Tag: Securities and Exchange Commission

North American Securities Administrators Association Proposes Model State Whistleblower Rewards Legislation

The North American Securities Administrators Association (NASAA) announced it released for public comment a proposed model law to help states incentivize individuals to come forward to report suspected wrongful violations of state securities laws and to protect whistleblowers.  According to NASAA President and Chief of the New Jersey Bureau of Securities Christopher W. Gerold, “The intent of this model legislation is to incentivize individuals who have knowledge of potential securities law violations to report it to state regulators in the interest of investor protection . . . [i]nformation from those with knowledge of securities law violations is a valuable enforcement tool to help regulators detect financial fraud and wrongdoing.”

The SEC whistleblower program that Congress created about 10 years ago in the Dodd-Frank Act has proven effective in combatting securities fraud and protecting investors.  Since the inception of the program, the SEC has paid more than $450 million in awards to whistleblowers.  SEC enforcement actions associated with those awards have resulted in sanctions totaling more than $2 billion.  Whistleblower awards can range from 10 percent to 30 percent of the monetary sanctions collected when the sanctions exceed $1 million.

Proposed Model State Securities Whistleblower Rewards Legislation

The proposed state whistleblower rewards legislation is modeled on the Dodd-Frank Act’s SEC whistleblower rewards provisions. Some of the key features include:

  • A whistleblower could obtain 10 to 30% of the monetary sanctions collected in any related administrative or judicial action stemming from original information that the whistleblower voluntarily provides to a state securities regulator.
  • Factors that would determine the award percentage include:
    • the significance of the original information provided by the whistleblower to the success of the administrative or judicial action;
    • the degree of assistance provided by the whistleblower in connection with the administrative or judicial action; and
    • the programmatic interest of the [Securities Administrator] in deterring violations of the securities laws by making awards to whistleblowers who provide original information that leads to the successful enforcement of such laws.
  • Information that could reasonably be expected to reveal the identity of a whistleblower would be exempt from public disclosure.
  • There are approximately 11 categories of whistleblowers that would be ineligible to receive an award, including (1) a whistleblower convicted of a felony in connection with the administrative or judicial action for which the whistleblower otherwise could receive an award; (2) a whistleblower who acquires the original information through the performance of an audit of financial statements required under the securities laws; (3) a whistleblower who knowingly or recklessly makes a false, fictitious, or fraudulent statement or misrepresentation as part of, or in connection with, the original information provided or the administrative or judicial proceeding for which the original information was provided; and (4) a whistleblower who has a legal duty to report the original information.

The model legislation also includes a whistleblower protection provision that would prohibit an employer from terminating, discharging, demoting, suspending, threatening, harassing, directly or indirectly, or in any other manner retaliating against, a whistleblower because of any lawful act done by the whistleblower:

  • in providing information to the [Securities Division] in accordance with this Act;
  • in initiating, testifying in, or assisting in any investigation or administrative or judicial action based upon or related to such information; or
  • in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201 et seq.); the Securities Act of 1933 (15 U.S.C. 77a et seq.); the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.); 18 U.S.C. 1513(e); any other law, rule, or regulation subject to the jurisdiction of the Securities and Exchange Commission; or [the Securities Act of this State] or a rule adopted thereunder.

Remedies for a whistleblower prevailing in a retaliation claim include:

  • reinstatement with the same compensation, fringe benefits, and seniority status that the individual would have had, but for the retaliation;
  • two (2) times the amount of back pay otherwise owed to the individual, with interest;
  • compensation for litigation costs, expert witness fees, and reasonable attorneys’ fees;
  • actual damages; or
  • any combination of these remedies.

Role of State Securities Regulators

Although the SEC is the primary securities market regulator and enforces federal securities laws, state securities regulators enforce “blue sky” laws designed to protect investors against fraudulent sales practices and activities that fall outside of the SEC’s jurisdiction, e.g., offerings that are not required to be registered with the SEC.  Most of the state securities laws are based on the Uniform Securities Act, which is intended to prevent the fraudulent sale of securities to investors.

Securities law enforcement at the state level plays a vital role in protecting investors.  According to the NASAA’s 2018 Enforcement Report, in 2017 state securities regulators received 7,988 complaints, took 2,105 enforcement actions, and ordered $486 million returned to investors. Incentivizing whistleblowers to report securities fraud could significantly enhance the ability of state securities regulators to protect investors.

The proposed model act is open for public comment through June 30, 2020.

© 2020 Zuckerman Law

For more on securities laws, see the National Law Review Securities & SEC law section.

