalties for the participants in the offering and rescission rights in favor of the investors.

For EB-5 programs, a widely used exemption from registration is Rule 506 of Regulation D, under which an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 non-accredited investors.  Historically, this exemption has prohibited general solicitation or advertising in connection with the offering, including publicly available web sites, social media, email campaigns, television advertising and seminars open to the general public.

The other commonly used exemption, Regulation S, has been less restrictive on general solicitation, but is not available for investors already present in the United States and does not preempt state securities law registration/exemption obligations, which often prohibit general solicitation.  Rule 506 does preempt such state laws (except as to notice filings and filing fees).  For many EB-5 programs and investors, there is no available exemption other than Rule 506 that does not also prohibit general solicitation.

In connection with the passage by Congress of the Jumpstart Our Business Startups (JOBS) Act in April 2012, Congress directed the SEC to remove the prohibition on general solicitation or general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors only and that the issuer takes reasonable steps to verify that all purchasers of the securities meet the requirements for accredited investors. The SEC initially proposed a rule to implement these changes in August 2012, but did not pass final rules on the changes to Rule 506 until now.

What changes were made to Rule 506?

The final rule adds a new Rule 506(c), which permits issuers (that is, the partnerships or other organizations actually issuing partnership interests and the like in exchange for EB-5 capital) to use general solicitation and general advertising  for the offer their securities, provided that:

  • All purchasers of the securities are accredited investors as defined under Rule 501; and
  • The issuer takes “reasonable steps” to verify that the purchasers are all accredited investors.

Who is an accredited investor?

Under Rule 501 of Regulation D, a natural person qualifies as an “accredited investor” if he or she is either:

  • An individual net worth (or joint net worth with a spouse) that exceeds $1 million at the time of the purchase, excluding the value of a primary residence; or
  • An individual annual income of at least $200,000 for each of the two most recent years (or a joint annual income with a spouse of at least $300,000 for those years), and a reasonable expectation of the same level of income in the current year.

What are reasonable steps to verify that an investor is accredited?

What steps are reasonable will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.  The SEC indicates that among the factors that issuers should consider under this facts and circumstances analysis are:

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
  • the amount and type of information that the issuer has about the purchaser; and
  • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for purchasers who are natural persons, including:

  • For the income test, reviewing copies of any IRS form that reports the income of the purchaser for the two most recent years and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
  • For the net worth test, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
    • With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
    • With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies;
  • As an alternative to either of the above, an issuer may receive a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that it has taken reasonable steps within the prior three months to verify the purchaser’s accredited status.

Simply relying on a representation from the purchaser, or merely checking a box on an accredited investor questionnaire, will not meet the requirement for objective verification. EB-5 Regional Centers should consider this carefully if they intend to make “accredited investor” determinations.

What actions must an issuer take to rely on the new exemption?

Issuers selling securities under Regulation D using general solicitation must file a Form D. The final rule amends the Form D to add a separate box for issuers to check if they are claiming the new Rule 506 exemption and engaging in general solicitation or general advertising. An issuer is currently required to file Form D within 15 days of the first sale of securities in an offering, but the SEC promulgated proposed rules to require an earlier filing.  See “Are there any other changes contemplated for Rule 506?” below.

Will the new rule affect other Rule 506 offerings that do not use general solicitation?

Not directly. The existing provisions of Rule 506 remain available as an exemption. This means that an issuer conducting a Rule 506 offering without using general solicitation or advertising is not required to perform the additional verification steps.

Who is excluded from using the Rule 506 exemption?

Under the new rule regarding “bad actors” required by the Dodd-Frank Act, an issuer cannot rely on a Rule 506 exemption (including the existing Rule 506 exemption) if the issuer or any other person covered by the rule has had a “disqualifying event.”  The persons covered by the rule are the issuer, including its predecessors and affiliated issuers, as well as:

  • Directors and certain officers, general partners, and managing members of the issuer;
  • 20% beneficial owners of the issuer;
  • Promoters;
  • Investment managers and principals of pooled investment funds; and
  • People compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.

What is a “disqualifying event?”

A “disqualifying event” includes:

  • Felony and misdemeanor criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions or restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
  • Final orders from certain regulatory authorities that:
    • bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or
    • are based on fraudulent, manipulative, or deceptive conduct and were issued within 10 years of the proposed sale of securities.
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
  • Suspension or expulsion from membership in or association with a self-regulatory organization (such as FINRA, the membership organization for broker-dealers).
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

What disqualifying events apply?

Only disqualifying events that occur after the effective date of the new rule will disqualify an issuer from relying on Rule 506. However, matters that existed before the effective date of the rule and would otherwise be disqualifying must be disclosed to investors.

Are there exceptions to the disqualification?

