Credit Risk Retention Rules Proposed. The SEC proposed rules to implement the credit risk retention requirements of Exchange Act Section 15G, which was added by Section 941 of the Dodd-Frank Act. The proposal would provide sponsors with options for meeting the five percent risk retention requirement. It would permit a 100 percent guarantee of principal and interest provided by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation to satisfy their risk retention obligations for the mortgage-backed securities they guarantee as long as they are in conservatorship or receivership with capital support from the United States. The proposal seeks to ensure that the amount of credit risk that is retained is meaningful while reducing the negative effect on the availability and cost of credit to consumers and businesses. The SEC, the Federal Reserve Board, OCC, FDIC, FHFA and HUD are authorized to adopt rules in specific areas under Section 15G, but will jointly approve any written interpretations, responses to requests for no-action letters and legal opinions, or other written interpretive guidance. Release No. 34-64148 is reported at ¶89,412.

 

SEC Proposes New Compensation Committees Listing Standards and Incentive Compensation Rules. The SEC proposed rules that would direct exchanges to adopt listing standards relating to the independence of members on a compensation committee, the committee's authority to retain compensation advisers and the committee's responsibility for the appointment, payment and work of any compensation adviser. The proposal would implement Section 952 of the Dodd-Frank Act. Once the rules are in effect, a listed company must meet the standards in order for its shares to continue to trade on that exchange. The SEC's proposal would require exchanges to adopt listing standards to require that each member of a company's compensation committee be a member of the board of directors and be independent. In determining a director's independence, the exchanges must consider factors such as the sources of the director's compensation, including any consulting, advisory or compensatory fee paid by the company. The exchanges must also consider whether a member of the board is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company. The proposal would eliminate the current disclosure exception for services that are limited to consulting on broad-based plans and the provision of non-customized benchmark data, but would retain the fee disclosure requirements along with the exemptions from those requirements. The SEC also proposed a rule jointly with the OCC, Federal Reserve Board, FDIC, OTS, NCUA, and FHFA  to implement Dodd-Frank Act Section 956. The proposed rule would require the reporting of incentive-based compensation arrangements by a covered financial institution and prohibit incentive-based compensation arrangements at a covered financial institution that provide excessive compensation or that could expose the institution to inappropriate risks that could lead to material financial loss.  Release No. 33-9199 is reported at ¶89,413, and Release No. 34-64140 is reported at ¶89,414.

 

Vesting of Options Not a “Purchase” Under Section 16(b). The vesting of options did not constitute "purchases" under Exchange Act Section 16(b), and according to a 9th Circuit panel, a company officer was therefore not entitled to defer the tax consequences of her option exercises. When the officer was hired, she entered into stock option arrangements involving the right to purchase a fixed number of shares on specified future dates. The officer exercised the options at a time when the market price greatly exceeded the option price. The issue before the 9th Circuit panel was whether the officer could postpone the tax consequences of her option exercises. If the calculation of income could be deferred until a period after the stock price dropped, the officer’s taxes would be significantly lower.

The panel explained that an employee ordinarily realizes income for tax purposes upon exercising options based on an amount equal to the fair market value of the stock on the date of exercise minus the option price. Section 83 of the Internal Revenue Code, however, allows recognition and valuation of income to be deferred if a profitable sale of the stock acquired through the exercise of the options could subject the taxpayer to suit under Exchange Act Section 16(b), which forbids a corporate insider from profiting on a purchase made within six months of a sale and requires the disgorgement of any profits. The district court granted the officer’s motion for summary judgment, using the Rule 11 frivolousness standard in determining whether a Section 16(b) suit would be viable and holding that the calculation and recognition of income attributable to the option exercises could be deferred for almost the entire period at issue.

The appeals court determined that the tax consequences of exercising options could be postponed if the taxpayer could show that if he or she had sold the stock, a suit brought under Section 16(b) would have an objectively reasonable chance of success. The panel noted language in Section 83 indicating that it applies when rights in property are "subject to a substantial risk of forfeiture" and "not transferable," and concluded that this meant that the section applies only if a Section 16(b) suit has a "realistic" chance of success. This standard, wrote the court, "roughly equates to a determination of whether a reasonably prudent and legally sophisticated person would not have sold her stock, because if a Section 16(b) suit had been brought against her, she likely would have been forced to forfeit the profit obtained by the sale."

