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SEC Examiners Release Cyber Observations: What You Need To Know

On January 27, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) announced its most recent Cybersecurity and Resiliency Observations. This report highlights specific practices that have been, and can be taken to enhance cybersecurity preparedness and incident response. The release of these observations is the latest move by the SEC demonstrating its increased attention to corporate cybersecurity practices. If you are a market participant supervised by OCIE, you may want to consider this report a benchmark to help navigate the SEC’s expectations when reviewing internal cybersecurity programs. The SEC has indicated that cybersecurity compliance and procedures remain a top priority—and they should be for you too.

OCIE Cybersecurity and Resiliency Observations

The OCIE, which reviews the effectiveness of market participants’ compliance programs, focused on seven areas in the cybersecurity report: governance and risk management; access rights and controls; data loss prevention; mobile security; incident response and resiliency; vendor management; and training and awareness. OCIE explained that it “felt it was critical to share these observations in order to allow organizations the opportunity to reflect on their own cyber-security practices.”

OCIE made clear that the most effective cybersecurity programs were those with proactive senior leaders committed to improving their organization’s cyber posture before an incident occurs. “Devoting appropriate board and senior leadership attention to setting strategy of and overseeing the organization’s cybersecurity and resiliency programs,” was a key observation.

Preventing data loss is a perennial focus of cybersecurity programs. OCIE observed a variety of tools and practices to ensure that sensitive data, including client information, was not lost, misused, or accessed by unauthorized users. These included frequent vulnerability scans of software and devices, utilizing encryption, keeping software patched with the latest updates, and monitoring for insider threats. On that last point, OCIE observed companies creating insider threat programs to identify specious behaviors, including escalating issues to senior leadership as appropriate.

Consistent with cybersecurity guidance from other sources but relatively new from the SEC, the report highlighted the risks associated with mobile devices, urging the implementation of security measures to prevent unauthorized access to sensitive systems. As corporate employees increasingly rely on mobile devices for work, the amount of sensitive data stored on those devices continues to grow, creating unique security concerns. OCIE observed companies implementing security measures that prevent users from saving sensitive information to personally owned devices and maintaining the ability to remotely clear data on employees’ devices, if necessary.

Addressing vendor management, OCIE underscored the increased risk related to vendor use of cloud services and the importance of due diligence when selecting vendors. Lastly, and arguably the most important topics addressed were incident response and training. OCIE stressed that market participants should be consistently testing and updating their incident response plans and training employees to identify and respond to cyber threats. These seven areas of focus provide important guidance for market participants regarding the expectations of OCIE examiners when conducting reviews.

Takeaways

With the release of the 2020 observations, the SEC continues to send the clear message that it expects market participants to not only respond timely and responsibly to cyber incidents, but also to proactively implement mitigation policies to reduce threats. Importantly, OCIE recognized that there is no one-size-fits-all approach.

Every organization should develop incident response plans that are tailored to their unique circumstances. Regulators continue to emphasize that is not enough to simply have policies on the books—companies must routinely update and practice those plans. Senior leaders should be involved in that process and should be prepared for the SEC and other regulators to closely examine their plans and other internal security protocols. Failure to do so is not only a regulatory issue, but creates private litigation risk.

The SEC is paying attention to and reiterating a common cybersecurity compliance roadmap: develop and implement cybersecurity plans to reduce risks, be prepared for regulatory scrutiny that may follow a cybersecurity incident, conduct staff training, and be prepared to respond to cybersecurity incidents.

ARTICLE BY Philip J. Bezanson, David Springer and Brittney E. Justice of Bracewell LLP.

More from the SEC in the Securities Law & SEC section of the National Law Review.

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.

ARTICLE BY Michael T. Foley and Laura N. Krcmaric of Katten Muchin Rosenman LLP.

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

Cardholders Seek to Capital-ize on Madden

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

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

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

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

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

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

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

Article by Scott A. Cammarn, Jonathan Watkins, Mark Chorazak and Aaron Lang of Cadwalader, Wickersham & Taft LLP.

More on financial issues on the National Law Review Financial Institutions & Banking page.

How the Trump Administration May Impact the Oversight and Enforcement of Dodd-Frank’s Whistleblower Protections

On the campaign trail, President Trump vowed to “dismantle” Dodd-Frank. Dodd-Frank was enacted in the wake of the 2008 financial crisis to curtail risky investment activities and stop financial fraud through increased oversight and regulation of the banking and securities industries. Among other things, it amended the Sarbanes-Oxley Act, Securities Exchange Act, and Commodity Exchange Act to include monetary incentives for individuals to blow the whistle on suspected financial fraud and stronger protections for whistleblowers against retaliation by their employers. President Trump has criticized Dodd-Frank, arguing that it is overbroad and inhibits economic growth. Now that he is in office, President Trump has the statute squarely in his crosshairs, and he is poised to impact its whistleblower protections on the legislative, administrative, and judicial fronts.