Yes. An exception from disqualification exists when the issuer can that show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.  The SEC can also grant a waiver of the disqualification upon a showing of good cause.

When do the new rules become effective?

Both rule amendments will become effective 60 days after publication in the Federal Register.  Publication normally occurs within two weeks after final rules are adopted.

Are there any other changes contemplated for Rule 506?

In connection with the foregoing final rules, the SEC separately published for comment a proposed rule change intended to enhance the SEC’s ability to assess developments in the private placement market based on the new rules regarding general solicitation. This proposal would require issuers to provide additional information to the SEC, including:

  • identification of the issuer’s website;
  • expanded information about the issuer;
  • information about the offered securities;
  • the types of investors in the offering;
  • the use of proceeds from the offering;
  • information on the types of general solicitation used; and
  • the methods used to verify the accredited investor status of investors.

Though this proposed rules is not specifically directed to EB-5 offerings, the SEC could use such information to enhance the monitoring it is already doing of EB-5 programs.

The proposed rule would also require issuers that intend to engage in general solicitation as part of a Rule 506 offering to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Then, within 30 days of completing the offering, the issuer would be required to update the information contained in the Form D and indicate that the offering had ended.

The proposed rule has a 60-day comment period.

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Does A Securities and Exchange Commission (SEC) Attorney Commit An Ethical Violation By Encouraging Whistleblowing Lawyers?

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The Harvard Law School Forum on Corporate Governance and Financial Regulation included a comprehensive post by Lawrence A. West which tackles the question of whether attorneys can be award seeking whistleblowers.  I want to approach the topic from the other direction.  May an SEC attorney actively solicit disclosure of client confidences from an member of the California State Bar?

California lawyers are governed by the State Bar Act (Cal. Bus. & Prof. Code §§ 6000 et seq.) and the California Rules of Professional Conduct adopted by the Board of Governors of the State Bar of California and approved by the Supreme Court of California pursuant to Sections 6076 and 6077 of the Business and Professions Code.  The federal District Courts located in California have adopted California’s statutes, rules and decisions governing attorney conduct.  Central District Local Rule 83-3.1.2, Eastern District Local Rule 180(e), Northern District Local Rule 11-4, and Southern District Local Rule 83.4(b).

Section 6068(e) provides that members of the California bar must “maintain inviolate the confidence, and at every peril to himself or herself to preserve the secrets, of his or her client”.   The only statutory exception permits, but does not require, an attorney to ”reveal confidential information relating to the representation of a client to the extent that the attorney reasonably believes the disclosure is necessary to prevent a criminal act that the attorney reasonably believes is likely to result in death of, or substantial bodily harm to, an individual”.

Rule 1-120 of the California Rules of Professional Conduct provides that a member “shall not knowingly assist in, solicit, or induce any violation of these rules or the State Bar Act,” including Section 6068(e).   Thus, an SEC attorney who is a member of the California State Bar (or subject to the local rules of the U.S. District Court) could be found to violate Rule 1-120 if she actively induces an attorney to violate of Section 6068(e).

Of course, the SEC has taken the position that its attorney conduct rules (aka “Part 205 Rules”) preempt conflicting state law.  However, there is a real question of whether the SEC acted in excess of its authority in purporting to immunize lawyers.  More importantly, it is questionable whether the SEC can preempt state law in this regard.  In 2004, I co-wrote a law review article for the Corporations Committee of the Business Law Section of the State Bar that considered these questions in detail, Conflicting Currents: The Obligation to Maintain Inviolate Client Confidences and the New SEC Attorney Conduct Rules, 32 Pepp. L. Rev. 89 (2004).  The other authors were James F. Fotenos, Steven K. Hazen, James R. Walther, and Nancy H. Wojtas.

If you think it is ok to violate your client’s confidences, you may want to reflect on the case of Dimitrious P. Biller.  In 2011, an arbitrator order Mr. Biller to pay his former employer $2.6 million in damages and $100,000 in punitive damages.   According to the arbitrator,Hon. Gary L. Taylor (Ret.), Mr. Biller “did the professionally unthinkable: he betrayed the confidences of his client.”  The arbitration award was confirmed by the trial court and upheld by the Ninth Circuit Court of Appeals, Biller v. Toyota Motor Corp., 668 F.3d 655 (9th Cir. 2012).  You may also want to consider what Justice Shinn had to say about an attorney who disclosed confidential client information after being ordered to do so by a trial court:

Defendant’s attorney should have chosen to go to jail and take his chances of release by a higher court

People v. Kor, 277 P.2d 94, 101 (Cal. Ct. App. 1954) (emphasis added).

Finally, you may want to put yourself in the position of a client.  How effectively represented would you feel if you knew that your lawyer could be rewarded for violating your confidences?  How would you feel about a government agency that believes it is permissible to encourage lawyers to do the “professionally unthinkable”?

