Tag: SEC

Investment Management Legal and Regulatory Update – October 2013

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SEC Issues Guidance Update for Investment Companies that Invest in Commodity Interests and Announces New Risk and Examinations Office

The staff of the Division of Investment Management has issued a Guidance Update that summarizes the views of the Division regarding disclosure and compliance matters relevant to funds that invest in commodity interests. The staff also announced the creation of a Risk and Examinations Office within the Division of Investment Management that will accompany the SEC’s Office of Compliance Inspections and Examinations (OCIE) on exam visits.

Disclosure of Derivatives and Associated Risks. Any principal investment strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it also anticipates will have a significant effect on its performance. In determining the appropriate disclosure, a fund should consider the degree of economic exposure the derivatives create, in addition to the amount invested in the derivatives strategy. This disclosure also should describe the purpose that the derivatives are intended to serve in the portfolio (e.g., hedging, speculation, or as a substitute for investing in conventional securities), and the extent to which derivatives are expected to be used. Additionally, the disclosure concerning the principal risks of the fund should similarly be tailored to the types of derivatives used by the fund, the extent of their use, and the purpose for using derivatives transactions.

Prior Performance Presentation. A newly registered fund that invests in commodity interests and that includes in its registration statement information concerning the performance of private accounts or other funds managed by the fund’s adviser is responsible for ensuring that such information is not materially misleading. Specifically, a fund that includes the performance of other funds or private accounts should generally include the performance of all other funds and private accounts that have investment objectives, policies, and strategies substantially similar to those of the fund.

Legend Requirement. Rule 481 under the Securities Act requires a fund to provide a legend on the outside front cover page that indicates that the SEC has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus and that any contrary representation is a criminal offense. The staff will not object if a fund that invests in commodity interests includes in the legend language that also indicates that the CFTC has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus.

Compliance and Risk Management. Day-to-day responsibility for managing a fund’s portfolio, including any commodity interests and their associated risks, rests with the fund’s investment adviser. In addition, the fund’s board generally oversees the adviser’s risk management activities as part of the board’s oversight of the adviser’s management of the fund. The staff expects that funds and their advisers would adopt policies and procedures that address, among other things, consistency of fund portfolio management with disclosed investment objectives and policies, strategies, and risks.

Each fund should have in place policies and procedures that are sufficient to address the accuracy of disclosures made about the fund’s use of derivatives, including commodity interests, and associated risks, as well as consistency of the fund’s investments in these derivatives with the fund’s investment objectives. For example, these policies and procedures should be reasonably designed to prevent material misstatements about a fund’s use of derivatives, including commodity interests, and the associated risks.

New Risk and Examinations Office. The update notes that a Risk and Examinations Office has recently been created within the Division of Investment Management to analyze and monitor the risk management activities of investment advisers, investment companies, the investment management industry and new products. The group will work closely with OCIE to make onsite visits to investment management firms.

Source: SEC Division of Investment Management Guidance, August 2013, 2013-05.

SEC Approves Registration Rules for Municipal Advisors

State and local governments that issue municipal bonds frequently rely on advisors to help them decide how and when to issue the securities and how to invest proceeds from the sales. Prior to passage of the Dodd-Frank Act in 2010, municipal advisors were not required to register with the SEC. This left many municipalities relying on advice from unregulated advisors. After the Dodd-Frank Act became law, the SEC established a temporary registration regime for municipal advisors that prohibited any municipal advisor from providing advice to, or soliciting, municipal entities or other covered persons without being registered. More than 1,100 municipal advisors have since registered with the SEC. The SEC recently adopted final rules that establish a permanent registration regime for municipal advisors.

Registered municipal advisors will also likely be subject to additional new regulation from the Municipal Securities Rulemaking Board (MSRB). In September 2011, the MSRB withdrew several rule proposals pertaining to municipal advisors pending adoption by the SEC of a permanent registration regime for municipal advisors. Among the proposals was a rule regulating political contributions by municipal advisors. The MSRB had previously indicated that it would resubmit the withdrawn rule proposals once a final definition of the term “municipal advisor” was adopted by the SEC.