From a legislative standpoint, President Trump has wasted no time in seeking to roll back Dodd-Frank’s statutory framework. Only two weeks after his inauguration, he issued an EO titled “Core Principles for Regulating the United States Financial System,” which directs the Treasury Secretary to consult with the heads of financial agencies, including the Commodity Futures Trading Commission and the Securities and Exchange Commission (“SEC”), to find ways to conform U.S. financial regulations, including Dodd-Frank, to the Trump administration’s “Core Principles.” These “Core Principles” (detailed in the second article of this Take 5) are broad-sweeping and include, among other things, requiring “more rigorous regulatory impact analysis” for new laws and “mak[ing] regulation efficient, effective, and appropriately tailored.” While the precise scope of these principles is undefined (perhaps intentionally so), they appear to demonstrate a clear first step toward deregulation in the financial sector and may be a shot across the bow signaling the President’s intent to scale back—or at least halt any expansion of—Dodd-Frank, including its whistleblower protections.

Additionally, President Trump is well positioned to substantially affect the SEC’s administrative enforcement of Dodd-Frank’s whistleblower laws. Dodd-Frank created the SEC Office of the Whistleblower (“OWB”) to enforce its comprehensive whistleblower program. As reported in the 2016 Annual Report to Congress on the Dodd-Frank Whistleblower Program, since the OWB was established, the SEC has (i) awarded more than $100 million in bounty awards to whistleblowers who provided information leading to successful enforcement actions, (ii) independently sued employers for retaliating against employees for reporting alleged securities violations, and (iii) made it a top priority to find and prosecute employers that use confidentiality, severance, and other agreements that impede their employees from communicating with the SEC.

The SEC’s enforcement agenda could change significantly, however, under the Trump administration. Specifically, in 2017, President Trump will have the opportunity to appoint four out of the five SEC Commissioners (three seats are now vacant, and another will become vacant in June). He has nominated Jay Clayton—a corporate attorney who has spent his career representing financial services firms in business transactions and regulatory disputes—to fill one of those vacancies and serve as SEC Chair. New SEC leadership may result in the potential replacement of the sitting OWB Chief and alter the OWB’s current enforcement strategies. Thus, through his administrative appointments, President Trump may attempt to temper the SEC’s aggressiveness and focus when it comes to enforcement of Dodd-Frank’s whistleblower protections to more closely reflect his vision for less onerous regulation of the financial sector.

The President is also uniquely situated to influence the application of Dodd-Frank in the courtroom. Indeed, President Trump has inherited more than 100 federal court vacancies that he must fill, including one on the U.S. Supreme Court, giving him the opportunity to shape how Dodd-Frank’s whistleblower laws will be interpreted and applied by federal judges across the country. One of the most critical issues that hangs in the balance is whether an employee who reports an alleged securities violation only to his or her employer, and not to the SEC, is protected by Dodd-Frank’s anti-whistleblower retaliation provision. At present, there is a circuit court split on this issue. In 2013, the U.S. Court of Appeals for the Fifth Circuit held in Asadi v. G.E. Energy United States, LLC, that an employee who only reports a suspected violation internally is not a protected whistleblower for the purposes of Dodd-Frank’s anti-relation provision. In 2015, however, the Second Circuit Court of Appeals reached the opposite conclusion in Berman v. Neo@Ogilvy LLC. The question has since come before the Sixth Circuit Court of Appeals (which declined to rule on it) and is currently pending before the Courts of Appeals for the Ninth and Third Circuits, and it will almost certainly end up before the U.S. Supreme Court for resolution. Accordingly, President Trump’s federal judicial appointments—particularly his nomination of Judge Neil Gorsuch to the U.S. Supreme Court—may play a pivotal role in establishing exactly who is protected under Dodd-Frank’s proscription against whistleblower retaliation.

Ultimately, it is unlikely that President Trump will actually be in a position to completely “dismantle” Dodd-Frank. Yet, there is no question that he has at his disposal the power to greatly impact the statute at the legislative, administrative, and judicial levels, and there is little doubt that change is on the horizon.

ARTICLE BY Jason Kaufman of Epstein Becker & Green, P.C.

IOSCO Releases Report on Fintech

The International Organisation of Securities Commissions (IOSCO) has released a new report that says that changes resulting from FinTech are testing the boundaries of full disintermediation through the use of technology. IOSCO is the international body that brings together the world’s securities regulators and is a global standard setter for the securities sector. IOSCO develops, implements and promotes adherence to internationally recognised standards for securities regulation. It works with the G20 and the Financial Stability Board on the global regulatory reform agenda.

The report incorporates the finding of three surveys:

the Committee on Emerging Risks (CER) and the Growth and Emerging Markets Committee (GEMC) survey to gain further insight on the types of FinTech firms in respective jurisdictions, key regulatory actions taken by members, and the practices of FinTech firms in onboarding investors;
the CER, the Affiliate Members Consultative Committee, and World Federation of Exchanges survey on distributed ledger technology; and
a GEMC survey reviewing the state of development of FinTech in emerging markets, including existing and potential regulatory implications.