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Securities and Exchange Commission (SEC) Issues Guidance on Resource Extraction Issuer Rules

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FAQs clarify which entities and payments are subject to the final rules.

On May 30, the Securities and Exchange Commission (SEC) released frequently asked questions (FAQs) providing guidance on certain aspects of its final rules for resource extraction issuers (the Resource Extraction Rules).[1] The Resource Extraction Rules, which were adopted on August 22, 2012 pursuant to section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), require companies that are engaged in the commercial development of oil, natural gas, or minerals and required to file annual reports with the SEC to disclose certain payments made to the U.S. federal government or foreign governments (and related entities) for the purpose of commercial development of oil, natural gas, or minerals.[2] The FAQs provide guidance, among other things, as to which issuers are subject to the reporting requirements, what the meaning of “minerals” is, which payments must be reported and how they should be reported, and the consequences of a failure to timely file a Form SD.

Questions Answered by the FAQs

Which entities are resource extraction issuers?

  • Holding companies may be resource extraction issuers. Question 1 clarifies that a holding company is a resource extraction issuer if a subsidiary or other controlled entity is engaged in the commercial development of oil, natural gas, or minerals.
  • Entities engaged in associated services only are not resource extraction issuers. Questions 2 and 4 clarify that an issuer providing services associated with the exploration, extraction, processing, and export of a resource is not a resource extraction issuer. Only issuers directly engaged in the commercial development of oil, natural gas, or minerals must disclose payments to governments. Issuers providing associated services not covered by the Resource Extraction Rules include the following:
    • Issuers providing hardware and logistics for exploration or extraction
    • Issuers providing hydraulic fracturing or drilling services for an operator
    • Issuers providing transport services, including between countries, so long as the issuer does not have an ownership interest in the transported resources

Question 4 further clarifies that transportation activities are generally not included within the definition of “commercial development” unless they are directly related to the export of a resource. Generally, however, the SEC staff would view the movement of a resource across an international border from one host country to another country by a company with an ownership interest in the resource as export.

  • The term “minerals” has been defined. Question 3 provides clarity as to the definition of “minerals” under the Resource Extraction Rules by stating that “minerals” are any materials commonly understood to be minerals. Materials extracted and gathered by means of mining activity—including any materials for which disclosure would be required under Industry Guide 7, “Description of Property by Issuers Engaged or to Be Engaged in Significant Mining Operations”[3]—are encompassed in the definition and include materials such as metalliferous minerals, coal, oil shale, tar, sands, and limestone.

Which payments are subject to the Resource Extraction Rules?

For payments to be subject to the Resource Extraction Rules, they must be made to further the commercial development of oil, natural gas, or minerals and take the forms of taxes, royalties, fees, production entitlements, bonuses, dividends, or payments for infrastructure improvements.

  • Certain payments are excluded. Questions 5, 6, and 8 clarify that certain payments are not subject to disclosure pursuant to the Resource Extraction Rules. These include the following:
    • Payments made to majority-owned government entities for services or activities that are ancillary or preparatory to the commercial development of oil, natural gas, or minerals, such as payments for providing transportation services to supply people or materials to a job site.
    • Penalties or fines related to resource extraction.
    • Corporate-level income tax payments to governments on income not generated by the commercial development of oil, natural gas, or minerals. (However, a resource extraction issuer is not required to segregate this income and may disclose that the information includes payments made for purposes other than the commercial development of oil, natural gas, or minerals.)
  • The format for payment disclosure has been clarified. Question 7 provides that a resource extraction issuer is to present payment information on an unaudited, cash basis for the year in which the payments are made.

What are the consequences of failing to timely file a Form SD?

Question 9 provides that, if a resource extraction issuer fails to timely file a Form SD, the issuer does not lose eligibility to use Form S-3.

[1]. View the FAQs here.

[2]. For more information on the Resource Extraction Rules and the implications for affected companies, see our September 19, 2012 LawFlash, “SEC Adopts Payment Disclosure Rules for Resource Extraction Issuers,” available here.

[3]. View SEC Industry Guide 7 here.

SEC Money Market Reform

Katten Muchin

On June 5, the Securities and Exchange Commission proposed major reforms to money market regulations that would significantly alter the way money market funds (MMFs) operate. The proposal sets forth two main alternative reforms, which may be adopted alone or in combination in a single reform package. The first proposed alternative would require all institutional prime MMFs to transition from operating with a stable share price to operating with a floating net asset value. The second generally would require every non-government MMF to impose a 2% redemption fee if its level of weekly liquid assets falls below 15% of its total assets, unless its board determines that the MMF’s best interest would be served by eliminating the fee or having a lower fee. The two proposed reforms are intended to, among other things, improve risk transparency in MMFs and reduce the impact of substantial redemptions upon MMFs during times of stress. The proposal also includes reforms designed to enhance MMFs’ disclosure, reporting, stress testing, and diversification practices.