Proposed Rule

In 2010, the SEC proposed a rule governing the permanent registration process. The proposal defined “municipal advisor” broadly and would have required municipal advisor registration of appointed board members of municipalities and people providing investment advice on all public funds. The SEC received more than 1,000 comment letters on the proposal, most of which raised concerns about the broad reach of the proposal.

Final Rule

The final rule requires a municipal advisor to register with the SEC if it:

  • provides advice on the issuance of municipal securities or about certain “investment strategies” or municipal derivatives; or
  • undertakes a solicitation of a municipal entity or obligated person.

The rule clarifies who is and is not a “municipal advisor” and offers guidance on when a person is providing “advice” for purposes of the municipal advisor definition. The rule exempts employees and appointed officials of municipal entities from registration and limits the type of “investment strategies” that will result in municipal advisor status. Additionally, instead of the proposed approach that would have required individuals associated with registered municipal advisory firms to register separately, the final rule requires firms to furnish information about these individuals.

Defined Terms

Advice. A person is providing “advice” to a municipal entity or an “obligated person” based on all of the relevant facts and circumstances, including whether the advice:

  • involves a recommendation to a municipal entity;
  • is particularized to the specific needs of a municipal entity; or
  • relates to municipal financial products or the issuance of municipal securities.

Advice, however, does not include providing certain general information.

An “obligated person” is an entity such as a non-profit university or non-profit hospital that borrows the proceeds from a municipal securities offering and is obligated by contract or other arrangement to repay all or some portion of the amount borrowed.

Investment Strategies. A person providing advice to a municipal entity or an “obligated person” with respect to “investment strategies” only has to register if such advice relates to:

  • the investment of proceeds of municipal securities;
  • the investment of municipal escrow funds; or
  • municipal derivatives.

Exemptions from the Municipal Advisor Definition

The following persons conducting the specified activities would not be required to register as a municipal advisor:

Registered Investment Advisers. Registered investment advisers and associated persons do not have to register if they provide investment advice in their capacities as registered investment advisers, such as providing advice regarding the investment of the proceeds of municipal securities or municipal escrow investments.

This exemption does not apply to advice on the structure, timing, and terms of issues of municipal securities or municipal derivatives. The SEC considers advice in these areas as outside the focus of investment adviser regulation.

Independent Registered Municipal Advisor. Persons who provide advice in circumstances in which a municipal entity has an independent registered municipal advisor with respect to the same aspects of a municipal financial product or issuance of municipal securities do not have to register, provided that certain requirements are met and certain disclosures are made.

Banks. Banks do not have to register to the extent they provide advice on certain identified banking products and services, such as investments held in deposit accounts, extensions of credit, funds held in a sweep account or investments made by a bank acting in the capacity of bond indenture trustee or similar capacity.

This exemption does not apply to banks that engage in other municipal advisory activities, such as providing advice on the issuance of municipal securities or municipal derivatives, in part because municipal derivatives were a source of significant losses by municipalities in the financial crisis.

Underwriters. Brokers, dealers and municipal securities dealers serving as underwriters do not have to register if their advisory activities involve the structure, timing and terms of a particular issue of municipal securities.

Registered Commodity Trading Advisor. Registered commodity trading advisors and their associated persons do not have to register if the advice they provide relates to swaps.

Swap Dealers. Registered swap dealers do not have to register as municipal advisors if they provide advice with respect to swaps in circumstances in which a municipal entity is represented by an independent advisor.

Public Officials and Employees. Public officials do not have to register to the extent that they are acting within the scope of their official capacity. This exemption addresses an unintended consequence of the proposed rule that generated significant public comment and created the impression that public officials and municipal employees would be covered if they provided “internal” advice.