The report particularly examines:

Financing Platforms, including Peer-to-Peer (P2P) lending and equity crowdfunding (ECF)
Retail Trading and Investment Platforms, including robo-advisers and social trading and investing platforms
Institutional Trading Platforms, with a specific focus on innovation in bond trading platforms
Distributed Ledger Technologies (DLT), including application of the blockchain technology and shared ledgers to the securities markets.

ARTICLE BY Jonathan Lawrence of K&L Gates

A New Regulatory Paradigm For The SEC Following the Election?

Many are speculating on the future of federal securities regulation as a result of the election of Donald J. Trump and the concomitant Republican control of both houses of Congress. Broc Romanek, for example, asks whether Michael S. Piwowar will become the SEC’s next Chairman. Broc notes that Commissioner Piwowar is an economist, not a lawyer. Since the SEC is concerned with financial regulation, a background in economics should be a strong plus.

Since I’ve already seen signs of holiday decorating in the stores, I’ve drawn up my own short wish list for whomever takes the helm of the SEC.

The SEC should fundamentally change its approach to evaluating regulations. When considering the adoption of any new substantive regulation, the fundamental question must always be “Why is this regulation necessary?” A regulation isn’t necessary simply because someone thinks it is a good idea or constitutes a perceived “best practice”. A regulation is necessary only when it can be demonstrated that there is some market impediment that can only be removed by government intervention. It seems that regulations are too often adopted in reverse. It is tantamount to a doctor, knowing that a drug has proved beneficial in some cases, prescribes it to her patients without first making a diagnosis. If a market impediment exists, then the regulatory effort should be directed at removing the impediment not imposing additional requirements.

The SEC should ask Congress to repeal Section 16(b) liability. When Congress enacted Section 16 more than four score years ago, it was recognized that it was a “crude rule of thumb”. Given the rapidity of modern trading, the arbitrary six month period seems positively quaint. The calculation of profits under the rule can be bizarre. In some cases, persons are liable even when they recognized no overall economic profit. Congress enacted the rule to deter insider trading, but many persons who are guilty of trading on the basis of material non-public information aren’t even subject to the rule. In practice, the rule has become an economic boon to a few lawyers and a technical trap for many. At eighty plus years, Section 16(b) has had a good run, but now is time for it to leave the stage.

The SEC should abandon and repudiate its attempts to co-opt attorneys. Attorneys are their clients’ advisers and advocates. They are not gatekeepers as the SEC has on occasion supposed. The SEC should amend its attorney conduct (Part 205) rules to eliminate the purported ability of lawyers to disclose client confidences to the SEC. See Conflicting Currents: The Obligation to Maintain Inviolate Client Confidences and the New SEC Attorney Conduct Rules, 32 Pep. L. Rev. 89 (2004) and this post. The SEC should also amend its whistleblower rules to eliminate the possibility of attorneys obtaining whistleblower awards. See SEC Condemns Breach Of Client Confidences While Offering Possible Bounties For Breaches.

Allow companies to pick their reporting periods. There has been much debate about whether publicly traded companies suffer from short-termism. Although short-termism may have multiple causes, the SEC’s rigid requirement of quarterly financial information pressures companies to focus on short-term results. Why not let companies pick their own reporting periods? This will allow companies to telegraph to the market whether they are focused on short-term or long-term performance. To those who say that this is a bad idea, I say why not let the market decide? If investors think that semi-annual or annual reporting is inadequate, then companies making those choices will be undervalued and will incur higher costs of capital. Some companies might even elect to report more frequently than every quarter (e.g., bi-monthly). The beauty of this approach is that it is transparent and allows the market to achieve equilibrium at the optimal time for each issuer.

Allow companies to decide whether they will be subject to routine SEC review. It is hard to assess the efficacy of SEC staff review of filings. I’m sure that the SEC believes that staff review improves disclosure and that may well be the case. One way to test that position, is to allow companies to elect whether to have their filings be subject to SEC staff review. These elections would be public. Investors could then decide whether SEC review reduces risk through enhanced disclosure (because companies will do a better job because they know they are subject to review and/or because the staff’s comments result in improved disclosure). The efficacy of review should be reflected in differences in the cost of capital.

Readers will note that repeal of the Dodd-Frank Act is not on my wish list. That is the subject of this blog by Cydney Posner at Cooley LLP. As a final note, this is my personal wish list and it does not necessarily represent the wish list of my firm, partners, or any my firm’s clients.

ARTICLE BY Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

SEC Releases Crowdfunding Rules for Securities Offerings

Investors will be able to purchase securities through Internet crowdfunding platforms under new final rules released by the Securities and Exchange Commission (SEC) in October. The final rules, known as “Regulation Crowdfunding,” originated in Title III of the Jumpstart Our Business Startups Act of 2012 (JOBS Act). The rules will take effect in May 2016.

Alongside Regulation Crowdfunding, the SEC also proposed amendments to Rules 147 and 504 under the Securities Act of 1933 (the Proposed Amendments). A brief review of Regulation Crowdfunding and the Proposed Amendments is provided below for companies or investors eager to discover new capital raising or investment opportunities and for broker-dealers interested in expanding into the crowdfund arena.