For additional information, read more.

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District Court Grants Motion to Compel Against Securities & Exchange Commission (SEC), Holding that “Facts” Are Not Work Product In SEC Confidential Witness Interviews

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In a recent Securities & Exchange Commission (“SEC”) investigation, the SEC interviewed three persons who had proffer agreements with the SEC and United States Attorney. In a subsequent SEC enforcement action, a defendant served interrogatories asking the SEC to identify the factual information disclosed in those proffer sessions. The SEC objected, and the defendant moved to compel. The SEC opposed the motion to compel, arguing that defendant sought information protected by the attorney work product doctrine, had not shown substantial need and unavailability, and had not deposed any of the witnesses, despite their identification in Rule 26 disclosures more than a year before. The magistrate judge granted defendant’s motion to compel, and the United States District Court for the Northern District of California confirmed the ruling. SEC v. Sells, No. C 11-4941 CW, 2013 WL 1411247 (N.D. Cal. Apr. 8, 2013).

There had already been an order in the case directing the SEC to answer identical interrogatories about another third-party witness. The SEC had acknowledged it was relying upon that witness’s statements as a basis for the allegations against the same defendant. The court rejected the SEC’s attorney work product objection because the interrogatories sought factual information, and not an attorney’s strategies or mental impressions. The court relied on an earlier decision, In re Convergent Technologies, 122 F.R.D. 555, 558 (N.D. Cal. 1988), in which the court reiterated the well-established principle that “the law does not permit counsel or litigants to use the work product doctrine to hide the facts themselves.” Nor does it shield from discovery the identities of the persons from whom an attorney learned such facts or the existence or non-existence of documents.

An interesting side note about the three witnesses is that their interviews were not recorded, unlike the other fourteen witnesses in this case. Because of this, any inconsistencies, disclosures of motives for their proffers or other potential impeachment evidence were not “otherwise available” to defense counsel. The SEC also advised the court that the three witnesses might testify at trial.

The lesson of this case is not to underestimate the value to defendants in SEC enforcement proceedings of specific, simply stated interrogatories. The SEC was not ordered to turn over its attorneys’ notes. Instead, it was ordered to answer interrogatories. This case also reminds lawyers not to give up, even when your adversary is far more powerful. In the words of the magistrate judge who handled “every possible objection” that the SEC had asserted to avoid answering, “Sunshine is ordinarily the best medicine for a party that is keeping discoverable information hidden in the dark. But where, as here, one party is repeatedly withholding relevant information, stronger medicine may be required.”

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Securities and Exchange Commission’s (SEC) Rule 10b5-1 Trading Plans Under Scrutiny

The National Law Review recently published an article, Securities and Exchange Commission’s (SEC) Rule 10b5-1 Trading Plans Under Scrutiny, written by the Financial, Corporate Governance and M&A Litigation Group of Barnes & Thornburg LLP:

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For more than a decade, corporate officers and directors of publicly traded companies have relied on trading plans, known as Rule 10b5-1 trading plans, in order to trade stock in their companies without running afoul of laws prohibiting corporate “insiders” from trading on material information not known to the general public. Historically, effective 10b5-1 plans have provided corporate insiders with an affirmative defense to allegations of unlawful insider trading.

Such plans typically involve a prior agreement between a corporate executive or board member and his or her broker. Under such agreements, the insider would provide standing trading instructions to the broker, requiring the broker to trade at a set stock price or a set time, for example. The broker would then effect the trade at the required price or time, regardless of the information held by the insider.

Recently, notwithstanding the Securities and Exchange Commission’s (SEC) longtime knowledge of potential abuses, such 10b5-1 plans have been under fire. In a Nov. 27, 2012, article in the Wall Street Journal titled “Executives’ Good Luck in Trading Own Stock,” the authors aired several complaints about such plans, including that “[c]ompanies and executives don’t have to file these trading plans with any federal agency. That means the plans aren’t readily available for regulators, investors or anyone else to examine. Moreover, once executives file such trading plans, they remain free to cancel or change them—and don’t have to disclose that they have done so. Finally, even when executives have such a preset plan, they are free to trade their companies’ stock at other times, outside of it.” The article went on to chronicle several purported abuses by officers and directors of such plans.

The current regulatory environment has simultaneously raised suspicions about plans and trades that are innocent, and potentially provided shelter for others that may be less so. In fact, in a Feb. 5, 2013, article in the Wall Street Journal entitled “SEC Expands Probe on Executive Trades,” the author noted that “[t]he Securities and Exchange Commission, expanding a high-profile investigation, is gathering data on a broad number of trades by corporate executives in shares of their own companies, according to people familiar with the probe.”