This exemption covers persons serving as members of a governing body, an advisory board, a committee, or acting in a similar official capacity as an official of a municipal entity or an obligated person. For instance, it covers:

  • members of a city council, whether elected or appointed, who act in their official capacity; and
  • members of a board of trustees of a public or private non-profit university acting in their official capacity, where the university is an obligated person by virtue of borrowing proceeds of municipal bonds issued by a state governmental educational authority.

Similarly, this exemption covers employees of a municipal entity or an obligated person to the extent that they act within the scope of their employment.

Attorneys. Attorneys do not have to register if they are providing legal advice or traditional legal services with respect to the issuance of municipal securities or municipal financial products.

This exemption does not apply to advice that is primarily financial in nature or to an attorney representing himself or herself as a financial advisor or financial expert on municipal advisory activities.

Accountants. Accountants do not have to register if they are providing accounting services that include audit or other attest services, preparation of financial statements, or issuance of letters for underwriters.

Registration Forms

The final rule requires municipal advisory firms to file the following through EDGAR:

  • Form MA to register as a municipal advisor; and
  • Form MA-I for each individual associated with the firm who engages in municipal advisory activities.

The temporary registration regime will remain in place until December 31, 2014. The new rule requires municipal advisors to register on a staggered basis beginning July 1, 2014. The expiration date of the temporary rules will be extended in order to allow municipal advisors to continue to remain temporarily registered during the staggered compliance period.

Sources: SEC Approves Registration Rules for Municipal Advisors, SEC Press Release 2013-185 (September 18, 2013); Registration of Municipal Advisors, SEC Release No. 34-70462 (September 18, 2013).

SEC Eliminates the Prohibition on General Solicitation and General Advertising in Certain Private Offerings to Accredited Investors

As we reported in our July Client Alert, the SEC amended Regulation D to implement a Jumpstart Our Business Startups Act (JOBS Act) requirement to lift the ban on general solicitation and general advertising for certain private offerings.

JOBS Act

Congress passed the JOBS Act in 2012, which directed the SEC to remove the prohibition against general solicitation and general advertising for securities offerings relying on Rule 506, provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers are accredited investors.

While issuers will be able to widely solicit and advertise for potential investors, the JOBS Act required the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities.

Rule 506(c)

The addition of 506(c) to the existing Rule 506 permits issuers, including hedge funds and other private funds, to use general solicitation and general advertising to offer their securities provided that:

  • all purchasers of the securities are accredited investors (as defined in Rule 501);
  • the issuer takes reasonable steps to verify that the investors are accredited investors;
  • all other conditions of the Rule 506 exemption are met; and
  • Form D is completed and the box is checked indicating that Rule 506(c) is being relied upon.

Verification of Accredited Investor Status

Under the new rules, the issuer will need to take reasonable steps to verify that each investor is accredited. Whether the steps taken are “reasonable” will be a principles-based determination by the issuer, in the context of the particular facts and circumstances of each purchaser and transaction. The SEC noted that the issuer should consider the nature of the purchaser and the amount and type of information that the issuer has about the purchaser; 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.

In response to comments received with respect to the SEC’s original rule proposal, the amendment to Rule 506 also includes a non-exclusive list of methods that issuers may use to verify that purchasers are accredited investors. The methods described in the final rule include the following:

  • Verification of Income. Review IRS forms filed for last two years and obtain a written representation of expected income for the current year.
  • Verification of Net Worth. Review documentation related to assets (bank and brokerage statements, CDs and independent appraisal reports) and liabilities (credit reports).
  • Third Party Verification. Obtain a written confirmation that a person is an accredited investor from a broker-dealer, investment adviser, attorney or CPA.
  • Existing Accredited Security Holder. For any investor who invested in an issuer’s prior Rule 506 offering as an accredited investor and remains an investor, obtain a written certification (at the time of a Rule 506(c) sale) that he or she still qualifies as an accredited investor.

Preservation of Existing Rule

The existing provisions of Rule 506 as a separate exemption are not affected by the final rule. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner and aren’t subject to the new verification rule.