Securities Class Action Filings Reach Record Levels in 2019

Securities fraud class action filings accelerated in 2019, according to a report released today by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse. The report, Securities Class Action Filings—2019 Year in Review, finds that filing activity remains elevated well above historical levels by several key measures.

For the third year in a row, plaintiffs filed more than 400 securities class actions. In 2019, there were 428 securities class actions across federal and state courts—the highest number on record—with 268 core filings and 160 M&A filings. This marks a historic high for core filings, surpassing even 2008 when class actions peaked in response to financial market volatility. Market capitalization losses in 2019 eclipsed $1 trillion for the second consecutive year.

The combined number of filings with 1933 Act claims in federal and state courts reached unprecedented levels.

The likelihood of core filings targeting companies listed on U.S. exchanges was also at its highest in 2019. This measure reached new levels due to the record number of filings, as well as an extended decline in the number of public companies over the last 15 years.

The impact of the U.S. Supreme Court’s 2018 decision in Cyan Inc. v. Beaver County Employees Retirement Fund continues to reverberate. The report, which includes expanded data on state court filings from 2010 to 2019, found that Securities Act of 1933 claims in state courts rose to 49 in 2019, a 40% increase from the previous year. Almost half of these had parallel actions in federal court.

“The increase in state court Section 11 filings under the 1933 Act has caused a sharp jump in the cost of D&O insurance for companies going public,” said Joseph A. Grundfest, director of the Stanford Law School Securities Class Action Clearinghouse. “Many IPO issuers have adopted rules that would move this litigation back to federal courts where these claims have traditionally been resolved. The enforceability of these provisions, however, has been challenged, and the IPO market is awaiting a decision by the Delaware Supreme Court that will likely define the contours of federal securities fraud litigation for years to come. That decision will likely be handed down before the end of April.”

Key Trends

  • Both Disclosure Dollar Loss (DDL) and Maximum Dollar Loss (MDL) decreased in 2019. DDL fell by 14% to $285 billion, and MDL by 9% to $1,199 billion as the size of the typical filing decreased.
  • Combined core federal filings in the Technology and Communication sectors grew by almost a third from 2018 and have more than doubled since 2017.
  • Second Circuit core federal filings increased to 103, the highest number on record. The Ninth Circuit’s core federal filings decreased by 25% to 52 filings.
  • Core federal filings against companies headquartered outside the United States increased to 57, the highest total on record. The likelihood of a core federal filing against a non-U.S. company increased from 4.8% to 5.6% from 2018 to 2019.
  • Beginning in the latter part of 2018, companies with connections to the cannabis industry were increasingly the target of federal class action filings. There were six such filings in 2018 and 13 in 2019.

Cyan Inc. v. Beaver County Employees Retirement Fund

In March 2018, the U.S. Supreme Court issued a unanimous opinion allowing plaintiffs to assert claims under the Securities Act of 1933 (1933 Act) in state courts. Under the 1933 Act, Section 11 allows investors to pursue damages for alleged misrepresentations or omissions in securities registration statements. It is generally believed that the ruling will lead to more securities class action filings in state courts based on this claim.

Read an excerpt of the report on 1933 Act Filings.

Read the report, Securities Class Action Filings—2019 Year in Review.

Figure 4 Securities Class Action Cornerstone Research

Copyright ©2020 Cornerstone Research

For more SEC litigation & regulation, see the National Law Review Securities & SEC section.

SEC Proposes Changes to Market Data Plans

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

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

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

©2020 Katten Muchin Rosenman LLP

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

SEC Proposes Significant Amendments to Investment Adviser Advertising Rule

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

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

I.  Overview of the Amendments

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

II.  Broadened Definition of “Advertisement”

A.  Overview

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

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

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

B.  Key Terms

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

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

III.  Advertising Standards

A.  General Prohibitions

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

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

B.  Specific Investment Advice

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

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

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

C.  Testimonials, Endorsements, and Third-Party Ratings

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

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

D.  Performance Advertising

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

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

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

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

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

E.  Portability

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

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

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

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

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

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

IV.  Administrative Provisions

A.  Internal Review and Approval of Advertisements

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

B.  Amendments to Form ADV

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

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

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

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

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

C.  Amendments to the Books and Records Rule

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

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

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

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

V.  Summary and Policy Considerations

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

18 See Release, pp. 64-65.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

41 See Release, pp. 103-05.

42 See Release, p. 105

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

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

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

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

© Copyright 2019 Cadwalader, Wickersham & Taft LLP

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

SEC Is Sued Again For Doing Nothing

Have you heard about a lawsuit filed earlier last week against the Securities and Exchange Commission due to its failure to respond to a petition asking the Commission to adopt political spending disclosure requirements?