Continuing, the panel found that the officer failed to demonstrate that a sale of her stock could have subjected her to a Section 16(b) suit with an objectively reasonable chance of success. The officer contended that her options were "purchased" on each date that they vested, which was approximately every six months, and which would preclude her from selling her stock during the two years in question; the government maintained that the options were purchased on the date that they were granted, creating a single, six-month period for Section 16(b) liability.

The court examined a 1991 SEC rulemaking release discussing the treatment of derivative securities for purposes of Section 16. The SEC rules, the panel observed, did not differentiate between vested and unvested securities, and the release interpreted the rule to mean that unvested securities are purchased under Section 16(b) when granted and that the vesting of the stock is not a reportable event under Section 16(a) and thus not a purchase under Section 16(b). The panel concluded that "the SEC’s interpretation that both vested and unvested securities are "purchased" when acquired governs treatment of [the officer’s] options." Additionally, because the vesting of the options was conditioned on the passage of time and continued employment, an exception for options contingent on meeting the performance targets did not apply. Therefore, the panel found that " a reasonably prudent and legally sophisticated person in [the officer’s] position would have felt free to sell her property, because, if a Section 16(b) suit had been brought against her, she would not have been forced to forfeit the profit obtained by the sale, nor would she have faced substantial legal expenses defending herself in a suit not readily dismissible." Finally, the panel determined that the district court had applied the incorrect standard in assessing the viability of a Section 16(b) suit and reversed the grant of summary judgment in favor of the officer. Strom v. U.S. (9thCir) is reported at ¶96,275.

5th Circuit Panel Affirms Skilling Convictions. On remand from the U.S. Supreme Court, a 5th Circuit panel affirmed the convictions of Jeffrey Skilling, a former high ranking official of Enron Corporation. In a jury trial, Mr. Skilling had been convicted of conspiracy, securities fraud, making false representations to auditors, and insider trading, and the 5th Circuit affirmed. On appeal to the U.S. Supreme Court, Mr. Skilling challenged the holding that he had conspired to commit honest services fraud. In response, the court construed the honest services wire fraud statute to be properly confined to cover only bribery and kickback schemes and remanded with instructions to determine whether the district court’s submission of the honest-services theory to the jury was harmless as to any of Skilling’s convictions.

On remand, the issue before the panel was whether the jury verdict would have been the same absent the error. The panel found that the submission of the honest-services theory to the jury was a harmless error and affirmed the convictions. According to the panel, the evidence presented at trial proved that Mr. Skilling conspired to commit securities fraud. "Based on our own thorough examination of the considerable record in this case," the panel wrote, "we find that the jury was presented with overwhelming evidence that Skilling conspired to commit securities fraud, and thus we conclude beyond a reasonable doubt that the verdict would have been the same absent the alternative-theory error."

According to the panel, the evidence overwhelmingly proved that Mr. Skilling and the coconspirators transferred losses and the risk-management books from one Enron entity to another so that the other would appear to be more profitable than it really was. The evidence also proved that Skilling falsely portrayed a company to the investing public as a low-risk company that was sustainable even though he knew that most of its profits came from highly volatile trading operations. The evidence also overwhelmingly proved that Skilling used two partnerships to hide Enron’s nonperforming assets and book earnings in order to meet its earnings targets, underreported the projected losses of Enron’s broadband division and, finally, manipulated Enron’s accounting reserves for contingent liabilities in order to hit specific earnings targets. Because all five of these fraudulent schemes were supported by overwhelming evidence, the panel found that the honest-services instruction was harmless error beyond a reasonable doubt. The panel vacated Mr. Skilling's sentence and remanded for resentencing. U.S. v. Skilling (5thCir) is reported at ¶96,274.

9th Circuit Enforces Facebook Settlement. 9th Circuit panel affirmed a district court decision enforcing a settlement agreement. Former classmates of Facebook founder Mark Zuckerberg claimed that Mr. Zuckerberg stole the idea for Facebook from them. The classmates, who operated a competing social networking site, sued Facebook in California, but the district court eventually dismissed them from the case for lack of personal jurisdiction and ordered the parties into mediation. The classmates agreed to give up their site in exchange for cash, a piece of Facebook and agreeing to end all disputes. The settlement, however, later fell apart during negotiations over the final deal, and Facebook moved for enforcement. The classmates argued that the settlement was unenforceable because it lacked material terms and had been procured by fraud, but the district court ordered that the agreement be enforced.