Key Points: What to Know About Regulation Crowdfunding

The Regulation Crowdfunding rules are extensive, but they can be more readily understood and categorized as: 1) operative provisions; 2) disclosure mandates; and 3) crowdfunding platforms.

Operative Provisions

Regulation Crowdfunding will: i) enable companies to raise up to $1 million, in the aggregate, over a 12-month period; ii) for individual investors whose annual income or net worth is less than $100,000, enable such investors to spend the greater of $2,000 or five percent of the lesser of their annual income or net worth on crowdfunding investments over a 12-month period; iii) for individual investors whose annual income or net worth equals or exceeds $100,000, enable such investors to spend ten percent of the lesser of their income or net worth on crowdfunding investments over a 12-month period. The goal is to allow more people to dabble in investments, and to level the playing field for investments by ensuring that even the wealthiest of individual investors cannot spend more than ten percent of their income or net worth on crowdfunding offerings in a given 12-month period. Also crucial to note are the following points:

Securities purchased in a crowdfunding transaction will be considered restricted securities and will be subject to resale restrictions for one year in most circumstances;
All of the new crowdfunding offerings will need to be completed with the assistance of a registered broker-dealer or done through a registered “funding portal,” to be discussed in greater depth below; and
Some companies are unable to use the exemption, including foreign companies, publicly-traded companies, and companies that are subject to disqualification under Regulation Crowdfunding.

Disclosure Mandates

Companies seeking to raise money through crowdfunding will have to meet specific disclosure requirements under Regulation Crowdfunding including:

The price of the securities to be offered;
How the price was determined;
The target offering amount;
The deadline to reach the target offering amount;
The funding deadline;
Whether the company intends to accept investments that will cause the target offering amount to be exceeded;
A discussion of the company’s financial health;
A discussion of the business and how proceeds from the offering will be used;
Information about directors, officers, and owners of 20 percent or more of the companies;
Certain related-party transactions; and
Financial statements of the company that may or may not need to be audited, depending on a fairly complex set of circumstances.

Crowdfunding Platforms

Regulation Crowdfunding contemplates the creation of crowdfunding portals to facilitate Internet-based transactions that, in theory, reduce costs and boost efficiency. The “funding portals” will need to be registered with the SEC via a new form – Form Funding Portal – and such portals will need to be registered as members of a national securities association (i.e., FINRA). In short, the funding portals will be the intermediary platforms through which all crowdfunding will be conducted, and these portals will need to comply with the following requirements:

Provide investors with informative materials explaining how to use the platform, what is being offered, and all relevant disclosures about the company, resale restrictions, investment limitations, and the like;
Take measures to reduce fraud risks, including by verifying with the companies offering securities that such companies are in compliance with Regulation Crowdfunding and that the companies are maintaining up-to-date records of their security holders;
Post and maintain mandatory disclosures for 21 days before any offerings are live (i.e., a waiting period of 3 weeks) and throughout the actual offering period;
Make available forums or other communication venues for investors to discuss offerings on the platform;
Explain how the intermediary is being compensated for hosting the transactions;
Require investors to set up accounts officially before being allowed to buy securities;
Have a reasonable basis to believe that investors are in compliance with the investment limitations (i.e., they will need to ensure investors are not exceeding their spending limits in a given 12-month period);
Provide adequate notices and confirmations at each step of the investment process;
Comply with maintenance and transmission of funds requirements; and
Comply with any requirements dealing with completion, cancellation, and re-confirmation of offerings requirements.

Crowdfunding intermediaries will be prohibited from providing access to companies they believe pose fraud or other problems that could negatively impact investor protections; holding financial interests in companies offering securities on their platforms, unless such financial interests are being used as consideration to pay the intermediaries for their services (subject to certain conditions); and paying third parties to provide information that will personally identify any investors or potential investors who may be using or planning to use the platform. Specific to funding portals as intermediaries, Regulation Crowdfunding also prohibits such portals from: offering investment advice or making purchase recommendations; soliciting purchases, sales, or offers; soliciting purchases, sales, or offers via promoters or other persons for pay; and holding or handling investors’ funds or securities. Despite the numerous prohibitions, Regulation Crowdfunding is intended to make transactions smoother and provide a safe harbor (i.e., set of guidelines) for funding portals, such that, if the portals follow the guidelines precisely, they can be assured that they are in compliance with Regulation Crowdfunding.

Key Points: What to Know About the Proposed Amendments

In an effort to balance the need to help smaller companies raise capital with the need to protect investors from fraudulent and misleading securities sales, the SEC has proposed amending Rules 147 and 504 as follows:

Rule 147 – This rule currently allows a safe harbor for exemption from costly registration for offers and sales made entirely within one state. The amendments are intended to make it easier for companies to make intrastate offerings of their securities by: 1) eliminating restrictions on offers (i.e., general solicitation and advertising will be allowed), though sales would still need to be made only to residents of the issuer’s state or territory; and 2) expanding the meaning of “intrastate offering” and the issuer eligibility requirements. The amended Rule 147 would apply to offerings registered in-state or conducted under an exemption from state law registration that caps the amount of securities allowed to be sold by an issuer at $5 million over a given 12-month period, along with spending limits for investors.
Rule 504 – This rule currently provides a safe harbor exemption from registration for certain small offerings. The amendments would boost capital-raising by increasing the aggregate amount of securities allowed to be offered and sold under Rule 504 from $1 million to $5 million, during any 12-month period. The amendments would boost protection for investors by prohibiting a set of defined “bad actors” from participating in such offerings.

