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SEC v. Greenstone Holdings, Inc.: Court Employs Proximate Cause Analysis to Hold Indirect Participant Liable for the Sale of Unregistered Securities

In SEC v. Greenstone Holdings, Inc., No. 10 Civ. 1302 (MGC), 2013 BL 186597 (S.D.N.Y. July 10, 2013), the court granted summary judgment to the SEC on claims relating to the participation by former counsel to Greenstone Holdings, Inc. (“Greenstone”) Virginia K. Sourlis (“Sourlis”) in the issuance and sale of Greenstone securities in violation of Section 5 of the Securities Act of 1933 (“1933 Act”).

According to the allegations, Greenstone, to avoid a liquidity crisis, sought to convert into a public company by purchasing the shares of a public shell company. “From September 2006 through June 2008, Greenstone distributed millions of shares of unregistered stock to the public.” 

 According to the SEC, Sourlis, an attorney, issued a single letter to Greenstone finding that certain shares met the requirements of Rule 144.  Specifically, in the letter dated January 11, 2006, Soulis addressed the issuance of shares in exchange for certain convertible promissory notes.  The letter specified that the notes had been issued by Greenstone’s predecessor shell corporation to some of its non-affiliate vendors and later assigned to Greenstone investors. As the court described:

Sourlis stated that no consideration was received by the company or by the vendors (referred to by Sourlis as “Original Note Holders”) in connection with the assignment, and that no commissions were paid in connection with the assignment. Sourlis stated that she had been told by the vendors that the original convertible notes had been held for at least two years prior to the assignment and that none of the vendors were “affiliates” of the company under Rule 144.

Sourlis concluded that the shares could be issued without a legend. 

The letter was delivered to Corporate Stock Transfer, Inc. (“CST”), the transfer agent for Greenstone. As a result, CST issued six million shares of Greenstone without restrictive legends. 

The court, however, found that the letter contained incorrect information.  

The convertible notes described by Sourlis did not even exist. Therefore, Sourlis's statement that she was informed by the vendors that they had held the notes for at least two years was necessarily false. Likewise, Sourlis's other statements—that the company had informed her that the notes were issued to various vendors; that the notes had been assigned to the four entities; and that no consideration was received by the company or vendors in the assignment for the notes—were also false.  

Pursuant to Section 5 of the 1933 Act, shares cannot be sold unless registered with the SEC or offered pursuant to an applicable exemption.  A Section 5 violation requires the SEC to show that (1) the defendant made direct or indirect offers to sell securities; (2) the offered securities were not effectively registered; and (3) interstate means were employed to facilitate the offers or sales of the securities in question.  To establish involvement in the offering, a person not directly engaged in the transfer of the title of a security can be held liable if she has “engaged in steps necessary to the distribution of [unregistered] security issues.”  The behavior must be more than di minimis to meet a “but for” standard with respect to the transaction.      

At the time of the Greenstone sales at issue, Rule 144 provided for a limited exemption from registration “if the securities were issued privately, solely in exchange for restricted securities of the same company, [and] if the restricted securities were more than two years old.” 

The court found sufficient involvement by Sourlis in the offering.  “CST required a legal opinion letter providing the authority to issue the unregistered shares without a restrictive legend.”  The shares “would not have issued the shares without Sourlis's letter.”  Such evidence was “sufficient to hold an attorney liable under Section 5.”  The alleged “lack of diligence on the transfer agent's part” was insufficient to “relieve Sourlis of liability.” 

The primary materials for this case may be found on the DU Corporate Governance website. 


The SEC Files Its Brief in the Appeal of the Conflict Minerals Rule

We have been following the progress of the conflict minerals rule (“Rule”)—the Rule implementing Section 1502 of Dodd-Frank that requires certain disclosures of the use of “conflict minerals” sourced from the Democratic Republic of Congo.  After the Rule was initially proposed it was challenged by the National Association of Manufacturers and others.  After some jurisdictional maneuvers the United States District Court for the District of Columbia in an opinion by Robert Wilkins, upheld the Rule, granting the SEC summary judgment.  That decision was appealed. On October 23rd the Securities Exchange Commission filed its brief in that proceeding.

In its brief the SEC criticized strongly the appellant’s arguments, stating that their challenges are premised on the novel and flawed assumption that the Commission should have re-evaluated Congress’s determination that the disclosures would ameliorate, rather than exacerbate, the crisis in the DRC. This erroneous contention animates appellants’ arguments that the Commission was required to use its exemptive and interpretive authority to reduce the statute’s costs even where the Commission reasonably concluded that doing so would undermine Section 1502’s purpose. It also underpins their arguments that the Commission could not implement Congress’s directive unless it confirmed Congress’s judgment that the statute would yield benefits, and that each regulatory choice made by the Commission had to be weighed against its ultimate effect in the DRC. Appellants’ position misconceives both the Commission’s role in mandatory Rulemakings and its approach to this Rulemaking.

The SEC addressed the central issues of the appeal, considering whether it acted reasonably in declining to include a de minimis exception to the Rule, whether its economic analysis complied with the Administrative Procedure Act and the 1934 Securities Exchange Act; and whether Section 1502 and the SEC Rule violate the First Amendment by mandating that issuers disclose factual information about their products.  In each case (no surprise) the SEC argued that it had acted appropriately and in full compliance with all statutory requirements.

What is most interesting in the brief is the repeated reference to Congressional mandate and the mandatory nature of this Rule.  It has been known from the start that the SEC was not thrilled to be tasked with crafting conflict mineral disclosure regulations but clearly had no option but to do so given Dodd-Frank Section.  Unlike some other Rule-making directives, Section 1502 left the SEC very little discretion, a fact the brief points out repeatedly.  For example, appellants argue that the SEC should have determined whether the Rule would further the stated goal of reducing violence in the DRC.  In response the SEC notes

In enacting Section 1502, Congress determined that the required disclosures will benefit the DRC. The Commission properly declined to second-guess that judgment and instead weighed whether its choices would provide the disclosure that Congress determined would further its humanitarian goals.

And far from pursuing these goals at all costs, as appellants assert, the Commission expressly endeavored to “reduce the burden of compliance … while remaining faithful to the language and intent of Section 1502.” In the few circumstances where the Commission did not accept recommendations to lower costs, it determined that the recommended alternatives would undermine the scheme Congress envisioned. These conclusions were reasonable in light of the statutory language, congressional purpose, and evidence in the administrative record. And given Congress’s mandate, the Commission’s analysis was appropriate under the Administrative Procedure Act (“APA”) and the Exchange Act.

The SEC took the same position (Congress made us do it) with regard to one of the fiercely debated aspects of the Rule--its failure to include a de minimis exception.  Appellants argued that a de minimis exception was appropriate because Congress did not “expressly prohibit” it and therefore the Commission had inherent authority to create one. In its brief, the SEC argues that the language and structure of Section 1502 showed that Congress did not intend for there to be such an exception because it did not include it in Section 1502 while it did include an express de minimis threshold in an analogous reporting provision of Dodd-Frank.

With regard to the First Amendment objections raised by appellants, the SEC once again referred directly to Congressional directive, stating that the Rule

requires the “disclosure of economically significant information designed to forward ordinary regulatory purposes.” Pharm. Care Mgmt. Ass’n v. Rowe, And courts have found it “neither wise nor constitutionally required” to subject the “[i]nnumerable federal and state regulatory programs [that] require the disclosure of product and other commercial information” to “searching” First Amendment scrutiny. Nat’l Elec. Mfrs. Ass’n v. Sorrell,  And because requiring issuers to disclose the products that have not been found to be DRC conflict free is reasonably related to Congress’s goal of promoting peace and security in the DRC,  [the] Rule …survives review.