It would appear, from news like this, that the SEC is concerned that corporate insiders are adopting or amending 10b5-1 plans when in possession of non-public information that might affect market participants’ decision to trade in the company’s stock. Such changes could nullify the use of a 10b5-1 plan as a defense.

Seemingly in reaction to the perceived manipulation of 10b5-1 plans, the Council of Institutional Investors (CII) submitted a letter to the SEC on Dec. 28, 2012, requesting that the SEC implement rulemaking to impose new requirements with respect to Rule 10b5-1 trading plans. The CII letter calls for company boards of directors to become explicitly responsible for monitoring 10b5-1 plans, which undoubtedly will subject boards to increased scrutiny by the SEC. In addition, the CII letter proposes stricter regulatory rules including:

  • Adoption of 10b5-1 plans may occur only during a company open trading window
  • Prohibition of an insider having multiple, overlapping 10b5-1 plans
  • Mandatory delay of at least three months between 10b5-1 plan adoption and the first trade under the plan
  • Prohibition on frequent modifications/cancellations of 10b5-1 plan

The CII also advocates pre-announced disclosure of 10b5-1 plans and immediate disclosure of plan amendments and plan transactions. Under the CII’s suggested new rules, a corporate board also would be required to adopt policies covering 10b5-1 plan practices, monitor plan transactions, and ensure that such corporate policies discuss plan use in a variety of contexts. A similar set of suggestions can be found in Wayne State University professor Peter J. Henning’s Dec. 10, 2012, article, “The Fine Line Between Legal, and Illegal, Insider Trading,” found online at:  http://dealbook.nytimes.com/2012/12/10/the-fine-line-between-legal-and-illegal-insider-trading/.

Given the uncertainty in the market concerning the current use of Rule 10b5-1 plans and the future of such plans, companies or individuals who may be subject to Rule 10b5-1 plans and/or future regulations in this area should consult with counsel before adopting or amending such plans.

© 2013 BARNES & THORNBURG LLP

Court Rules SEC Cannot Invoke Its Investigatory Powers to Circumvent Discovery Rules

The National Law Review recently published an article regarding the SEC’s Investigatory Powers written by Jennifer Tomsen of Greenberg Traurig, LLP:

GT Law

 

A Texas federal district court recently refused to reconsider its order imposing sanctions on the U.S. Securities and Exchange Commission (“SEC”) for conducting an “extra-judicial deposition” of a third party without providing notice to defendants in a pending civil action to which the third party’s testimony was relevant. Order on reconsideration, SEC v. Life Partners Holdings, Inc. et al., Case No. 1:12-CV-00033-JRN, in the United States District Court for the Western District of Texas, Austin Division (Sept. 27, 2012)[Doc. 56]; original order dated Aug. 17, 2012 [Doc. 47]. The court determined that the SEC obtained the testimony for use in the pending case and could not invoke its investigatory powers to do an end-run around the governing discovery rules.

The orders were entered in a case brought by the SEC against financial services firm Life Partners Holdings, Inc. and three of its executives, Brian Pardo, R. Scott Penden, and David M. Martin. The SEC alleged that defendants systematically underestimated life expectancy estimates the company used to price life settlement transactions so as to create a false appearance of a steady stream of earnings.

After the SEC complaint was filed but before the parties’ Rule 26(f) conference, the SEC deposed a non-party witness, the auditor for Life Partners. The SEC did not seek the court’s permission to depose a witness prior to the conference and did not give notice to defendants. Defendants sought to preclude the SEC from using any documents or testimony obtained by the witness for any purpose relating to the litigation. The SEC argued that the deposition was a valid exercise of its regulatory authority to investigate potential violations of federal securities laws and was not an attempt to obtain ex parte discovery.

Although the filing of a civil action “does not inhibit the SEC’s broad authority to investigate securities-law violations,” administrative agencies are bound by the Federal Rules of Civil Procedure (“FRCP”) when they are parties in a civil action. The rules require leave of court to take a deposition before the Rule 26(f) conference, and notice to all parties must be provided. The question for the court was whether the deposition was taken as part of a regulatory investigation unrelated to the civil action.

The SEC claimed it was investigating the auditor to ensure he had fulfilled his professional obligations, but District Judge James R. Nowlin found the deposition was not taken solely to investigate matters outside the complaint. The auditor was examined regarding Life Partners’ revenue recognition and other practices, “as well as Defendants Pardo, Peden, and Martin’s knowledge of the same — all of which form the very bases of Plaintiff’s Complaint in this case.” The court also rejected the SEC’s assertion that testimony relating to the civil suit “inadvertently came out.” The SEC relied on SEC v. O’Brien, 467 U.S. 735 (1984) for the proposition that the target of an SEC investigation is not entitled to notice of investigative subpoenas issued to third parties. The court held that O’Brien did not apply because the subpoena was issued after the Complaint was filed “and with the intention of obtaining evidence against the named Defendants.”