The classmates argued on appeal that the absence from the settlement agreement of over 130 pages of documents, including stock purchase agreements and releases, rendered it unenforceable because the terms in the documents, if required and typical of acquisition documents, were material. The panel found that the terms in the documents were not "material" in the sense that they were necessary to the contract, but rather that the documents contained important terms that affected its value. Contracts omitting the latter type of terms are enforceable in California so long as the terms it does include are definite enough for the court to determine whether a breach has occurred, the panel explained. The settlement agreement, the panel stated, easily passed this test and even specified how to fill in the alleged missing material terms.

The classmates also alleged that they had been fraudulently misled about the actual value of Facebook’s shares and sought rescission of the settlement under Exchange Act Section 29(b). The classmates argued that they did not discover their claims until after they had signed releases ending all disputes against Facebook. The panel held that the classmates were sophisticated litigants who should have understood that the type of broad release used in this case includes both known and unknown securities claims and that "an agreement meant to end a dispute between sophisticated parties cannot reasonably be interpreted as leaving open the door to litigation about the settlement negotiation process." Accordingly, the release was valid under Section 29. In any event, the panel continued, the classmates' fraud claims failed on the merits because a confidentiality agreement precluded the classmates from introducing in support of their claims any evidence of what occurred during mediation. The panel concluded by describing the classmates as parties seeking "to gain through litigation what they were unable to achieve in the marketplace" and that it saw no reason for allowing them to back out of the deal they made. The Facebook, Inc. v. Pacific Northwest Software, Inc. (9thCir) is reported at ¶96,283.

 

CCH Blue Sky Law Reporter  

 

Florida, Illinois and Texas Set Forth Procedures For IA Switch From Federal to State Advisory Status. Investment advisers transacting business in Florida, Illinois or Texas must follow procedures set forth by the Florida Office of Financial Regulation, Illinois Securities Department or Texas Securities Board, respectively, for how to switch their advisory status from federal to state because their total amount of assets under management is (or will be) no more than $100 million on July 21, 2011, the date the “switch” is required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. ¶17,561, ¶23,234 and ¶55,830I.

 

Illinois Emergency Adopts Written Exam for Salespersons Exclusively Engaged in Investment Banking. Salespersons intending to deal exclusively in investment banking must take and pass the Investment Banking Representative Examination (Series 79), as well as either the Series 63 or 66 Exam, under rule changes adopted by emergency of the Illinois Securities Department, effective March 10, 2011 for a maximum 150 days. “FINRA” is added to a definitions rule and replaces the “NASD” in the salesperson exam rule. ¶22,613 and ¶22,685.

 

Louisiana Proposes Supervisory Requirement for Dealers and Investment Advisers. Dealers, investment advisers, federal covered investment advisers, and their officers, directors and partners would create, maintain and enforcement written procedures for supervising their salespersons and investment adviser representatives, under a rule proposed by the Louisiana Office of Financial Institutions. ¶28,550.

 

Michigan Administrative Order on Investment Advisers Aligns with Dodd-Frank. The sixth transition order to come out of the Michigan Office of Financial & Insurance Regulation since the State's adoption of the Uniform Securities Act of 2002 on October 1, 2009 amends the parts of the first and fourth transition orders at ¶32,663 and ¶32,666, respectively, pertaining to custody and performance-based compensation for investment advisers, and adjusts the "institutional investor" definition in Michigan's investment adviser de minimis exemption. The amendments comprising the sixth transition order are necessary to incorporate changes the Dodd-Frank Wall Street Reform and Consumer Protection Act made to federal investment adviser rules that will take effect July 21, 2011. ¶32,668.

 

North Carolina Clarifies Financial Reporting Requirements for IAs with Custody of Client Funds. North Carolina-registered investment advisers with custody of their clients’ funds or securities or who require prepayment of advisory fees of at least $500 per client six months or more in advance must send the North Carolina Securities Division a copy of an audited balance sheet within 90 days of the advisers’ fiscal year-end. The balance sheet must conform to generally accepted accounting principles and be audited by an independent public accountant or CPA in accordance with generally accepted auditing standards accompanied by an opinion as to the adviser’s financial position with a note of the principles used to prepare it, the basis of included securities, and any other explanations needed to clarify the opinion. ¶43,520.