The agency noted that even if some heighted scrutiny applied, the Rule would pass muster because it “directly and materially advance a substantial government interest in a narrowly tailored manner.” R.J. Reynolds Tobacco Co. v. FDA.  In support of this argument, the SEC noted that “Congress stated explicitly that the violence in the DRC “warrant[ed]” Section 1502’s disclosure provision. “

This is simply an overview of the SEC’s arguments.  Common to all however is the bottom line position that “Congress made us do it” and that in light of congressional mandates the agency did the best it could.    Oral argument has not yet been scheduled in the appeal.  Regardless of the ultimate outcome, the case continues to highlight the problems facing disclosure regulation today.  The SEC is being asked to craft disclosure regulations under non-discretionary mandate from Congress in areas that have little to do with the agency’s core mission or competence.  The result is problematic regulations that end up tied up in extensive litigation.  Surely there is a more efficient and effective way to proceed.


Be Careful of Title Inflation: Court Extends Right to Advancement to Non-Managerial “Vice-President”

A recent case in the US District Court for the District of New Jersey is worthy of consideration given the not uncommon corporate practice of bestowing fancy titles on employees.  Many companies engage in title inflation—handing out titles that have little to do with actual job responsibilities.  They should be careful when they do so as demonstrated by Aleynikov v. Goldman Sachs Group. In that case, the court held that an individual with the job title of “vice president” was entitled to advancement of legal fees exceeding $700,000 despite Goldman’s claim that the employee’s job title was the result of title inflation and that he was simply “a midlevel computer programmer with no managerial responsibilities.”  In its opinion the court considered the import of Delaware law permitting advancement and the proper interpretation of Goldman’s by-laws. 

DGCL Section 145(e) 6 authorizes the advancement of expenses being incurred in pending proceedings. Its aim is to provide "immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings." Del. Code Ann. tit. 8, § 145(a) & (b)).  Provision for advancement is typically made in a corporation’s articles or by-laws.  In this case, the relevant provision was found in Section 6.4 of GS Group's By-laws which state:

  • The Corporation shall indemnify to the full extent permitted by law any person made or threatened to be made a party to any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that such person or such person's testator or intestate is or was a director or officer of the Corporation, is or was a director, officer, trustee, member, stockholder, partner, incorporator or liquidator of a Subsidiary of the Corporation . . . . Expenses, including attorneys' fees, incurred by any such person in defending any such action, suit or proceeding shall be paid or reimbursed by the Corporation promptly upon demand by such person and, if any such demand is made in advance of the final disposition of any such action, suit or proceeding, promptly upon receipt by the Corporation of an undertaking of such person to repay such expenses if it shall ultimately be determined that such person is not entitled to be indemnified by the Corporation. The rights provided to any person by this by-law shall be enforceable against the Corporation by such person, who shall be presumed to have relied upon it in serving or continuing to serve as a director or officer or in such other capacity as provided above.

The By-Laws define “officer” in relevant part as follows:

  • when used with respect to a Subsidiary or other enterprise that is not a corporation or is organized in a foreign jurisdiction, the term "officer" shall include in addition to any officer of such entity, any person serving in a similar capacity or as the manager of such entity. 

The case in question raised the issue of whether Sergey Aleynikov, who worked at Goldman, Sachs & Co. ("GSCo") could obtain advancement of legal fees from. Goldman Sachs Group, Inc. ("GS Group"- the parent company GSCo). GSCo. Is a New York limited liability partnership, and therefore is "a Subsidiary or other enterprise that is not a corporation" with-in the By-laws. Aleynikov claimed that because he held the title of "vice president" he was on officer under the By-Laws and hence entitled to advancement.

In the initial proceedings in the case the court stated:

  • A "vice president"—Aleynikov indisputably held that title—would ordinarily be considered an "officer" in a corporate context. In a non-corporate partnership entity like GSCo, however, "officer" and "vice president" have no fixed definition. Moreover, it does not appear that Aleynikov, a computer programmer, performed functions normally associated with the status of officer or manager. The definition of a non-corporate "officer" in GS Group's By-laws is circular and unhelpful. Aleynikov argues that I should therefore let the burden of ambiguity fall on GS Group, take the title of "vice president" at face value, and declare him eligible for advancement of fees. GS Group urges, however, that "vice president" can be something of a courtesy title in its industry. It further alleges that it has established a process of appointment that clearly distinguishes between officers and non-officers. If true, this would be highly relevant; an entity may decide whom to designate as an officer.

The court began its analysis by recognizing Delaware's strong statutory policy favoring advancement of fees and expenses which for the court suggested that the “By-Laws should be read liberally and expansively.”

In its defense, Goldman argued that established practices of GSCo. showed that GSCo had a practice of appointing its officers only by "formal resolution," and noted that there was no such resolution appointing Aleynikov. Goldman produced eleven "Written Consents of the General Partner of Goldman, Sachs & Co" which named or removed officers of GSCo.  However, Goldman did not produce any evidence that the appointment by resolution procedure for naming officers was established or documented, nor did it “explain how a reader of By-Laws Section 6.4 would know that, for a non-corporate subsidiary, specifically a New York limited liability partnership, an "officer" is, and only is, an individual who has been appointed by written resolution of the general partner.”  “Goldman thus proffers evidence of a practice, not a policy, with its roots apparently in regulatory, but anyway not indemnificatory, concerns. This evidence does not solve the definitional issue: the meaning of the term "officer" in Section 6.4 [3] of the By-Laws.”

So what about the title?  Aleynikov argued that because he held the title of "vice president" he was an officer under the "plain and commonly-understood meaning" of the term. Goldman replied that Aleynikov's job designation was simply the result of the common practice of title inflation.  “Vice president is merely a functional title, because it connotes a level of seniority between associate and managing director.”  The title is held by "thousands at the firm and across the financial services industry"' and the By-laws could not have been intended to cover so many.

While accepting the reality of title inflation, this argument failed to sway the court.   First, if the title was handed out in the “bounteous” way alleged by Goldman, it would not prevent individuals given that title in a corporate entity from being covered by the By-Laws, as the court felt it was clear that corporate vice-presidents are officers.   “So even taking Goldman's account at face value, it cannot be just the sheer number of vice presidents, or the industry's over-exuberance in bestowing the title, that bars Aleynikov’ s  position from consideration.”  “It may be the case that Goldman (or the industry of which it is a part) has been profligate in conferring the title of vice president. If so, Goldman must bear the consequences of that profligacy. Goldman might easily have chosen to be more sparing with job titles, or to confer them in some other way. It might easily have drafted its By-Laws to restrict indemnification to a well-defined class. It did not.”

The court then went on to apply “ordinary rules of contract interpretation, finding “it likely that the average person in the street would consider a vice president to be an officer.  The court noted the manner in which Delaware applies contract rules in the context of a business's bylaws or organizational agreements:

  • In general terms, corporate instruments such as charters and bylaws are interpreted in the same manner as other contracts. Absent ambiguity, their meaning is determined solely by reference to their language. To demonstrate ambiguity, a party must show that the instruments in question can be reasonably read to have two or more meanings. And "[m]erely because the thoughts of party litigants may differ relating to the meaning of stated language does not in itself establish in a legal sense that the language is ambiguous." 
  • Ordinarily, when corporate instruments are ambiguous, the court must consider the relevant extrinsic evidence in aid of identifying which of the reasonable readings was intended by the parties. There are situations, however, when this general rule is inapplicable. For example, when a court is asked to construe a limited partnership agreement drafted solely by the corporate general partner, it will resolve all ambiguities against the general partner as drafter and in favor of the reasonable expectations of the public investors.  Harrah's Entertainment, Inc. v. JCC Holding Co., 802 A.2d 294, 309-10 (Del. Ch. 2002)
  • Under Delaware law, the doctrine of contra proferentem has particular force with respect to the governing or constitutive documents of a business organization. Almost by definition, a person who joins such an organization will not have had the opportunity to negotiate the terms of such documents. "[W]here the contract in dispute is an entity's organizing document, like the Partnership Agreement, a dispositive order following motion practice may be appropriate even where the contract is ambiguous." Stockman, 2009 Del. Ch. LEXIS 131, 2009 WL 2096213 at *5 (emphasis added; interpreting an indemnification and advancement provision in a partnership agreement).
  • When an agreement . . . makes promises to parties who did not participate in negotiating the agreement, Delaware courts apply the general principle of contra proferentem, which holds that ambiguous terms should be construed against their drafter. The contra proferentem approach protects the reasonable expectations of people who join a partnership or other entity after it was formed and must rely on the face of the operating agreement to understand their rights and obligations when making the decision to join

Thus, because the By-Laws were ambiguous as the meaning of “officer” that ambiguity was resolved against the drafter—here Goldman.  The fact that Aleynikov had not read the By-Laws was irrelevant--“Goldman cannot escape from its burden as drafter by recourse to Aleynikov’ s ignorance of his rights. Whether or not Aleynikov actually read and relied on the By-Laws—and realistically, how many employees do?—he was entitled to rely on the rights granted by the By-Laws. “For these reasons, the court construed By-Laws Section 6.4[3] against its corporate drafter, Goldman, and held that the term "officer" encompassed Aleynikov's position as a vice president of GSCo. 