Form D

In connection with these changes, Form D has been amended to require issuers to indicate whether they are relying on 506(c), which permits general solicitation and advertising in a Rule 506 offering.

The rule amendments became effective September 23, 2013.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. IA-3624 (July 10, 2013).

SEC Adopts Rule to Disqualify “Bad Actors” from Rule 506 Offerings

The SEC recently approved amendments to Rule 506 to set forth the “bad actor” (commonly known as “bad boy”) provisions that could disqualify issuers from relying on the rule. The Dodd-Frank Act directed the SEC to adopt the amendments in order to prevent issuers from relying on the Rule 506 safe harbor if certain “bad actors” were involved in the offering.

As required by the Dodd-Frank Act, the SEC approved disqualifications under Rule 506 that are substantially similar to the disqualifications found in other securities regulations. Persons covered by the bad boy provisions include: issuers; directors, executive officers, other officers participating in the offering, general partners or managing members of issuers; beneficial owners of 20% or more of the issuer’s voting equity securities; investment managers to an issuer that is a pooled investment fund and directors, executive officers, other officers participating in the offering, general partners or managing members of the investment manager; promoters connected with the issuer; persons compensated for soliciting investors as well as the directors, officers, general partners or managing members of any compensated solicitor. The disqualifying events include:

  • securities-related criminal convictions;
  • securities-related court injunctions and restraining orders;
  • final orders of a state securities commission, state insurance commission, state or federal bank, savings association or credit union regulator or the CFTC barring an individual from association with regulated entities or from engaging in securities, insurance or banking business or finding a violation of any law pertaining to fraudulent, manipulative or deceptive conduct;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies 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 suspension or bar from associating with a member of, a securities self-regulatory organization; and
  • SEC stop orders pertaining to the filing of a registration statement or the suspension of an exemption.

Reasonable Care Exception. Under this exception, an issuer would not lose the benefit of the Rule 506 safe harbor if it can show that 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.

Disclosure of Pre-Existing Disqualifying Events. Disqualification applies only for disqualifying events that occur after September 23, 2013, the effective date of this rule. Matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Disqualification of Felons and Other Bad Actors from Rule 506 Offerings, SEC Release No. 33-9414 (July 10, 2013).

SEC Proposes Amendments to Private Offering Rules (Regulation D and Form D)

In partial response to the many comments that the SEC received with respect to its proposed JOBS Act amendments to Rule 506, the SEC recently proposed the following amendments to the private offering rules.

Advance Notice of Sale. Under the proposal, issuers that intend to engage in general solicitation as part of a Rule 506 offering would be required to file the Form D at least 15 calendar days before engaging in general solicitation for the offering. Also, within 30 days of completing an offering, issuers would be required to update the information contained in the Form D and indicate that the offering has ended.

Additional Information about the Issuer and the Offering. Under the proposal, issuers would be required to provide additional information such as:

  • types of general solicitation used;
  • methods used to verify accredited investor status;
  • publicly available website;
  • controlling persons;
  • industry group;
  • asset size;
  • breakdown of investor types (accredited/non-accredited and natural person/entity) and amounts invested; and
  • breakdown of use of proceeds.

Disqualification. Under the proposal, an issuer would be disqualified from using the Rule 506 exemption in any new offering if the issuer or its affiliates did not comply with the Form D filing requirements in a Rule 506 offering.

Legends and Disclosures. Under the proposal, issuers would be required to include certain legends or cautionary statements in any written general solicitation materials used in a Rule 506 offering. The legends would be intended to inform potential investors that the offering is limited to accredited investors and that certain potential risks may be associated with such offerings.

In addition, if the issuer is a private fund and includes information about past performance in its written general solicitation materials, it would be required to provide additional information in the materials to highlight the limitations on the usefulness of this type of information. The issuer also would need to highlight the difficulty of comparing this information with past performance information of other funds. The proposal also requests public comment on whether other manner and content restrictions should apply to written general solicitation materials used by private funds.