Conclusion: Timelines for Regulation Crowdfunding and the Proposed Amendments

The new Regulation Crowdfunding rules and forms will be effective 180 days after they get published in the Federal Register (i.e., in May 2016). The forms that will enable funding portals to get registered with the SEC will become effective on January 29, 2016, thereby allowing the funding portals to be active or ready for transactions months before any transactions under the new rules are allowed by law.

Regarding the Proposed Amendments to Rules 147 and 504, the SEC is welcoming public comments, and will continue to do so for a 60-day period, which will end approximately by the end of the year. Crowdfunding has been the subject of much discussion and debate as evidenced by the nearly three years it took the SEC to promulgate Regulation Crowdfunding. It is still too early to predict whether crowdfunding will emerge in 2016 as a successful alternate path for capital-raising for small companies. Indeed, only time will tell whether the SEC will manage to balance its primary goal of investor protection with the ambitious aim of offering a more grassroots-level option of raising money.

To review the text of Regulation Crowdfunding and the Proposed Amendments, see the following links from the SEC: http://www.sec.gov/rules/final/2015/33-9974.pdf and http://www.sec.gov/rules/proposed/2015/33-9973.pdf.

Article By Corporate Services at Dickinson Wright of Dickinson Wright PLLC

Failure to Investigate Could Mean “Game-Set-and-Match” for EB-5 Investors: SEC Case against Brother-in-Law of Tennis Star Andre Aggasi Shows Risk for Would-be Immigrant Investors

On August 25, 2015, the U.S. Securities and Exchange Commission (SEC) filed a civil fraud suit against Lobsang Dargey, a Bellevue, Washington-based real estate developer and alleged fraudster, who also happens to be a brother-in-law of tennis star Andre Agassi. Dargey had ventured into the EB-5 Program as a developer and regional center owner, securing designation by United States Citizenship and Immigration Services (USCIS) for two regional centers, Path America SnoCo and Path America KingCo. The complaint is relevant to both investors and regional centers in the EB-5 industry, as well as to lawyers advising issuers in EB-5 offerings.

Dargey has now landed in hot water for engaging in fraud and deceit in the EB-5 offering process, as well as for using related Path America companies to siphon investor funds into his own pockets. The SEC has charged him for making false and misleading statements in EB-5 offering documents, alleging that since 2012 Dargey has exploited the EB-5 Program to defraud investors seeking investment returns and a lawful path to U.S. permanent residency. Among the allegations is misappropriation of $17.6 million in investor funds.

Summary of the SEC’s Complaint

The SEC alleges that Dargey, through his solely owned and controlled entity Path America, LLC, had diverted to himself and for his own personal benefit millions of dollars he had raised from Chinese nationals for EB-5 projects sponsored by Path America-owned regional centers. Path America had raised money for projects including the proposed Potala Farmers Market (a hotel, apartment and retail project in Everett, Washington), as well as the Potala Tower (a proposed 440 foot, 40-story hotel-and-apartment tower) in Seattle. Path America serves as the managing member of both USCIS designated regional centers and had unfettered control over the entire EB-5 investment process for the offerings.

In bringing the suit, the SEC also obtained a temporary asset freeze against Dargey and numerous related corporate defendants to prevent Dargey from pursuing his recently-announced plans to raise an additional $95 million from investors. According to the SEC, Dargey spent some of the siphoned funds on a $2.5 million home in Bellevue as well as at various gambling casinos. He also diverted EB-5 funds to projects that were unrelated to those disclosed in his offering documents to investors, meaning that the green card petitions pursued by EB-5 investors would be infirm.

A Path to America Fraught with Securities Fraud

The Path America case raises questions about investments buttressed by stories that seem to-good-to-be-true: Dargey left his Tibetan homeland and goat-herding profession in 1997 to pursue opportunities in the United States, as a house painter though he didn’t speak a word of English, and later rose to become a successful real estate developer. Dargey’s personal biography was almost certainly a lure to investors, and he conditioned the EB-5 market with his life story. In the media, Dargey touted his personal journey from Buddhism to capitalism, creating a background narrative for his real estate ventures and perceived success. Dargey’s story should caution investors to thoroughly examine the organizations backing the EB-5 projects in which they invest despite any personal affinity or connectivity with the background of a project promoter. Although the SEC has not directly asserted that this case involved affinity fraud, it is clear that Dargey targeted Chinese investors who may have felt an affinity with him. This is a common tactic employed by a schemer in affinity fraud.