The case sounds a note of caution for companies that have engaged in title inflation.  Handing out fancy titles may make both employee and employer feel good, but it has lasting implications.  If a company choose to engage in the practice, it should careful consider the language in its charter documents that create rights to indemnification and advancement.  Inattention to these matters may lead, as it did in this case, to a company being forced to advance funds to an individual the company believes has stolen its property—a “galling” result indeed.


Saad v. S.E.C.: “Capital Punishment” as Sanctions Requires a Close Review by the Commission 

In Saad v. S.E.C., 718 F.3d 904 (D.C. Cir. 2013), the D.C. Circuit Court of Appeals found error with the Securities and Exchange Commission’s (the “Commission”) affirmation of a lifetime bar—the securities industry’s equivalent of capital punishment—of the petitioner as sanctions for fraudulent conduct. The D.C. Circuit remanded the case back to the Commission for a more thorough review, finding that the Commission had abused its discretion “in failing to adequately address all of the mitigating factors” in determining the appropriate sanctions.   

According to the allegations made by the Commission, John Saad was employed by Penn Mutual Life Insurance Company and was registered with Penn Mutual’s broker-dealer affiliate firm, a FINRA member-firm. In July 2006, Saad was scheduled to attend a conference in Memphis that was later cancelled. Saad instead was alleged to have checked into an Atlanta hotel and submitted falsified and forged receipts—including air travel to Memphis and a two-day hotel stay—to his employer for reimbursement. Also, on a separate occasion, Saad allegedly submitted a falsified receipt to his employer for the replacement of his business cell phone.  Saad was discharged by his employer in September 2006.

In September 2007, FINRA initiated disciplinary proceedings against Saad, alleging “conversion of funds.” A FINRA Hearing Panel found that Saad deceived his employer and FINRA investigators, and that his misconduct “constituted conversion of his employer’s funds.” As sanctions, the Hearing Panel leveled a lifetime bar against Saad’s association with any member firm in any capacity. Saad appealed to FINRA’s National Adjudicatory Counsel, and then the Commission, which both affirmed the Hearing Panel’s sanctions. Most notably, the Commission rejected Saad’s claim that circumstances existed sufficient to mitigate his misconduct—such as his discharge prior to the hearing and other personal struggles ongoing at the time of the fraud.  

Circuit courts must be highly deferential to the Commission’s decisions regarding sanctions, reviewing these decisions “to determine whether th[e] conclusions are arbitrary, capricious, or an abuse of discretion.” Despite this deferential standard, the D.C. Circuit concluded that the Commission abused its discretion in failing to consider certain mitigating factors.

The court explained, “If the Commission upholds a sanction as remedial, it must explain its reasoning in so doing; as the circumstances in a case suggesting that a sanction is excessive and inappropriately punitive become more evident, the Commission must provide a more detailed explanation linking the sanction imposed to those circumstances.” In particular, the court noted that the Commission failed to consider two key mitigating factors in confirming the lifetime bar: (1) Saad’s employer discharged him prior to FINRA’s detection of the misconduct; and (2) Saad’s personal struggles, including stress related to a hospitalized infant and a stressful work environment.

The Commission had “implicitly denied that they were [mitigating] when it stated that it denied all arguments that were inconsistent with the views expressed in the [Commission’s] decision.” The court held that this contention was “unacceptable,” explaining that when it said the Commission should address potential mitigating factors, it meant “the Commission should carefully and thoughtfully address each potentially mitigating factor supported by the record.”        

Accordingly, the court concluded that the Commission had abused its discretion because it failed to address mitigating factors properly raised by Saad. The court remanded the case back to the Commission to address “all potentially mitigating factors that might militate against a lifetime bar.” 

The primary materials for this case may be found on the DU Corporate Governance website.


SEC Release: Level Global Agrees to Pay More Than $21.5 Million to Settle SEC Insider Trading Charges

On April 29, 2013, the Securities and Exchange Commission (“SEC”) issued a press release announcing that Connecticut based hedge fund advisory firm, Level Global Investors LP (“Level”), agreed to pay over $21.5 million to settle insider trading allegations against its co-founder Anthony Chiasson, former Level analyst Spyridon "Sam" Adondakis, five investment professionals, and the hedge fund advisory firm Diamondback Capital Management.  SEC Press Release No. 2013-76, 2013 WL 1811840 (April 29, 2013).

The SEC grounded its claim on the contention that Adonakis was a member of a group of analysts that illegally obtained sensitive financial information regarding the expected earnings of Dell, Inc. and Nvidia Corp.  This information, according to the allegations, included key fundamental financial data such as revenues, profit margins, and other indicators that the companies’ quarterly results would “differ significantly from the consensus expectations of Wall Street analysts.”

During 2008 and 2009, Adonakis allegedly passed this information on to Chiasson who then used the tip to execute trades on behalf of Level’s funds.  The SEC asserted that Level continuously engaged in insider trading after gaining access to companies’ quarterly performance data.  As a result of the settlement agreement, the court required Level to return $10,082,725 of illegally obtained profits, to pay prejudgment interest of $1,348,824, and to pay a penalty fee of $10,082,725.  Additionally, the court ordered permanent enjoinment of future violations of 10(b), 10b-5, and 17(a).

Level and its members neither admitted nor denied any of the SEC’s allegations and the investigation remains ongoing. As a result of this settlement, the SEC sought to remind the industry that hedge fund managers will be held accountable when “their employees violate the securities laws.”

The primary materials for this case may be found on the DU Corporate Governance website.


SEC v. Wyly: SEC Can Seek Disgorgement Based on Measures of Unjustly Acquired Tax Benefits

In SEC v. Wyly, the Securities and Exchange Commission (“SEC”) sought disgorgement for unpaid federal income taxes against Charles Wyly and Samuel Wyly (“Wylys”), two of the four defendants in the case.  No. 10 Civ. 5760 (SAS), 2013 BL 158497 (S.D.N.Y. June 13, 2013).  The court held that if the Wylys were found liable for the fraud claims relating to the alleged misrepresentation of ownership and control of their trust entities, then the SEC would have the opportunity to make a case for disgorgement at that time.

According to the allegations, the Wylys set up overseas trusts that had the appearance of non-grantor trusts.  Non-grantor trusts have a tax rate on capital gains of essentially zero, while grantor trusts are taxed at the rate of the beneficial owner. 

The SEC asserted that the trusts were structured more like grantor trusts due to the continued exercise of dominion and control over the assets by the Wylys.  The SEC further asserted that the Wylys had misrepresented the status of the trusts, thereby achieving an unjust tax benefit.  As a result, the SEC sought disgorgement of the federal income tax that the Wylys would have paid if they had properly disclosed the beneficial ownership of the trusts.  The Wylys argued, however, that the SEC could not seek disgorgement of the amount because the Secretary of the Treasury had “exclusive authority to assess and collect taxes.”

A district court has “broad power to fashion equitable remedies” for violations of the securities laws.  SEC v. First Jersey Secs., Inc., 101 F.3d 1450, 1474 (2d Cir. 1996).  The purpose of disgorgement is to “deprive violators of their ill-gotten gains.”  Any risk in the uncertainty of calculating the disgorgement “should fall on the wrongdoer whose illegal conduct created that uncertainty.”  Concurrently, Congress has granted the Secretary of the Treasury the exclusive authority to assess and collect taxes.  The Tax Code states there is “no civil action for the collection or recovery of taxes.”  26 U.S.C. § 7401.