SEC-logoGOLD

But must the Commission act on the petitions that are submitted to it?  Rule 192 of the Commission’s Rules of Practice requires only that the Commission acknowledge receipt and give notice of any action taken by the Commission:

The Secretary shall acknowledge, in writing, receipt of the petition and refer it to the appropriate division or office for consideration and recommendation.  Such recommendations shall be transmitted with the petition to the Commission for such action as the Commission deems appropriate.  The Secretary shall notify the petitioner of the action taken by the Commission.

At least three fundamental requirements are absent from Rule 192.  First, the rule doesn’t require the Commission to take action.  Second, the rule doesn’t require the Commission to act promptly. Finally, the rule doesn’t require the Commission to explain its reasons for denying a petition. Indeed, Rule 192 falls far short of the requirements of the Administrative Procedure Act as explained by then Circuit Court Judge Ruth Bader Ginsberg:

Section 4(e) of the Administrative Procedure Act, 5 U.S.C. § 553(e), commands that “[e]ach agency shall give an interested person the right to petition for the issuance … of a rule.”  Section 6(a), 5 U.S.C. § 555(e), requires “prompt notice” in the event an agency denies such a petition.  Further, section 6(a) directs that when a denial is not self-explanatory, “the notice shall be accompanied by a brief statement of the grounds for denial.”

Ass’n of Investment Bankers v. Securities and Exchange Commission, 676 F.2d 857, 864 (1982).

One obvious issue for the plaintiff in this most recent lawsuit is whether judicial review is even available.  The plaintiff doesn’t allege that the Commission has actually denied his petition.  To the contrary, the plaintiff admits that “To date, the SEC has given no indication it is still considering whether to recommend the issuance of such a proposed rule, nor has it otherwise responded to the pending rulemaking petitions”.  The complaint cites WWHT, Inc. v. Federal Communications Com., 656 F.2d 807 (D.C. Cir. 1981) but that case involved an actual order denying a petition for rulemaking.

Even if the court decides that a failure to respond is tantamount to a denial, plaintiff will still have an uphill climb.  As Judge Edwards observed in WWHT, Inc. review is “very limited”.  The court will also have to grapple with the conundrum of how to conduct a review when there is no record.

ARTICLE BY Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP
© 2010-2015 Allen Matkins Leck Gamble Mallory & Natsis LLP

SEC (Securities and Exchange Commission) Gives Insider Trader a $30,000 Slap On The Wrist

DrinkerBiddle

On April 23, 2014, the SEC agreed to settle insider trading charges against Chris Choi, a former accounting manager at Nvidia Corporation who allegedly set into motion a trading scheme that reaped nearly $16.5 million in illicit profits and avoided losses. Given the amount of the purported loss, the fact that Choi was the original “tipper,” and the fact that nearly every other member of the scheme has been indicted, the Choi settlement seems like nothing more than a slap on the wrist: a $30,000 penalty without admitting to the insider trading allegations. The Choi settlement also represents a notable departure from the SEC’s recent insider trading fines and penalties against “tippers.”

According to the SEC’s complaint, on at least three occasions during 2009 and 2010, Choi tipped material nonpublic information about Nvidia’s quarterly earnings to his friend Hyung Lim. SEC v. Choi, No. 14-cv-2879 (S.D.N.Y. Apr. 23, 2014). Lim passed the information along to Danny Kuo, a hedge fund manager at Whittier Trust Company, who passed the information to his boss and to a group of managers at three other hedge funds.

Kuo and the other tippee-hedge fund managers used Choi’s information to trade in advance of Nvidia earnings announcements and reaped trading gains and/or avoided losses of approximately $16.5 million.

The SEC alleged that Choi was liable for this trading because he “indirectly caused trades in Nvidia securities that were executed” by the hedge funds and “did so with the expectation of receiving a benefit and/or to confer a financial benefit on Lim.” The SEC charged him with violations of Section 10(b) of the Exchange Act (and Rule 10b-5) and Section 17(a) of the Securities Act.

Choi, without admitting or denying the SEC’s allegations, agreed to settle the matter and to the entry of an order: (1) permanently enjoining him from violations of Section 10(b), Rule 10b-5, and Section 17(a); (2) barring him from serving as an officer or director of certain issuers of securities for five years; and (3) ordering him to pay a $30,000 penalty.