The court also rejected the claim that there was no prejudice because the SEC provided the deposition transcript to defendants, who were free to depose the auditor themselves. The court determined that the lack of notice deprived defendants of their ability to cross-examine the auditor and object to the testimony elicited.

The court asserted, “Plaintiff cannot administer an extra-judicial deposition regarding an investigation, elicit testimony during that deposition regarding allegations made in the Complaint for use against defendants, and then claim immunity from the FRCP by labeling the deposition as ‘investigative.’” The multiple violations of the FRCP warranted sanctions because the deposition without notice to opposing counsel “frustrated the fair examination” of the witness. In addition to awarding Defendants $5,000 in attorney’s fees, the court prohibited the SEC from using the deposition testimony in the civil case.

In a motion for reconsideration, the SEC claimed that the court had “introduced a new rule of law” that “upon the filing of a civil suit, the Commission may not use its investigatory powers to investigate any related violations.” The court rejected this interpretation of its order. It noted that the SEC Enforcement Manual itself cautioned staff about issuing investigative subpoenas after commencement of a civil action because “[a] court might conclude that the use of investigative subpoenas to conduct discovery is a misuse of the SEC’s investigative powers and circumvents the court’s authority and limits on discovery in the Federal Rules of Civil Procedure.”

While the deposition in this case appears to have been a fairly transparent effort to circumvent the FRCP to gain discovery for use in the civil case, the court’s order reinforces important limits on the SEC’s investigatory powers. The court sent a clear signal that it would not tolerate abuses of those powers to gain an advantage  over civil litigants. Defendants in an SEC proceeding should be alert for the possibility of such abuses. They will find strong support in this order should the SEC take non-party depositions without notice that could be relevant to the civil suit.

©2012 Greenberg Traurig, LLP

Continued Uncertainty Surrounding the Future of the SEC’s “Neither Admit Nor Deny” Settlement Practice

The Securities Litigation Group of Vedder Price recently had an article regarding the SEC published in The National Law Review:

Since US District Court Judge Jed S. Rakoff of the Southern District of New York rejected a $285 million settlement between the Securities and Exchange Commission (SEC) and Citigroup Global Markets Inc. (Citigroup) last fall, both the SEC and federal courts have grappled with the future of what had been the SEC’s long-standing practice of permitting companies to settle cases without admitting any liability. However, the Second Circuit’s recent decision to stay the proceedings before the Southern District of New York, pending the resolution of the SEC and Citigroup’s appeals of Judge Rakoff’s settlement rejection, suggests that the appellate court may eventually set aside Judge Rakoff’s rejection of the parties’ settlement.

In SEC v. Citigroup, Judge Rakoff held that the proposed consent judgment between the SEC and Citigroup was “neither fair, nor reasonable, nor adequate, nor in the public interest” because Citigroup had not admitted or denied the allegations set forth by the SEC1. Per Judge Rakoff, the proposed settlement did “not serve the public interest, because it ask[ed] the Court to employ its power and assert its authority when it does not know the facts.”2

In the immediate aftermath of Judge Rakoff’s ruling, Robert Khuzami, the Director of Enforcement at the SEC, issued a statement, noting that Judge Rakoff’s decision “ignore[d] decades of established practice throughout federal agencies and decisions of the federal courts.”3Further, Khuzami stated that “[r]efusing an otherwise advantageous settlement solely because of the absence of an admission also would divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court.”4

Notwithstanding Khuzami’s criticism of Judge Rakoff’s decision, in early January 2012, the SEC announced a policy change involving cases in which parallel criminal proceedings result in convictions or admissions of securities law violations. In such situations, per the new SEC policy, the “neither admit nor deny” language is no longer available, and the conviction or admission would be incorporated into the civil disposition. This policy change will likely have little impact on most defendants, since the bulk of cases brought by the SEC do not involve criminal proceedings.