The Wylys argued that the SEC was foreclosed from seeking disgorgement in the form of taxes because the authority to collect taxes rests solely with the Secretary of the Treasury.  In effect, they argued that the SEC action was “the equivalent of a tax collection action”.  The court first found that the claim did not arise in a civil action seeking the recovery of taxes, but in a civil action for securities law violations.

Second, the court found that there was no prohibition on using tax benefits as a measure of unjust enrichment under the Tax Code or the Exchange Act.  Finally, the court found that there was no “express limitation on the SEC’s authority to calculate and disgorge any reasonable approximation of profits causally connected to the violation.”  As a matter of law, the court found that the SEC was not foreclosed from seeking disgorgement measured as a tax benefit.

The court also determined that the SEC had sufficiently plead a causal connection between the alleged tax benefit and the alleged securities violations.  The SEC had provided sufficient evidence from the Wylys’ records and meeting minutes that the overseas trusts were created partly for tax advantages and that the IRS might look at SEC filings to search for inconsistencies. 

The court also addressed the issue of double recovery of the alleged tax benefit by the SEC and by the IRS.  The SEC pointed out that the IRS investigated the overseas trusts and decided not to pursue tax liability against the Wylys.  The court determined that the SEC should not be precluded on the premise that the IRS might change its previous decision. 

The court held that the SEC could make a case for disgorgement, as measured by tax benefits, should the Wylys be found liable for any fraud claims. 

The primary materials for this case may be found on the DU Corporate Governance website.


Tremont Sec. Law v. Tremont Grp. Holdings: Plaintiffs Get a Chance to Amend

In Tremont Sec. Law v. Tremont Grp. Holdings, Inc., multiple Plaintiffs with similar actions against Tremont Group Holdings (“Defendants”) filed complaints to recover assets lost in the Madoff Ponzi scheme, and the complaints were consolidated before a single judge.  Master File No. 08 Civ. 11117, 2013 BL 235336 (S.D.N.Y. Sept. 3, 2013).  Defendants moved to dismiss the complaints and the Plaintiffs moved for leave to amend, requesting requested that the court stay its decision on the motion to dismiss until the Supreme Court of the United States decides the Troice cases currently before it.  The court granted the motion to dismiss with leave to amend the compliant and denied the motion to stay.

According to the complaints, various Plaintiffs invested in three of Tremont’s funds: Rye Select Broad Market Fund, the Rye Select Broad Market XL Fund, and the Rye Select Broad Market Prime Fund.  Plaintiffs alleged that Defendants falsely represented the quality of the investment strategy used by the funds and the quality of the due diligence undertaken in connection with the investments.  Plaintiffs further alleged that their investments were blindly turned over to Bernie Madoff’s Ponzi scheme, evidencing a lack of due diligence, and that Defendants’ assertions of consistent gains were false.

The Plaintiffs brought a number of state law claims including fraud, negligence, breach of fiduciary duty, breach of contract, and professional malpractice.  The Defendants moved to dismiss the case pursuant to the Securities Litigation Uniform Act (“SLUSA”).  The SLUSA “[1] bars covered collective actions, [2] brought under state law [3] that allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”

The court found the first and second element present.  All of the claims were brought under state law.  As for the requirement of a collective action, SLUSA defined the term as a single class action, a single action with more than 50 plaintiffs, or a group of lawsuits filed in the same court that have “common questions of law or fact, in which (I) damages are sought on behalf of more than 50 persons; and (II) the lawsuits are joined, consolidated, or otherwise proceeds as a single action for any purpose.”  The original actions were filed separately and none had 50 or more plaintiffs.  After the actions were consolidated, however, the action sought damages on behalf of more than 50 plaintiffs, therefore satisfying the first element.

The third element required that the action allege a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.  The court found that the state law claims “revolve[d] around allegations of misrepresentation.”  Id.  (“This court and others in this circuit routinely dismiss state-law claims like plaintiffs' claims for negligence, breach of fiduciary duty, etc. when those claims are included in a broader complaint that substantially revolves around allegations of misrepresentation.”).  Consequently, the court granted the motion to dismiss, finding the action precluded by SLUSA.

Plaintiffs moved for leave to amend the complaint to include additional factual allegations and replace state law claims with federal securities claims.  Defendants argued that Plaintiffs deliberately filed the individual actions in state court in an attempt to avoid the SLUSA’s effect and, as a result of the undue delay, should not be granted leave to resign.  Leave to amend is generally liberally granted at the early stages of litigation; however, it may “only be given when factors such as undue delay or undue prejudice to the opposing party are absent.”  The court found that there was no evidence that the original pre-consolidation filings were made in bad faith and, as a result, denial of leave to amend would be too harsh a result. 

The court denied the Plaintiffs’ motion to stay because the Supreme Court decision was not likely to be forthcoming. 

The primary materials for this case may be found on the DU Corporate Governance website.



Lackluster Law Reviews and the Changing Landscape of Legal Scholarship

Adam Liptak's article in the NYT about the decline in law review covers some familiar ground for anyone who has been teaching in a law school. Faculty are at the mercy of untrained students. Articles are often excessively long and too dense. Some faculty latch onto a good idea and then promptly repeat it over and over in successive articles.

But beyond rehashing old ground, the article really did a disservice to the universe of legal scholarship.  A description that empasized hard copy law review articles and law review placement may have been accurate 20 years ago. But today, the landscape has changed. For one thing, there are legal blogs that get ideas out quickly and efficiently. They are being cited more and more often. See Essay: Law Faculty Blogs and Disruptive Innovation (noting that as of June 2012, law blogs had been cited in at least 88 legal opinions and more than 6,340 citations in assorted law reviews and other legal publications).

Second, there are online supplements to law reviews that publish shorter and more timely pieces. Admittedly, many of these supplements are struggling to attract high quality submissions. Nonetheless, they provide a forum for shorter pieces designed to be published quickly and, often, to affect an ongoing debate. At the University of Denver, the law review published an entire edition on the JOBS Act, recent legislation adopted in the securities area. The papers were all written by students under very tight supervision (on my part). The scholarship was short, direct and useful.

Third, there is SSRN. Sometimes it seems as if the tyranny of the student selection process has only been replaced by the perfidy of the download count. Nonetheless, as a practical matter, the easy availability of papers on SSRN to some degree reduces the importance of the student selection process. Substitutes for quality such as the reputation of the particular review (often really the reputation of the particular law school) that published an article are less important when quality can be judged first hand by downloading the piece on SSRN.

Fourth, whatever the criticism, amicus brief writing by faculty seems to be far more common. Faculty are in a position to write something that less resembles a polemic and more resembles an explanation. Particularly in the business area, law clerks at the Supreme Court are often unversed in such areas as the federal securities laws.  An amicus brief from faculty has the ability to influence the outcome, either by convincing the justices or by preventing some interpretive mistakes in the final opinion, whatever the outcome.

A thousand flowers are blooming in the realm of legal scholarship, compensating for many of the problems associated with traditional law reviews. The real problem is that the reward system at law schools still functions as if the law review article and the law review placement process constituted the sole judge of a faculty member's intellectual contribution. It remains sage advice to any untenured faculty member to stay away from blogging (at least if it reduces the time available for traditional law review articles). Pieces published in online supplements of law reviews are subject to an "online discount." See Essay: Law Faculty Blogs and Disruptive Innovation at 541. As a result, some faculty who would be better off blogging or writing shorter online pieces are forced into the straitjacket of traditional articles.

The problem, therefore, is not legal scholarship. The problem is the hidebound views within the academy that act as if the Internet had never arrived and hard copy law review articles remained the only coin of the realm.


Alonso v. Weiss: Claim for Fraudulent, Deceptive, or Manipulative Act by a Registered Investment Advisor Dismissed for Failure to State a Claim

In Alonso v. Weiss, No. 12 C 7373, 2013 WL 3810896 (N.D. Ill, July 22, 2013), the United States District Court for the Northern District of Illinois dismissed Plaintiff’s claim due to the expiration of the statute of limitations.