If true, the allegations levied by the SEC make a strong case against Dargey for securities fraud, which is at the heart of the complaint. An element of any claim of securities fraud is the defendant’s state of mind, specifically, whether the defendant acted with “scienter” or “fraudulent intent.” Frequently, aggrieved investors in actions to recover their investment losses have tried to establish scienter by pointing to a defendant’s “motive and opportunity” to commit fraud. The Dargey case illustrates how control of numerous related entities involved in this EB-5 financing program may give a defendant ample “opportunity” to siphon off investor funds and commit fraud, while keeping investors in the dark about material changes to how he used investor funds. Nine different corporate entities were named as defendants in this case, and, according to the SEC’s Complaint, Dargey maintained control over all of them to such a degree that he was able to repeatedly transfer funds between the entities and into accounts that he controlled, eventually withdrawing large sums of cash which he used to gamble and purchase real estate. A quick records search on the State of Washington’s Secretary of State’s corporate records database reveals that Dargey (or a member of his executive team listed on his company website) is in fact the registered agent for each of these companies.

The Dargey case serves as a reminder to investors in EB-5 regional center projects (or any other investment vehicle) to be thorough and circumspect in evaluating the organizational structure of any enterprises set up to achieve the advertised goals, particularly where numerous inter-related projects are involved and particularly where the entire enterprise appears to be under the control of just one individual. Unlike Mr. Dargey’s rags-to-riches success story, some opportunities are just too good to be true.

Related Party Transactions Can Be Traps for Unwary EB-5 Regional Centers and Issuers

Regional centers and issuers of EB-5 investments should also consider carefully the lessons in Dargey’s case about potential SEC scrutiny of related party transactions.

USCIS designated regional centers that handle investor funds and that facilitate offerings also need to be cautious, even when they think they are doing everything properly. The SEC is showing an increased interest in the EB-5 Program, and this interest appears to be here to stay.

One hot topic is related party transactions that, when improperly concealed, keep investors in the dark about the economic relationships among multiple related entities in a deal. Disclosures about related party transactions should not be buried in a Private Placement Memo (PPM), but should be identifiable and written in clear language. If a regional center, developer and general partner are essentially one and the same party in your deal, your offering could be subject to a higher level of scrutiny later particularly with respect to whether all material disclosures were properly presented in offering documents. Related party transactions require careful and robust disclosures so that investors can evaluate the substance of potential conflicts. Such disclosures belong to the total mix of information that a reasonable investor would need to know in order to make an investment decision. The omission of such disclosures can lead to litigation later with the SEC and investors.

While transparency to investors is paramount, so too is fairness. If you are conducting an offering with related party transactions, ensure that you have a commercially reasonable basis for the economics of your deal. Also have objective controls on how investor funds are managed and spent. One practice tip is to engage an auditor that provides annual or even semi-annual or quarterly reports to investors. Even regional center owners or managers who don’t engage in criminal or egregious conduct can find the SEC knocking at the door and alleging fraud when material facts in a deal are not disclosed to investors, or when there are questions about how investor funds were handled.

Another strategic tip: hire qualified securities counsel to understand what you need to disclose in your offering documents when you have a related party transaction. What constitutes a material disclosure is complex. Suffice it to say that counsel needs to be engaged in all aspects of an offering’s preparation to guide an issuer on whether disclosures are sufficient when a deal goes to market. An omission could result in allegations or findings later that offering documents contained false or misleading statements. An omission of a material fact about related party transactions can have dire consequences including rescission in favor of investors, an SEC finding of securities fraud under Section 10(b) of the 1933 Securities Act and exposure under Rule 10b-5, one of the most important rules promulgated by the SEC with respect to securities fraud. Allegations by the SEC that an issuer or regional center has made false and misleading statements in an offering process can lead to assets being frozen and costly civil fraud litigation, particularly where the SEC can show opportunity to commit fraud through related party dealings.

How Can Regional Centers and Issuers of EB-5 Securities Mitigate Litigation Risks?

Every EB-5 regional center or issuer should consider adding a securities litigator to the offering team before introducing a deal into the marketplace. In the current climate, guidance on risk mitigation in an offering is critical. Having counsel involved early on during drafting sessions of an offering is an effective way to understand your disclosure obligations as you prepare a PPM. A securities litigator following the lifecycle of your offering – from inception of a business plan to closing of a deal – can serve as an excellent advisor to issuers in preventing problems and miscommunications with investors and government agencies. In the current climate, risk mitigation is an important component of EB-5 regional center business planning and operations.

Conclusion

The SEC is the ultimate referee in an EB-5 deal. Playing ball by the rules matters, especially when it comes to ensuring that material facts are disclosed to investors. Disclosures are the “sweetspot” of a PPM. A PPM without the right disclosures is about as effective as tennis racquet with no sweetspot. You’ve lost the match before the first serve.

If SEC litigation increases in the EB-5 realm, then we expect that otherwise lawabiding and compliant regional centers could be inadvertently swept up into costly litigation. This will be true even with regional centers who make a good faith effort to comply with the law. An SEC complaint against your regional center could seriously impede your ability to do business, even if you have the law and facts in your court. Therefore, now’s the time to add securities litigation counsel to your EB-5 team, if you haven’t done so already. Securities litigation counsel experienced in the purchase and sale of securities, the Foreign Corrupt Practices Act (FCPA), disputes with the SEC over what constitutes materiality in an offering, and other relevant areas can help you mitigate risk, protect investors and raise funds as you intended.