In recent months, other US district courts have mimicked the reasoning employed by Judge Rakoff in rejecting no-admit, no-deny settlements. For example, in December 2011, US District Court Judge Rudolph T. Randa of the Eastern District of Wisconsin took issue with a proposed settlement between the SEC and Kass Corp. CEO, Michael Koss, and requested that the SEC provide additional information showing why the settlement was in the public interest.  In response, the SEC redrafted the proposed settlement agreement. More recently, US District Court Judge Richard A. Jones of the Western District of Washington rejected a proposed no-admit, no-deny settlement between the SEC and three individual defendants. Judge Jones criticized the SEC for seeking judgments against the defendants while reserving the right to request disgorgement remedies and civil penalties in the future.5

On March 15, 2012, in a per curiam opinion, a three-judge panel of the Second Circuit granted the motions of the SEC and Citigroup to stay district court proceedings, pending the resolution of their interlocutory appeals that seek to set aside Judge Rakoff’s decision rejecting the parties’ proposed settlement.6Although the panel did not hold that Judge Rakoff’s settlement rejection was improper, the Second Circuit concluded that the SEC and Citigroup had shown a likelihood of success on the merits of their appeals, which justified staying the lower court proceedings. Notably, the panel wrote that Judge Rakoff was likely incorrect in rejecting the proposed settlement on public policy grounds, stating that it is not “the proper function of federal courts to dictate policy to executive administrative agencies.”7

While the lower court proceedings remain stayed, on March 31, 2012, the Second Circuit scheduled oral arguments on the pending appeals for late September 2012.  Until then, the future of the SEC’s long-standing “neither admit nor deny” settlement practice will continue to remain unsettled.

1 SEC v. Citigroup Global Markets, Inc.,__ F. Supp. 2d __, 2011 WL 5903733, at *6 (S.D.N.Y. Nov. 28, 2011).

2 Id.

3 Robert Khuzami, Public Statement by SEC Staff: Court’s Refusal to Approve Settlement in Citigroup Case (Nov. 28, 2011), available at:http://www.sec.gov/news/speech/2011/spch112811rk.htm.

4 Id.

5 SEC v. Merendon Mining (Nevada), Inc. et al., No. 10 CV 00955 (Mar. 5, 2012).

6 SEC v. Citigroup Global Markets, Inc., __ F. 3d __, 2012 WL 851807 (2d Cir. Mar. 15, 2012).

7 Id. at

© 2012 Vedder Price

SEC Speaks 2012

The Securities Litigation Group of Vedder Price recently had an article, SEC Speaks 2012, published in The National Law Review:

The US Securities and Exchange Commission (SEC or the Commission) held its annual SEC Speaks conference in Washington, DC from February 24–25, 2012. This past year was devoted to modernization initiatives and calls for renewed efforts to increase the unprecedented 735 enforcement actions filed in the fiscal year that ended September 30, 2011.

Chairman Mary L. Schapiro began the conference by noting the strides the SEC has made in improved modernization initiatives, including better hiring and training and more sophisticated technology, research capabilities and operational management. Schapiro specifically emphasized broadened hiring efforts to bring nonlawyer industry experts on staff, including traders and academics, as well as doubling the staff’s training budget and enhancement of the new agencywide electronic discovery program. Schapiro also lauded the staff’s increased ability to recognize threats and move rapidly to address them.

Robert Khuzami, director of the SEC’s Division of Enforcement, echoed chairman Schapiro’s remarks and emphasized the ongoing efforts to bring cases arising from the financial crisis, in addition to the nearly 100 actions brought to date against individuals and/or entities—more than half of which include CFOs, CEOs or other senior officers. Jason Anthony in the Structured and New Products Unit also addressed the SEC’s “very large focus” on financial crisis cases, reporting that the SEC has brought 95 actions against entities and individuals arising out of the financial crisis and has obtained almost $2 billion in monetary relief.

Matthew Martens, chief litigation counsel, discussed the SEC’s litigation record and settlement practices, in light of the uproar stemming from Judge Rakoff’s refusal last year to approve the SEC’s settlement with Citigroup. According to Martens, it is the SEC’s policy to accept settlements with recoveries that the SEC could reasonably expect to receive at trial, and he argued that it would be a mistake to reject settlements simply because they lack admissions of liability. Martens also noted that the use of detailed public complaints ensures that the public is adequately put on notice regarding any wrongful conduct that allegedly has occurred, and he stressed that out of approximately 2,000 cases settled in the past three years, judges have challenged settlements in fewer than ten instances.

Kara Brockmeyer, chief of the SEC’s specialized FCPA Unit, announced the December 2011 launch of the “FCPA Spotlight” page on the Commission’s website, which includes links to every FCPA action ever brought by the SEC and also provides FCPA case statistics going back five years. Brockmeyer noted that the SEC brought 20 FCPA actions in 2011 (19 companies, one individual) and collected $255 million in sanctions. Brockmeyer promised that “more will be coming,” including cases targeting the pharmaceutical industry. Indeed, in 2012, the SEC has already charged 14 individuals and five companies with FCPA violations. She also touched on various international developments in anticorruption enforcement, including recent antibribery laws passed in Russia and China, and noted that Switzerland recently brought its first foreign corruption case. Brockmeyer indicated that the SEC is seeing more and improved cooperation in connection with foreign corruption cases between regulators and across borders.