Plaintiffs, limited partners in various investment funds managed by the Nutmeg Group, LLC (“Nutmeg”), brought suit against Leslie J. Weiss, Barnes & Thornburg, LLP, and Nutmeg (collectively “Defendants”). According to the allegations, Nutmeg, a registered investment advisor (“IA”), was the sole general partner of the funds.   The funds, among other things, invested in private investments in public equity transactions (“PIPE”).  In this case, the PIPEs involved convertible debentures that could be converted into common stock. 

In 2009, the Securities and Exchange Commission ("SEC") brought an action against Nutmeg and sought the appointment of a receiver. The court appointed Weiss. Plaintiffs brought an action under the Investment Advisor’s Act alleging that Weiss failed to distribute quarterly statements seeking rescission of the advisory agreements between Nutmeg and the funds.  

Section 206(4) of the Investment Advisers Act prohibits an adviser from engaging in “any act, practice, or course of business which is fraudulent, deceptive, or manipulative.” 15 U.S.C. § 80b-6(4).  The Section does not, however, require evidence of “fraudulent intent.”  Rule 206(4)-2, adopted pursuant to that Section, specifically define an IA’s failure to disseminate quarterly accounts as a fraudulent, deceptive, or manipulative act. 

Defendants argued that the claim should be dismissed because the statute of limitation had expired. The IAA required that cases be bought within the earlier of one year from discovery of the violation or three years from the violation. Plaintiffs, however, argued that the court was required to look to the limitations period contained in Sarbanes-Oxley (“SOX”).  SOX provided a limitation period of the earlier of two years from the discovery of a violation or five years from the occurrence of the violation. The statute applied to actions involving “a claim of fraud, deceit, manipulation, or contrivance.” 28 U.S.C. § 1658(b).

The court concluded that the limitations period in the IAA controlled. SOX required a claim of fraud, deceit, or manipulation. The claim under Section 206, however, did not. SOX did not apply “to claims under the securities laws that [did] not require any showing of fraudulent intent.”  Nor did the legislative history alter this result. The court noted that had Congress wished to extend the limitation period for every private securities action, it could have explicitly done so.

The primary materials may be found on the DU's Corporate Governance Site


Real Time Disclosure and the Future of the Securities Laws

The WSJ published an article that discussed a movement toward real time disclosure of economic data.  The article noted that, in an era of Iphones and apps, the reporting of world economic data may "be headed for a substantial revision."  The article discussed a company that had 

  • deployed 700 smartphone-equipped workers across 25 cities to capture images of products as their prices change daily. Software automatically tags the location of the products down to the individual store and analyzes the images—items such as meat and produce—to gauge quality differences. A user viewing the information can zoom in on images of the products at each retail location, making it a store-shelf version of Google Street View.

In effect, the process promised to provide inflation related data daily, sidestepping the need to wait for the monthly report from the government.  Moreover, the approach meant that the data could be obtained on a real time basis, rather than a dated snapshop provided by the government.    

The effort to make economic data real time is really an effort to provide markets with a greater quantity of raw data on a much quicker basis.  The market, rather than the government, can draw its own conclusions and can do so at the most efficient frequency.  Much of this is made possible by technology, both the improved technical performance of the relevant hardware and the increased ability of software to perform complex functions.  

Corporate disclosure is subject to many of the same limitations that apply to government distribution of economic data.  Companies do not disclose information on a real time basis.  Moreover, information is disclosed after the quarter closes, a snapshot that is already out of date when revealed.  

The movement toward real time reporting of economic data suggests that pressure will eventually build for quicker disclosure of corporate information, particularly the underlying raw data.  Admittedly, there would be huge problems to resolve before this could occur, including liability, the need to make corrections, and the use of the information by competitors.  

One way to begin the approach, however, would be to require increased disclosure on a real time basis of specified types of information during the interim between periodic reports.  The Commission has the authority to require this type of disclosure.  In a seldom mentioned or used provision, SOX amended Section 13 of the Exchange Act to provide:   

  • (l) REAL TIME ISSUER DISCLOSURES- Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations, as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest. 

The provision, therefore, provides a statutory basis for real time disclosure.  There is no real movement for this to occur.  Nonetheless, as more and more raw data in other areas becomes available to the market on a real time basis, corporate disclosure may well change in order to keep pace.  When that occurs, the Commission has the authority to make it happen.  


SEC Chairman Voices Concern About Information Overload

At a speech given on October 15th at the National Association of Corporate Directors Board Leadership Conference SEC Chairman Mary Jo White expanded on her remarks in an earlier talk and voiced concern about “information overload.” –the problem of too much disclosure reducing the overall efficacy of the disclosure regime.  Chairman White said the SEC will review corporate disclosure rules to determine if investors are benefiting from the proliferation of information currently required to be disclosed.

While careful to note that investors benefit from disclosure, Chairman White stated

“I am raising the question ... as to whether investors need and are optimally served by the detailed and lengthy disclosures about all of the topics that companies currently provide in the reports they are required to prepare and file with us….We must continuously consider whether information overload is occurring as rules proliferate and as we contemplate what should and should not be required to be disclosed going forward."

“I’m not suggesting investors haven’t benefitted from this information—much, if not all, of it could be relevant and necessary, even though some insist investors don’t take advantage of it.  I am asking if investors need and are served by the detailed disclosures companies currently provide to the SEC. It can lead to info overload.”

Part of the impetus for this review stems from Section 108 of the JOBS Act which requires the SEC to review current disclosure requirements and consider how to simplify and update them for emerging growth companies. Chairman White indicated that “before we can move to improvements, we need to know why we have the information we have in disclosure today.”

White noted that the rise of the Internet and social media has rendered some disclosures essentially meaningless.  Investors no longer turn to filed reports to discover such information as dilution or historical share prices for example because such information is instantly available elsewhere.  In addition, investor pressure over the years has led to more voluntary issuer disclosure because companies want to avoid potential litigation. 

She also suggested that disclosure could be more carefully tailored to the industry in which a particular issuer operates, suggesting that the specialized Industry Guides covering issuers in the oil and gas, mining and bank holding fields need revision to accommodate changes in those industries over time.  In addition she noted the increased internationalization of many industries and questioned whether international disclosure standards should be used as models for SEC requirements.

Reaction to the speech from organizations representing companies and institutional investors was largely positive.  "Chair White's panoramic approach to disclosure overload makes sense," said Amy Borrus, a deputy director at the Council of Institutional Investors. "Longer isn't necessarily better. Plain-English, well-organized discussions that highlight key facts and areas of interest concisely are more valuable—to companies and their shareowners—than a jargon-laced data-dump."  In a similar vein, Tom Quaadman, a vice president at the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, said "We have seen a constant creation of disclosures, some of which may be irrelevant and immaterial to the needs of users," he said. "This has created an overload that has disenfranchised retail shareholders and forced investors to sort through the clutter at their own peril."

Chairman White’s comments are a welcome addition to the voices arguing that the SEC is drowning in disclosure.  However, she could have gone further.  It is interesting to note that she did not elaborate in her speech on the expanding use of SEC disclosure to advance political and social goals that stray far from the core mission of the SEC.  She did allude to this concern, stating that “When disclosure gets to be “too much” or strays from its core purpose, it could lead to what some have called “information overload” – a phenomenon in which ever-increasing amounts of disclosure make it difficult for an investor to wade through the volume of information she receives to ferret out the information that is most relevant.”  She did not mention specifically matters that past blogs on this site have focused on –specifically, the conflict minerals rule and the resource extractive industries regulations.  Each of those rules were implement by the SEC because of Congressional mandate—despite agency reluctance and the fact that neither is related to the core mission of the SEC. 

The SEC does not have the option to disregard Congressional mandate and must implement whatever rules it is legally directed to.   That does not mean the disclosure is necessary or effective; it simply means that it has to be done.  Chairman White’s recent speeches show the need to think more carefully about the manner in which SEC disclosure regulation is used.  We can only hope that the agency (and Congress) will work to simplify and streamline the process.   No one is suggesting that disclosure is not a net good.  But it must be used effectively to permit that good to be realized.