Article By Adam L. Sisitsky & Douglas Hauer of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

Second Circuit Dismisses Suit Over FBI’s Wiretapping of Marital Conversations in Securities Fraud Investigation

Federal Bureau of Investigation (FBI) wiretapping played an important role in the wide-ranging insider trading investigation and subsequent trials of Galleon Group LLC principals and traders. During his criminal prosecution, former Galleon trader, Craig Drimal, unsuccessfully moved to suppress evidence obtained via an authorized wiretap of his cell phone because of a failure to minimize interception of calls with his wife. His wife, Arlene Villamia Drimal, is now pursuing civil claims against FBI agents for wiretapping her personal telephone conversations with her husband, but her claims have thus far been unsuccessful. On May, 15, the US Court of Appeals for the Second Circuit dismissed Ms. Drimal’s complaint without prejudice to repleading, finding that her conclusory pleading failed to state a claim under Title III of the Omnibus Crime Control and Safe Streets Act of 1968, which requires the government to “minimize the interception of communications not otherwise subject to interception.” The Second Circuit also found fault with the lower court’s assessment of the agents’ qualified immunity defense.

In connection with a federal criminal investigation, the US District Court for the Southern District of New York authorized a wiretap of Mr. Drimal’s cell phone, but stressed that monitoring must “immediately terminate when it is determined that the conversation is unrelated [to criminal matters].” FBI agents also were instructed to “discontinue monitoring if you discover that you are intercepting a personal communication solely between husband and wife.” Despite these instructions, agents allegedly monitored approximately 180 private marital calls between the Drimals that were unrelated to the investigation. Although the district court denied Mr. Drimal’s suppression motion in his criminal matter, it identified 18 calls that were “potentially violative” and observed that the agents’ failure to minimize monitoring of private calls was “inexcusable and disturbing.” Ms. Drimal brought her separate civil lawsuit following the conclusion of her husband’s criminal case with his entry of a guilty plea and subsequent sentencing.

At the district court level, the FBI agents unsuccessfully moved to dismiss Ms. Drimal’s complaint for failure to state a claim and on qualified immunity grounds. The Second Circuit reversed that decision, holding that Ms. Drimal’s complaint was insufficient because it merely stated, in a conclusory fashion, that the interception of marital calls violated Title III, without reference to a duty to minimize. The Second Circuit noted that Title III does not prohibit outright the monitoring of privileged calls. With respect to the agents’ qualified immunity defense, the court of appeals held that the district court should have evaluated each agent’s minimization efforts under an “objective reasonableness” standard based on the particular circumstances, rather than as a group. The Second Circuit vacated the lower court decision and directed dismissal of the complaint with leave to replead, stating that amending the complaint would not be futile.

Drimal v. Makol, Nos. 13-2963 and 13-2965 (2d Cir. 2015)

ARTICLE BY Emily Stern & Margaret J. McQuade of Katten Muchin Rosenman LLP

Whistleblower Award Update 2015

There was not much activity from the SEC Office of the Whistleblower (OWB) in the months since it announced the highest whistleblower award to date in September 2014, but that changed in February when it issued a number of denials.

Awards:

In the Matter of the Claim for Award, Exchange Act Rel. No. 72947. On August 29, 2014, the SEC issued its first award under the Dodd-Frank Act to an employee who performed audit and compliance functions. The employee, who had compliance responsibilities, received an award of $300,000. Generally, information provided to an individual with compliance responsibilities is not considered “original.” Such an employee is entitled to an award, however, if they first report the misconduct to the company and it subsequently fails to take action within 120 days. See 17 C.F.R. §§ 240.21F-4(b)(4)(iii)(B),v(v). This exception applied to the claimant because he reported the conduct to his supervisor 120 days prior to submitting it to the Commission.

In the Matter of the Claim for Award, Exchange Act Rel. No. 73174. In September 2014, the SEC announced a record-breaking whistleblower award of $30 million. The significance of this award was discussed in a previous blog post.

In the Matter of the Claim for Award, Exchange Act Rel. No. 74404. The SEC did not announce its next whistleblower award until March 2015. This award was the first ever to a former corporate officer who learned of a violation as a result of another employee reporting misconduct through corporate and compliance channels. Typically, officers who learn about fraud through another employee or through a compliance process are not eligible for an award under the whistleblower program. See 17 C.F.R. § 240.21F-4(b)(4)(iii)(A). However, the SEC’s bounty rules provide an exception that makes an officer eligible for an award if he or she provides the information to the SEC more than 120 days after other responsible personnel possessed the information and failed to adequately act on it. See 17 C.F.R. § 240.21F-4(b)(4)(v)(C). The former corporate officer fell within that exception and the SEC awarded the officer between $475,000 and $575,000 for reporting original, high-quality information regarding misconduct under the Dodd-Frank Act.