David Bergers, the SEC’s regional director in Boston, discussed Enforcement’s enhanced ability to pursue potential wrongful conduct based upon the delegation of formal order authority to senior officers in the Division, which permits the SEC to escalate an investigation more quickly and to compel testimony and document production. Bergers also noted that, under the streamlined Wells notice process, the SEC will allow only one post-Wells meeting so that settlement negotiations do not delay recommending an action to the Commission, which is consistent with Dodd-Frank’s requirement that an action be filed within 180 days of a Wells notice, with any extension requiring the Commission’s approval. Bergers stressed that the Enforcement staff is taking this deadline “very seriously.”

Commissioner Daniel Gallagher focused his comments on “failure to supervise” liability for a broker-dealer’s legal and compliance personnel. Although legal and compliance officers are not automatically considered “supervisors,” they can fall under this category when the facts and circumstances of a particular case reveal that they held the requisite degree of responsibility, ability or authority to affect the conduct of other employees such that they have become a part of the management team’s collective response to a problem. Gallagher acknowledged that “robust engagement on the part of legal and compliance personnel raises the specter that such personnel could be deemed to be ‘supervisors’ subject to liability for violations of law by the employees they are held to be supervising,” which then leads to “the perverse effect of increasing the risk of supervisory liability in direct proportion to the intensity of their engagement in legal and compliance activities.” Gallagher did conclude that the issue “remains disturbingly murky” and called upon the Commission to provide a framework that encourages such personnel to provide the necessary guidance without fear of being deemed “supervisors.”

Sean McKessy, chief of the SEC’s Office of the Whistleblower, reported that the new Whistleblower Program stemming from Dodd-Frank has resulted in hundreds of high-quality tips. McKessy stressed that his office has engaged in significant internal outreach to educate staff across the divisions to ensure they understand the type of information that should be captured from whistleblowers as well as how to process award payments, which Dodd-Frank directs the SEC to pay in amounts between 10 and 30 percent of monetary sanctions to individuals who voluntarily provide original information that leads to successful enforcement actions resulting in sanctions over $1 million. According to McKessy, the current priority is to improve and maintain communication with whistleblowers and their counsel, and he noted that the office has successfully returned more than 2,000 calls within 24 business hours of receiving the tip on the hotline.

In response to criticism that Dodd-Frank’s Whistleblower Program will stifle internal reporting, McKessy defended the approach as “balanced” because it includes “built-in incentives” that enable whistleblowers to report internally first yet still remain eligible for the award. McKessy also volunteered that his experience has been that a significant majority of the tips received were—according to the whistleblowers themselves—reported first internally within their respective companies, and said that he was “hard pressed” to think of an example in which the whistleblower did not first report internally.

Merri Jo Gillette, regional director in Chicago, commented on the expansion of aiding and abetting liability under Dodd-Frank, noting that the SEC now has more flexibility to assert aiding and abetting claims under the Securities Act and the Investment Advisers Act, as well as to seek civil monetary penalties. Prior to Dodd-Frank, the SEC was required to show that an aider and abettor knowingly provided substantial assistance, but now the SEC may prove the charge under a “knowing or reckless state of mind” standard. Gillette remarked that the SEC will continue to look at the application of aiding and abetting liability to so-called corporate gatekeepers, such as accountants and lawyers.

In terms of changes to civil penalties under Dodd-Frank, Gillette explained that the most significant development is the SEC’s authority to seek penalties in administrative proceedings as well as expanded authority to penalize secondary actors, as the SEC may now explicitly seek penalties against persons who commit direct violations and who were “causes” of direct violations.

Speakers at the conference continued to emphasize the importance of auditor independence. Because the SEC’s auditor independence standards are broader than those of the American Institute of CPAs (AICPA), the Accounting Enforcement panel cautioned that companies considering an initial public offering should carefully review the scope of their auditor’s services for compliance with the SEC’s more stringent requirements. Fraud enforcement in the context of financial reporting also continues to be a high priority for the SEC. The SEC warned that additional areas of focus will be cross-border transactions, disclosures, revenue recognition, loan losses, valuation, impairment, expense recognition and related-party transactions.

The revamped SEC now appears ready to expand upon its enforcement efforts in 2012, which is reflected within President Obama’s proposed budget for 2013, reflecting an 18.5 percent increase over the SEC’s 2012 appropriation, and which would permit the agency to increase its staff by 15 percent. This budget increase would support the Commission’s touted technology initiatives and continued expansion of the agency’s system to identify suspicious patterns and behaviors quickly and more effectively. The SEC appears engaged to exceed last year’s record number of enforcement actions, especially via the capabilities afforded by Dodd-Frank.

© 2012 Vedder Price