The SEC and Interactive Data: An Example in Practice

The SEC's Investment Advisory Committee (where I serve as Secretary) adopted a resolution recommending that the Commission "adopt a 'Culture of Smart Disclosure' that promotes the collection, standardization, and retrieval of data filed with the SEC using machine-readable data tagging formats."  Tagged data can be analyzed in a more comprehensive fashion through the use of software.  The resolution is here

Currently, the Commission requires data to be submitted in an interactive format in a few narrow instances.  One of them happens to be the Form D that is required to be filed in connection with offerings under Regulation D.  See Rule 503 of Regulation D, 17 CFR 230.503.  Moreover, the Commission has facilitated this approach by providing an online version of the form that automatically converts to an interactive format when filed.

As a result, the information provided in all Form Ds can be analyzed in a broad and cost effective manner.  This can be seen from some of the analysis that the SEC provided in connection with recent reforms of Regulation D.  The recent proposal calling for changes to Regulation D contained considerable empirical analysis of the companies using the Regulation and the amount of capital raised.  See Exchange Act Release No. 69960 (July 10, 2013). 

The proposal was also accompanied by a study conducted by employees of the Division of Economic and Risk Analysis that examined the attributes of offerings under Regulation D (breaking down the offerings by the type of issuer so that data can be examined for both operating companies and investment pools such as hedge funds).  The data provided by DERA was only possible because the Form D was filed using an interactive format.  As the Proposing Release noted:

  • Until 2008, however, issuers made Form D filings in paper format, making the extraction of information for large-scale statistical analysis problematic. In 2008, we adopted rule and formamendments that mandated the electronic filing of Form D on the Commission’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) system in a structured format.  As a result of these amendments, which were phased in from September 2008 to March 2009, Form D filings are now machine-readable, and the Commission, its staff, other securities regulators and the public at large now have a greater ability to analyze the Regulation D offering market through the information supplied in electronic Form D filings.

To provide a sense of magnitude, data not using an interactive format must be studied and analyzed one filing at a time.  Had DERA been forced to use this method, the task would have been overwhelming.  DERA relied on data from 2009 to 2012.  This entailed an examination of 110,000 filings under Regulation D (see Table 2 of the DERA Study), including filings for approximately 67,000 new offerings (see table 6b of the DERA Study).  The fact that the data was filed in an interactive format is what made this possible.

More documents should be filed with the Commission in an interactive format.  Moroever, as the Form D shows, the Commission can faciliate this through online forms.  The resolution of the IAC specifically recommended that some of the information in proxy statements (executive compensation and shareholder proposals) along with mutual fund voting information be tagged.  But those specific examples are only a beginning.  As the analysis of Regulation D shows, data filed in an interactive format can provide considerable insight and be used to drive regulatory policy in a cost effective fashion. 


Bartesch v. Cook: Securities Fraud Complaint Dismissed; Court Declines to Adopt “Materialization of Risk” Test for Loss Causation

In Bartesch v. Cook, No. 11-1173-RGA, 2013 BL 107722 (D. Del. Apr. 23, 2013), the United States District Court for the District of Delaware dismissed a securities fraud complaint for failure  to adequately plead materiality and scienter under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). Additionally, the court specifically declined to adopt a “materialization of risk” test for loss causation.

According to the complaint, Raser, an energy company, went operational in April 2009 with its first geothermal power plant developed using a new “rapid deployment” strategy. Although Raser's Q1 2009 10-Q stated that the “rapid deployment” strategy was successful, a later statement announced that the power plant would likely never achieve intended energy production. The company took a $52.5 million impairment on the asset. Later the same year, Raser recognized a further write-down of the power plant. In April 2011, the company filed for Chapter 11 bankruptcy protection. 

Plaintiffs claimed Raser’s SEC filings were false and misleading in violation of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). Plaintiffs asserted that Defendants, former officers and directors of Raser, failed to disclose problems caused by the “rapid deployment” system, lacked any reasonable basis for optimistic statements regarding future production of the power plant, and did not recognize an impairment of the power plant asset in a timely manner.

Section 10(b) of the Exchange Act requires a plaintiff to establish a material misrepresentation that was the cause of the economic loss, as well as scienter, or a wrongful state of mind. Under the heightened pleading standards of the PSLRA, forward-looking statements are protected from liability if they are accompanied by “meaningful cautionary language.” 

Plaintiffs pointed to allegedly false statements indicating that Defendants believed Raser had "demonstrated" the ability "to quickly develop geothermal power projects using our rapid deployment business model."  Defendants, according to Plaintiffs, knew or were reckless in not knowing that the statement was false because the "rapid deployment business model" was a "failure."   The court noted, however, that Raser's SEC filings “disclosed the issues it faced during the development and launch” and had cautioned that “it could not be certain any of those efforts would ‘allow [it] to operate the Thermo No. 1 plant at full capacity.’”  As a result, the statements were not false when considered in light of the total mix of available information.     

Plaintiffs further argued that Defendants’ stated production expectations for the power plant were baseless, and therefore false and misleading. The court held that these statements fell under the PSLRA’s safe harbor because of accompanying cautionary language included in the “Risk Factors” section of Raser’s SEC filings. The “Risk Factors” specifically addressed Raser’s ability to operate the power plant at full capacity and to successfully develop additional power plants. 

The court also held that Plaintiffs did not sufficiently plead scienter under the PSLRA. Plaintiffs failed to allege any knowledge by Defendants of the falsity of  any statement by the company or any personal benefit by the individual Defendants that could be used to infer motive. With respect to the individual Defendants, it was insufficient to show their role in the alleged fraud solely through reference to their position at Raser or their role as signers of Raser’s SEC filings or Sarbanes-Oxley certification.  Likewise, fraud liability could not extend to anyone who was not an officer or director “at the time of the challenged statement because they would not have had the required ‘ultimate authority over the statement, including its content and whether and how to communicate it.’”

With respect to loss causation, the court declined to adopt the “materialization of risk” test. The test allows loss causation to be plead by demonstrating that the defendant exposed the plaintiff to a previously undisclosed risk which subsequently “materialized.” The court, however, determined that the third circuit had not adopted this test and, as a result, plaintiffs were required to allege a corrective disclosure that exposed the fraud.

Nor had Plaintiffs sufficiently alleged corrective disclosure. As the court reasoned, over 98% of the decline in Raser's stock price during the class period occurred before the first impairment charge was taken. Thus, the purported corrective disclosure could not have been a substantial factor in causing any class member's alleged damages.

Therefore, because the Plaintiffs failed to meet the heightened PSLRA pleading standards and the allegedly misleading statements included in Raser’s SEC filings were accompanied by cautionary language, the court granted Defendants’ motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.


SEC Press Release: UBS to Pay $50 Million to Settle SEC Charges of Misleading CDO Investors

On August 6, 2013, the Securities and Exchange Commission ("SEC") brought an administrative proceeding against UBS Securities for violations of Section 17(a)(2) and 17(a)(3) of the Securities Act of 1933 ("Securities Act"). 15 USC 77q(a)(1) & (2). The alleged violation occurred during the structuring of a collateralized debt obligation ("CDO") when UBS failed to disclose that it retained millions of dollars in upfront cash obtained as a result of the acquisition of collateral for the CDO. The Press Release is here:

According to the Press Release, UBS structured a CDO that consisted of credit default swaps ("CDS") on subprime residential mortgage backed securities (RMBS). “The CDS essentially operated as a kind of insurance against certain defaults in the underlying RMBS.” In acquiring the CDS, the collateral manager received upfront payments of $23.6 million. The payments resembled “‘points’ like those on a mortgage." UBS, according to the Commission, retained the payments. 