Not only is Choi’s settlement a significant departure from the resolutions obtained by his “downstream” tippees, a number of whom were convicted on criminal charges of insider trading, it is a departure from recent SEC “tipper” settlements. For example:

  • A former executive at a Silicon Valley technology company, who allegedly tipped convicted hedge fund manager Raj Rajaratnam with nonpublic information that allowed the Galleon hedge fund to make nearly $1 million profit, agreed to pay more than $1.75m to settle the SEC’s insider trading charges. See SEC Charges Silicon Valley Executive for Role in Galleon Insider Trading Scheme.
  • A physician who served as the chairman of the safety monitoring committee overseeing a clinical trial for an Alzheimer’s drug being jointly developed by two pharmaceutical companies, who allegedly tipped a hedge fund manager with safety data and eventually data about negative results in the trial approximately two weeks before they became public, which allowed the hedge fund to make nearly $276 million in gains, agreed to pay more than $234,000 in disgorgement and prejudgment interest to settle the SEC’s insider trading charges. The physician’s penalty may have been mitigated by the fact that he cooperated with and received a non-prosecution agreement from the U.S. Attorney’s Office in a parallel criminal action. See SEC Charges Hedge Fund Firm CR Intrinsic and Two Others in $276 Million Insider Trading Scheme Involving Alzheimer’s Drug.
  • A former executive director of business development at a pharmaceutical company located in New Jersey, who allegedly tipped a hedge fund manager (a friend and former business school classmate) with material nonpublic information regarding the company’s anticipated acquisition that allowed the manager to make nearly $14 million in gains, escaped criminal prosecution and agreed to pay a $50,000 penalty to settle the SEC’s insider trading charges. See SEC Charges Pharmaceutical Company Insider and Former Hedge Fund Manager for Insider Trading, Resulting in Approximately $14 Million in Profits.

There are a few reasons the SEC may have settled with Choi for such a small civil penalty. First, the SEC recently settled with Lim, the second chain in the insider trading scheme. Lim tentatively agreed to disgorgement or to pay a penalty once he has completed his cooperation with the U.S. Attorney’s Office for the Southern District of New York and has been sentenced in its pending, parallel criminal action¾ i.e., United States v. Lim, 12-cr-121 (S.D.N.Y.). It also could be Choi’s limited financial means. We likely will never know the reason for the SEC’s agreed-upon resolution, but the fact of the resolution may have some value to other defendants.

Article By:

William L. Carr
Kevin A. Wisniewski
Of:
Drinker Biddle & Reath LLP

 

SEC (Securities and Exchange Commission) Guidance on the Testimonial Rule and Social Media

Godfrey Kahn

In March 2014, through question and answer format, the Division of Investment Management issued an Investment Management Guidance Update on an adviser’s or investment advisory representative’s (IAR) ability to use social media and to promote client reviews of their services that appear on independent, third-party social media sites.

Section 206(4) of the Advisers Act and Rule 206(4)-1(a)(1) (the testimonial rule) prohibit investment advisers or IARs from publishing, circulating, or distributing any advertisement that refers to any testimonial concerning the investment adviser or any advice, analysis, report, or other service rendered by such investment adviser. While the rule does not define “testimonial,” the staff previously has interpreted it to mean a “statement of a client’s experience with, or endorsement of, an investment adviser.”

Third Party Commentary. The guidance clarifies that in certain circumstances, an investment adviser or IAR may publish public commentary from an independent social media site if (i) the social media site’s content is independent of the investment adviser or IAR, (ii) there is no material connection between the social media site and the investment adviser or IAR that would call the site’s or the commentary’s independence into question, and (iii) the investment adviser or IAR publishes all of the unedited comments appearing on the independent social media site. The staff explained that publishing commentary that met these three criteria would not implicate the concerns of the testimonial rule and, therefore, an investment adviser or IAR could include such commentary in an advertisement.

Inclusion of Investment Adviser Advertisements on Independent Sites. The guidance also addresses the existence of an investment adviser’s or IAR’s advertisement on an independent site and notes that such presence would not result in a prohibited testimonial provided that (i) it is readily apparent to the reader that the advertisement is separate from the public commentary and (ii) advertising revenue does not influence, in any way, the determination of which public commentary is included or excluded from the independent site.

Reference by Investment Adviser to Independent Social Media Site Commentary in a Non-Social Media Advertisement (e.g., radio or newspaper). In the guidance, the staff explained that investment advisers or IARs could reference, in a non-social media advertisement, an independent social media site. For example, an adviser could state in its newspaper ad “see us on Facebook or LinkedIn” to signal to clients and prospective clients that they can research public commentary about the investment adviser on an independent social media site. In contrast, however, the investment adviser or IAR may not publish any testimonials from an independent social media site in a newspaper, for example, without implicating the testimonial rule.