 

Alleged Breach of Dealer Certification Could Serve as Basis for Liability. Denying a motion to dismiss in King County v. Merrill Lynch & Co., a federal district court (W.D. Wash.) ruled that the plaintiff sufficiently alleged misrepresentations or omissions by a dealer in connection with the plaintiff's purchase of commercial paper that could serve as a basis for liability under the Washington State Securities Act. The plaintiff, a county government that invested cash reserves for county agencies and public entities, alleged that it had a long-standing written agreement with the defendants whereby the dealer certified that it had implemented reasonable procedures and controls designed to preclude imprudent investment activities arising out of transactions conducted between the parties. Additionally, the plaintiff alleged that the defendants were aware that the issuers of the commercial paper were at high risk of illiquidity and default. Moreover, the plaintiff claimed that the defendants knew that the credit ratings associated with the commercial paper were unreliable and that the defendants were engaged in activities to rid themselves of the same securities that they had represented as prudent to the plaintiff. Given the long-standing written agreement between the parties and the alleged non--public information possessed by the defendants, the court reasoned, the plaintiff pleaded enough facts to survive a motion to dismiss. King County v. Merrill Lynch & Co. is reported at ¶74,902.

 

 

Aspen Federal Securities Publications  

 

Securities Regulation, by the late Louis Loss, Joel Seligman & Troy Paredes. The new Fourth Edition of Volumes VI and XI (Finding Devices) of the cornerstone Securities Regulation treatise will soon be available online. This Fourth Edition volume fully incorporates the large number of legislative, regulatory, and case law changes since Securities Regulation, Third Edition was published.

 

Hot Topic of the Month

 

This month's hot topic is the credit risk retention requirements of Exchange Act Section 15G. The SEC recently approved a joint proposal with the federal banking agencies to implement the credit risk retention requirements of 1934 Act Section 15G, which require that securitizers of asset-backed securities retain a minimum of five percent of the credit risk of the assets that collateralize the asset-backed securities. The proposal seeks to ensure that the amount of credit risk that is retained is meaningful while reducing the negative effect on the availability and cost of credit to consumers and businesses. The agencies are authorized to adopt rules in specific areas under Section 15G, but will jointly approve any written interpretations, responses to requests for no-action letters and legal opinions, or other written interpretive guidance. The agencies will jointly approve any exemptions, exceptions or adjustments to the final rules.

The proposal would provide sponsors with options for meeting the five percent risk retention requirement. It would permit a 100 percent guarantee of principal and interest provided by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation to satisfy their risk retention obligations for the mortgage-backed securities they guarantee as long as they are in conservatorship or receivership with capital support from the U.S. The proposed rules additionally authorize exemptions from the risk retention requirements for certain transactions such as those involving government-insured or guaranteed assets and for asset-backed securities that are collateralized solely by “qualified residential mortgages” (“QRMs”), and establish the terms and conditions under which a residential mortgage would qualify as a QRM. The proposal defines QRMs to ensure that they are of high credit quality based on such criteria as the borrower’s credit history, payment terms and loan-to-value ratio.

Section 15G generally requires the securitizer of asset-backed securities to retain not less than five percent of the credit risk of the assets collateralizing the asset-backed securities and prohibits the securitizer from directly or indirectly hedging or otherwise transferring that credit risk. Securitizers are defined as those who issue or organize and initiate asset-backed securities. Section 941 of the Dodd-Frank Act, which added Section15G, requires the SEC and the federal banking agencies to jointly prescribe regulations to require a securitizer to retain a material portion of the credit risk of any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party. When securitizers retain a material amount of risk, they have "skin in the game," aligning their economic interests with those of investors in asset-backed securities.

We publish related information in a wide range of resources (e.g., Federal Securities Law Reporter, SEC Today, Securities Regulation – Loss, Seligman & Paredes, etc.), and document types (laws, regulations, releases, newsletter articles, treatise discussion). For example:

• Federal Securities Law Reporter
  • Release No. 34-64148 at ¶89,412
  • Dodd-Frank Act Section 941 at ¶58,219
  • Exchange Act Section 15G at ¶26,000T
• Dodd-Frank Wall Street Reform and Consumer Protection Act: Law, Explanation and Analysis (e.g. ¶4255 and ¶54,500)
• SEC Today

• SEC Approves Proposals on Credit Risk Retention and Listing Standards for Compensation Committees (3-31-11)

• Securities Regulation – Loss & Seligman (e.g., Chapter 3.A.1)
• Corporate Finance and the Securities Laws – Johnson & McLaughlin (e.g., §14.00)
• Jim Hamilton’s World of Securities Regulation (e.g. 4-26-11)

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