Marketing materials disclosed that UBS had received a $10.8 million fee but did not otherwise disclose the upfront payments. The SEC asserted that the practice resulted in a disclosure violation. As the press release stated:

  • Not only did UBS go on to market the deal using materials that omitted any reference to its retention of the upfront payments, but the materials inaccurately represented that the CDO had to acquire all collateral at either fair market value or the price it was acquired by UBS. This representation was inaccurate because the CDO did not receive the $23.6 million in upfront cash kept by UBS as an additional undisclosed fee, and the collateral was not acquired at fair market value.

The primary materials for this case may be found on the DU Corporate Governance website.



SEC Chair Voices Doubts on Conflict Minerals Rules

Previous posts have discussed in detail the conflict minerals rule promulgated by the SEC in order to implement Section 1502 of Dodd-Frank.  I noted in those posts that the SEC did not want to take on the task of crafting disclosure regulations aimed at ended conflict in the DRC, not because it in anyway disagreed with the aim of the regulations but because it questioned whether the SEC is the appropriate body to be tasked with that mission.  At the time the rule was under consideration then SEC Chair Mary Shapiro acknowledged that the Commission lacked expertise on the mining of conflict minerals and the disclosure matters mandated by the statute. 

Now Chair Mary Jo White is sounding the same note.  In a speech at Fordham the Chairwomen contrasted the method of implementation of the conflict minerals provision with an attempt in the 1970’s by the SEC to implement a Congressional mandate that federal agencies consider environmental values as part of their regulatory missions.  The SEC responded by requiring certain environmental disclosures by way of a lengthy implementation process.  What is critical is that thought the process the SEC  maintained flexibility to respond to comments and concerns because the Congressional directive  the SEC was acting under left discretion to the SEC to act creatively and in a manner it felt best accomplished the statute’s general goal.  In contrast, according to Chairwoman White Section 1502 of Dodd-Frank was “quite prescriptive, essentially leaving no room for the SEC to exercise its independent expertise and judgment in deciding whether or not to make the specified mandated disclosures.”

In addition to noting the lack of flexibility recent Congressional mandates have afforded the SEC, Chair White voiced a broader concern that this author and many others have long been stating.  She recognizes that the SEC cannot ignore statutory mandates directing the agency to engage in rule-making. 

As a prosecutor, I recognize that when Congress and the President enact a statute mandating such a rule, neither I nor the Commission has the right to just say “no.”  We cannot say that a law does not comport with our mission as we see it, and ignore a Congressional mandate.  We cannot put it in a drawer or tuck it away.  That would be impermissible nullification of the law and independence run amok. 

However, she questions the wisdom of placing such a responsibility on the shoulders of the SEC, noting that the Congressional mandate in regard to conflict minerals seems

“more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.

That is not to say that the goals of such mandates are not laudable.  Indeed, most are.  Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share.

But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.  

I could not agree more.  The SEC is being charged with ever expanding disclosure regulation obligations, some of which relate closely to the stated mission of the agency and seem logical for the agency to take on.  Others, like conflict minerals as well as others, have little to do with the core mission and would be better handled by other entities.  More disclosure is not the answer to all societal problems—instead, as noted by former SEC Commissioner Troy Paredes, it can lead to information overload and investor ennui.  Congress should be more thoughtful when considering disclosure as a panacea and if it concludes that disclosure is the answer, should more carefully allocate responsibility for it.


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Empirical Evidence)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

In this post, we bring the discussion full circle.  The first post noted the data cited by the Chair showing the decline in the purchase of equity securities by middle income families.  Encouraging the return of these families to the market likely will depend at least in part upon an approach to regulation that is designed to provide small investors with greater confidence in the markets.

One of the structural concerns that has long existed with respect to the stock exchanges is the problem of enforcement.  (Concerns over enforcement by the exchanges are discussed in the legislative history to the Exchange Act).  Only the exchanges enforce listing standards.  Shareholders, according to the current state of the law, lack a right to bring an action for violations of listing standards.  Moreover, the exchanges have the authority to exempt companies from listing standards that are designed to protect shareholders.  The system for doing so is not transparent.  For posts on the issue, go here and here.

Finally, it is clear that there is at least some issuer confusion over the listing standards, something that can lead to non-uniform interpretations.  Take as an example the standard for independent directors.  Under the rules of the NYSE, directors are not independent if they have a "material" relationship with the company.  The determination of "material" is, however, left to the board.  In the recent debate over the changes to the listing standards for compensation committees, arguments were made that the NYSE should adopt a more explicit definition of director independence, including an explicit requirements that boards consider personal and business relationships with executive officers.

The NYSE declined, concluding that the requirement to consider "material" relationships already encompassed the requirement.  As the NYSE reasoned:

  • Brown, the AFL-CIO, IBT and CII all argue that relationships between the director and the senior executives of the listed company should be included as an explicit factor for consideration in compensation committee independence determinations. The NYSE Exchanges note that the existing independence standards of the NYSE Exchanges all require the board to make an affirmative determination that there is no material relationship between the director and the company which would affect the director’s independence. Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary.

In approving the final listing standards, the Commission declined to make the exchanges add personal relationships as an explicit consideration.  Nonetheless, the release indicated the SEC's view that the relationships should be considered.  As the adopting release noted

  • in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence.

The statement is useful but buried in an isolated release.  Anyone examining the listing standards will not see an explicit command to consider personal relationships.  Moreover, since directors typically receive questionnaires that are based upon the explicit language of the rule, they may not even be asked about their personal relationships.  As a result, boards considering whether a director has a "material" personal relationship may not even know about the relationships.

Moreover, even if boards consider these relationships, there is no meaningful guidance in the listing standards on the determination of the materiality of the relationships.  Thus, it is likely that boards use  very different standards in considering the issue.  Investor cannot, therefore, be sure that boards, in determining independence, screen for all material relationships or apply uniform standards.  This diminishes investor confidence in the securities markets.

In considering a restructuring of the markets, therefore, thought must be given to the role of the exchanges in the governance process.  Thought should likewise be given to the enforcement mechanisms for listing standards.  Listing standards benefit investors but only if they impose meaningful standards and are adequately enforced.  


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Exchange Regulation and Self-Regulatory Model)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

The Chair indicated in her speech that traditional assumptions about market structure needed to be tested.  They included a reexamination of self regulation ("Does the current approach to self-regulation limit or support exchange trading models?") and the balance between regulatory and profit making functions.  As she noted: 

  • This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

We have written extensively about the role of exchanges on this Blog.  When the NYSE became a for profit company, there was concern about the ability of the exchange to adequately perform its traditional regulatory function.  The NYSE addressed the concerns by forming a non-profit (NYSE Regulation) with an independent board (although some of the independent directors could be from the holding company) to perform regulatory functions. 

Concerns always existed about whether this model would adequately insulate the regulatory function from the for profit motives of the holding company.  Moreover, the holding company retained some degree of influence both as a result of interlocking directors and because the holding company provided the financing for the regulatory subsidiary (the holding company has committed to providing "adequate funding" to NYSE Regulation but has not made the funding agreement public). 

While the formation of NYSE Regulation allowed the NYSE to hold onto its regulatory function, notwithstanding the conversion to a for profit company, the desire for profit maximization appears to have had an unexpected impact.  The NYSE began to shear off significant parts of its regulatory functions.  Broker-dealer oversight for the most part went to FINRA (as part of the merger with the NASD).  Market surveillance likewise went to FINRA.  A post on this phenomena is here.  To the extent that regulatory functions were consistent with maximizing profits, the exchanges presumably would have retained them. 

The costs associated with regulation must, of course, be weighed against the benefits.  Regulatory functions provide at least two benefits.  First, there is immunity from lawsuits arising out of the regulatory function.  Nasdaq is seeking to dismiss claims arising out of the Facebook IPO on the basis of immunity.  At the same time, however, the doctrine is likely to decline in importance.  As the Weissman case out of the 11th Circuit shows, courts are more likely to view actions by "for profit" exchanges as commercial and not regulatory.  Those actions are not protected from immunity. 