Submission of Written General Solicitation Materials to the SEC. Under the proposal, issuers would be required to submit written general solicitation materials to the SEC through an intake page on the SEC website. Materials submitted in this manner would not be available to the general public. As proposed, this requirement would be temporary, expiring after two years.

Guidance to Private Funds about Misleading Statements. In its current form, Rule 156 under the Securities Act provides guidance on when information in mutual fund sales literature could be fraudulent or misleading for purposes of the federal securities laws. Under the proposal, the rule would be amended to apply to the sales literature of private funds.

Comments on the proposal originally were due on September 23, 2013. However, “in light of the public interest,” the SEC re-opened the comment period until October 30, 2013.

Sources: SEC Approves JOBS Act Requirement to Lift General Solicitation Ban, Commission Also Adopts Rule to Disqualify Bad Actors from Certain Offerings and Proposes Rules to Enable SEC to Monitor New Market and Bolster Investor Protections, SEC Press Release 2013-124 (July 10, 2013); Amendments to Regulation D, Form D and Rule 156, SEC Release No. IC-30595 (July 10, 2013).

SEC Charges Investment Adviser for Misleading Fund Board About Algorithmic Trading Ability

The SEC charged an investment adviser and its former owner for misleading a mutual fund’s board of directors about the firm’s ability to conduct algorithmic currency trading so the board would approve the adviser’s contract to manage the fund.

The case arises out of an initiative by the SEC Enforcement Division’s Asset Management Unit to focus on the “15(c) process” – a reference to Section 15(c) of the Investment Company Act that requires a fund’s board to annually evaluate the fund’s advisory agreements. Advisers must provide the board with truthful information necessary to make that evaluation.

“It is critical that investment advisers provide truthful information to the directors of the registered funds they advise,” said Julie M. Riewe, Co-Chief of SEC Enforcement Division’s Asset Management Unit. “Both boards and advisers have fiduciary duties that must be fulfilled to ensure that a fund’s investors are not harmed.”

The SEC’s Enforcement Division alleged that Chariot Advisors LLC and Elliott L. Shifman misled the fund’s board about the nature, extent, and quality of services that the firm could provide. In two presentations before the board, Shifman misrepresented that his firm would implement the fund’s investment strategy by using a portion of the fund’s assets to engage in algorithmic currency trading. Chariot fund’s initial investment objective was to achieve absolute positive returns in all market cycles by investing approximately 80% of the fund’s assets under management in short-term fixed income securities, and using the remaining 20% to engage in algorithmic currency trading.

According to the SEC’s order instituting administrative proceedings, Chariot Advisors did not have an algorithm capable of conducting such currency trading. This was particularly significant because in the absence of an operating history the directors focused instead on Chariot Advisors’ reliance on models when the board evaluated the advisory contract. Even though Shifman believed that the fund’s currency trading needed to achieve a 25 to 30% return to succeed, Shifman allegedly did not disclose to the board that Chariot Advisors had no algorithm or model capable of achieving such a return.

The SEC alleges that for at least the first two months after the fund was launched, Chariot Advisors did not use an algorithm model to perform the fund’s currency trading as represented to the board, but instead hired an individual trader who was allowed to use discretion on trade selection and execution. According to the order, the trader used a technical analysis, rules-based approach for trading that combined market indicators with her own intuition.

The SEC further alleges that the misconduct by Shifman and Chariot Advisors caused misrepresentations and omissions in the Chariot fund’s registration statement and prospectus filed with the SEC and viewed by investors.

A hearing will be scheduled before an administrative law judge to determine whether the allegations contained in the order are true and whether any remedial sanctions are appropriate.

Sources: SEC Charges North Carolina-Based Investment Adviser for Misleading Fund Board About Algorithmic Trading Ability, SEC Press Release 2013-162 (August 21, 2013); In the Matter of Chariot Advisors, LLC and Elliott L. Shifman, Investment Company Act Release No. 30655 (August 21, 2013).

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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