Client Lists. The guidance also addressed posting of “contacts” or “friends” on the investment adviser’s or IAR’s social media site. Such use is not prohibited, provided that those contacts or friends are not grouped or listed in a way that identifies them as current or former clients. The staff carefully noted, however, any attempts by an investment adviser or IAR to imply that those contacts or friends have received favorable results from the advisory services would implicate the testimonial rule.

Fan/Community Pages. The guidance stated that a third-party site operating as a fan or community page where the public may comment ordinarily would not implicate the testimonial rule. However, the guidance cautioned investment advisers or IARs to consider the material connection and independence rules discussed above prior to driving user traffic to such a site, including through the publication of a hyperlink.

Sources: Investment Management Guidance Update, No. 2014-4, Guidance on the Testimonial Rule and Social Media (March 2014); Investment Company Institute Memorandum Regarding the Advisers Act Testimonial Rule and Social Media Guidance (April 1, 2014).

Article By:

Christopher M. Cahlamer
Elizabeth J. Chandler
Laura A. Hawkins
Susan Hoaglund
Helge Lee
Of:
Godfrey & Kahn S.C.

New SEC Rule Helps Entrepreneurs Raise Capital

GT Law

Start-ups, small businesses, venture capi- talists and hedge funds can for the first time in 80 years begin openly advertising to raise money in private offerings. The change by the Securities and Exchange Commission is part of the JOBS Act requirement to amend Rule 506 of Regulation D to permit general solicitation. While opening the gates for general solicitation, the SEC has simultaneously tightened rules to protect investors.

Prior to the new rules that be- came effective Sept. 23, companies seeking to sell securities to raise capital had to either register the offerings or qualify for exemptions from registration. The costs and complexities of public offerings often were beyond the reach of many small businesses. The new public solicitation rules make it possible for startups, small businesses, venture capitalists and hedge funds to search for investors via the internet, newspaper and other ads, social media and other general solicitation methodologies — previously forbidden territory. At the same time, they avoid the challenges and costs that come with the full registration process.

The new rules are complex, and ensuring compliance will invariably require advice from securities lawyers and investment bankers who can help companies raise capital safely. This includes ensuring they qualify for the traditional exemption or are in the “safe harbor” of the new rule. While this involves cost and time commitments, the new avenues for fund raising are still less complex and ex- pensive than traditional registered offerings. For example, offerings under the original Rule 506 exemption (now retained as a Rule 506(b) offering) allowed companies to raise an un- limited amount of capital from an unlimited number of accredited investors, but not from more than 35 nonaccredited investors. The new alternative, Rule 506(c), allows companies to generally solicit potential investors, gaining access to wider au- diences through solicitation and advertising methods previously unavailable – good news for startups and small companies.

Other changes require issuers to provide ad- ditional information about the 506(c) offerings and require companies using the new rule to take “reasonable steps” to ensure every inves- tor is qualified. The definition of a “reasonable step” is not clear under the new rule. It will take time to fully understand what the SEC views as a “reasonable step.” Practitioners will want issu- ers to document in their files that the companies did more than just take the investors’ word that the investors are accredited. It is generally understood that tax returns, certifications from tax accountants, review of bank account statements or other independent confirming information about potential investors will suffice to meet the “reasonable steps” standard.

Another change imposed by the new rules: a “bad actor” disqualification. This means issuers and other market participants will be disquali- fied from relying on Rule 506 when felons or other bad actors participate in Rule 506 offerings. As part of the adoption of these new rules, the SEC also voted to issue new companion rules containing stronger investor protections. Theseinclude requiring entrepreneurs who take advantage of the new general solicitation rules to (i) provide additional information about their capital raising offerings, (ii) provide more information about the in- vestors who are participating in the offerings, and (iii) require companies to file Form D with the SEC at least 15 calendar days before engaging in general solicitation and within 30 days of completing the offerings to update the informa- tion contained in the Form D and indicate that the offerings have ended.

Although it remains to be seen whether these rules will make it easier for entrepreneurs to raise money, the new rule changes will certainly allow companies to reach more potential inves- tors in a more cost-effective manner. If handled properly, entrepreneurs should have a powerful new vehicle at their disposal to support the de- velopment and growth of their companies.

This article was previously publsihed in Daily Business Review.

Article By:

 of

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:

Barnes & Thornburg

 

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

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