Second, exchanges may view the ability to set the regulatory agenda and determine the degree of enforcement as a competitive advantage.  Listing standards are currently determined by the exchanges.  They may prefer to set and enforce these standards rather than turn them over to regulators.  The issue may, however, become moot.  Congress is increasingly shifting to the Commission the authority to directly regulate listing standards, something that has occurred with respect to audit committees (see Rule 10a-3, 17 CFR 240.10a-3) and compensation committees.  See Rule 10c-1, 17 CFR 240.10c-1.     

The actions of the exchanges, therefore, suggest a growing realization that the costs associated with the regulatory function outweigh the benefits.  As the residual regulatory functions generate increased costs and headaches (take for example the $10 million penalty paid by Nasdaq for the problems associated with the Facebook IPO), the temptation will exist for the exchanges to seek to entirely abandon the role.


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (For Profit Status and the Need for Resilience)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets.

With respect to operational integrity, the Chair pointed out that "the U.S. equity and options markets have experienced a spate of events that call into question whether the markets have achieved the right balance." The exchanges have been having a tough time of things with respect to technology.

Nasdaq incurred technological problems in connection with the Facebook IPO. Technological problems also apparently interrupted trading for several hours at Nasdaq in August. The Chair has encouraged the exchanges to "improve the resilience" of their technology. As she stated:

  • I met with executives of the exchanges last month and challenged them to together develop and implement the necessary steps to improve the resilience of the technology surrounding critical market infrastructures. In short order, we expect to receive comprehensive action plans that address the standards necessary to establish highly resilient and robust systems for securities information processors.

The unaddressed issue is the relationship between the "resilience" sought by regulators and the "resilience" provided by for profit companies.  Certainly regulators prefer the technology used in secondary trading to be sufficiently resilient so as to avoid all failures.  For profit companies, however, likely make a different calculus.  Profit maximization entails a balance that takes into account both the need for resilience and the alternative use of the funds.  The result may well be a level of resilience that is less than what regulators prefer.   

Add in that the stock exchanges, in conducting a profit maximizing analysis, may have less incentive than traditional "for profit companies" to devote funding to resilience.  For profit companies must take take into account the consequences of inadequate resilience.  One of the consequences is the risk of liability that can arise out of private law suits.  The potential for liability in turn provides an incentive to increase the resilience of the technology. 

Yet as we have noted on this Blog, exchanges have immunity when performing their regulatory function.  Indeed, one of the critical cases reaffirming the right to immunity by the exchanges was written by then Judge, now Justice, Sotymayor.  Immunity provides a mechanism for extinguishing private suits that allege damages based upon the regulatory function of the exchange. 

The defense of immunity has, for example, arisen in the litigation against Nasdaq over the Facebook IPO. The exchange asserts that the suits are barred by immunity.  See REPLY MEMORANDUM IN FURTHER SUPPORT OF DEFENDANTS’ MOTION TO DISMISS THE CONSOLIDATED AMENDED CLASS ACTION COMPLAINT, In re Facebook IPO Secur. Litigation, Sept. 26, 2013, at 1 ("In this action, plaintiffs seek to recover losses they claim to have sustained as a result of systems issues NASDAQ encountered in the execution of one of its core regulatory functions as a national securities exchange – the commencement of trading in a listed security following an IPO. The doctrine of SRO immunity bars such claims, whether fashioned as negligence claims or securities fraud claims."). 

Of course, in fairness, the problems with the Facebook IPO have cost Nasdaq a significant amount.  The exchange has paid $10 million to the SEC and set up an "accommodation policy" for claims "arising from system difficulties that Nasdaq experienced during the initial public offering ("IPO") of Facebook, Inc."  Exchange Act Release No. 67507 (July 26, 2012).  Plaintiffs in the IPO Litigation state that Nasdaq has agreed to pay up to $62 million as part of the Accommodation Proposal. 

All of this suggests there may be a permanent misalignment between the interests of regulators and the interests of for profit stock exchanges.  It raises the issue, which has surfaced periodically, about whether regulatory functions and for profit status are compatible.  The issue should be weighed as the SEC considers structural reforms to the market. 



The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (Empirical Evidence and Data Tagging)

We are discussing the speech given by the Chair of the SEC on structural reform of the securities markets. 

As the Chair noted, the fundamentals of market activities have changed dramatically in recent years.  The changes include:

  • High-frequency trading in firms that "represent more than half of all trading volume."
  • "Dark" venues "which now appear to execute more than half of the orders of long-term investors."

As markets become more complex, "so to has the complexity of the 'diagnoses' offered and the 'solutions' proffered."  Nonetheless, she called for a "focus on fundamentals."  The fundamentals?

  • Technology matters (aka the need for operational integrity).
  • Assumptions about market structure should be identified and tested
  • Decisions, to the extent possible, should be based upon "empirical evidence." 

The need for empirical evidence in restructuring the market is critical.  As the Chair noted:  "For our part, we are engaging in a wide-ranging effort to seek out better sources of data to better assess today’s complex markets."  The only mention in the speech, however, was data obtained from "MIDAS, the market information and data analysis system that the SEC staff began operating in January." 

Omitted, however, was the vast amount of data that could be mined from filings made with the SEC.  To do so, the information will have to become more easily accessible, particularly through software tools that facilitate recovery and analysis. 

In this regard, the Investor Advisory Committee has recommended that the Commission:

  • "adopt a 'Culture of Smart Disclosure' that promotes the collection, standardization, and retrieval of data filed with the SEC using machine-readable data tagging formats" and implement the culture by "Requiring each operating division within the SEC to integrate data tagging into all future rulemaking and rule revision efforts that involve the collection of data by the SEC".  

As the resolution observed:

  • Data tagging will enable investors, regulators, and other capital market participants to
    retrieve information in a cost effective and highly usable fashion. It will facilitate the SEC’s
    ability to monitor securities markets and assess the costs and benefits of regulatory practices.  Tagging can also facilitate investor participation in the governance process. As the SEC’s Proxy Plumbing Release stated: “If issuers provided reportable items in interactive data format, shareholders may be able to more easily obtain specific information about issuers, compare  information across different issuers, and observe how issuer-specific information changes over time as the same issuer continues to file in an interactive data format.”

Market restructuring requires empirical data.  Data tagging would facilitate the recovery of the type of data needed to determine policy outcomes in this area. 


The SEC and Structural Reform to the Securities Markets: The Role of the Stock Exchanges (The Disappearing Households)

The regulatory agenda of the new Chair of the SEC is gradually taking shape.   Her most recent indication of a possible direction was a speech given before the Security Traders 80th Annual Market Structure Conference in Washington, DC. on October 2.  Appropriately enough, the Chair spoke about possible changes in market structure. 

Chairman White noted the importance of the secondary markets in the US but included some sobering statistics.  The number of listed companies had fallen from 8000 in 1997 to 4900 in 2013.  Moreover, the number of households with equity participation reached a high of 65% in 2007 but has "since declined each year, despite the general rise in equity price levels."  A footnote in the speech indicates that the current percentage of households with equity investments is 52%.

A more complete review of the data on household ownership demonstrates some uncomfortable trends.  The data cited in the footnotetracks reponses to this question:

  • Do you, personally, or jointly with a spouse, have any money invested in the stock market right now – either in an individual stock, a stock mutual fund, or in a self-directed 401-K or IRA?

The data shows that the percentage answering affirmatively throughout the first decade of the new millenium was almost always above 60%.  Since 2010, however, the percentage has been consistenly below 60%, hitting a fifteen year low in 2012 (53%) and 2013 (52%).  In other words, the percentage of equity ownership by household has dropped precipitously.  Moreover, as might be expected, the drop has been particularly severe in middle income families.  From 2008 to 2013, the income bracket of $30,000 to $74,999 has seen a 16% drop.   

The data at least suggests that ordinary investors are increasingly fleeing the market.  The phenomena requires examination.  While the drop in the market represents an explanation for some of the decline, it is likely not a complete explanation.  For one thing, investors did not flee in the same percentages during the dot com collapse.  

In considering a restructuring of the market, a search should be undertaken for an explanation for the departure of middle class families.  Once uncovered, that should factor into any plan by the Commission to restructure the market.  These goals may well differ from those applicable to other types of investors in the market place. 

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