Denials:

In the Matter of Pipeline Trading Systems LLC, Notice of Covered Action 2011-194. Pipeline Trading Systems LLC (“Pipeline”) and two of its top executives agreed to pay $1 million for the company’s failure to disclose to customers that a majority of orders placed on its “dark pool” trading platform were filled by a trading operation affiliated with Pipeline. The SEC denied the claimant an award because he did not meet the definition of a “whistleblower” under the Exchange Act. (Denial Order Aug. 15, 2014).

In the Matter of the Claim for Award, Exchange Act Rel. No. 72947. On August 29, 2014, the SEC denied an award to a second claimant because the information provided did not lead to the successful enforcement of the covered action and did not contribute to the ongoing investigation.

SEC v. James Roland Dial, Case No. 4.12-CV-01654 (S.D. Tex. 2012), Notice of Covered Action 2012-66. The defendants caused Grifco International Inc. to issue more than 13 million unrestricted securities to themselves and then sold the securities shortly after into a rising artificial market (caused by their dissemination of false and misleading information). The defendants were ordered to pay disgorgement and prejudgment interest. The SEC denied the claimant an award because (1) claimant did not provide “original information” within the meaning of Section 21F(a)(1) of the Exchange Act and Rule 21F-4(b)(1)(iv), (2) the information provided by claimant did not lead to successful enforcement of a covered judicial or administrative action within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a) and 21F-4(c), and (3) claimant was not a “whistleblower” within the meaning of Section 21F(a)(6) of the Exchange Act and Rule 21F-2 because he did not provide information relating to a possible violation of the federal securities laws in accordance with the procedures set forth in Rule 21F-9(a) under the Exchange Act. (Denial Order Feb. 13, 2015).

SEC v. Harbert Management Corporation, HMC-New York, Inc. and HMC Investors, LLC, 12-cv-5029 (S.D.N.Y. 2012), Notice of Covered Action 2012-89. Here, the SEC denied the claimant an award because (1) he did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c), and (2) he failed to submit information in the form and manner that is required under Rules 21F-2(a)(2), 21F-8(a) and 21F-9(a) & (b) of the Exchange Act. (Denial Order Feb. 13, 2015).

SEC v. Kenneth Ira Starr, 10 civ 4270 (S.D.N.Y. 2010), Notice of Covered Action 2012-129. On March 3, 2011, Starr was sentenced to 90 months in prison, ordered to pay more than $30 million in restitution, and ordered to forfeit more than $29 million in connection with his misappropriation of investor funds in connection to a series of cases filed against him by the government, which included charges of money laundering, wire fraud, fraud by an investment advisor, and misappropriation of client funds. This specific action arose from Starr’s misappropriation of at least $8.7 million of his clients’ money. The SEC denied the claimant an award because he or she did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c). (Denial Order Feb. 13, 2015).

SEC v. George Wesley Harris, No. 3:09-cv-01809-M (N.D. Tex. 2009), Notice of Covered Action 2011-206. The Northern District of Texas entered a $4.8 million judgment against Harris and his co-defendants for operating a fraud scheme that promised returns for investing in oil drilling projects in Texas and New Mexico. The SEC denied the award because (1) claimant did not provide information that led to the successful enforcement within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a) and 21F-4(c), and (2) claimant also did not provide the Commission with original information within the meaning for Section 21F(b)(1) of the Exchange Act because Claimant’s submission was not derived from claimant’s independent knowledge or independent analysis. The SEC further noted that the claimant made a false statement on the Form WB-APP, which was signed under penalty of perjury, by stating he or she was “the 44th President of the United States.” (Denial Order Feb. 13, 2015).

The OWB denied two other claims, one on February 13, 2015, and one on February 16, 2015, in orders that make it impossible to tell the name or nature of the underlying action. Both claims were denied, however, because the information provided by the whistleblowers did not provide information that led to the successful enforcement of an action within the meaning of Section 21F(b)(1) of the Exchange Act and Rules 21F-3(a)(3) and 21F-4(c). Specifically, the information did not (1) cause the Commission to (i) commence an examination, (ii) open or reopen an investigation, or (iii) inquire into different conduct as part of a current Commission examination or investigation under Rule 21F-4(c)(1) of the Exchange Act; or (2) significantly contribute to the success of a Commission judicial or administrative enforcement action under Rule 21F-4(c)(2) of the Exchange Act.

Finally, the Second Circuit upheld the SEC’s denial of an award to a whistleblower who provided information to the SEC before the enactment of the Dodd-Frank Act in July 2010. Styker v. S.E.C., No. 13-4404-ag, 2015 U.S. App. LEXIS 3765 (2d Cir. Mar. 11, 2015). The whistleblower submitted information from 2004-2009 to the SEC, which eventually led to a $24 million settlement with Advanced Technologies Group. The Second Circuit rejected the whistleblower’s argument that the SEC went beyond its congressionally mandated authority, and it deferred to the SEC’s interpretation of the law that information submitted prior to July 2010 does not qualify for an award. Id. at *8-9.

ARTICLE BY

William L. Carr

Daniel E. Brewer

Lucas B. Michelen

Tag: securities

SEC Examiners Release Cyber Observations: What You Need To Know