CCH Federal Securities Law Reporter

SEC adopts financial responsibility rules for broker-dealers. The SEC voted unanimously to adopt amendments to its rules dealing with the financial responsibility of broker-dealers, including amendments to its net capital rule, customer protection rule, books and records rules, and notification rule. Amendments to the customer protection rule are intended to close the gap between the definition of "customer" in Rule 15c3-3 and its definition under the Securities Investor Protection Act (SIPA). Also, under the amendments, a broker-dealer's calculation of net capital must include liabilities assumed by a third party if it cannot demonstrate that the third party will be able to pay the liabilities.

The SEC amended its books and records rules to require large broker-dealers to document the controls they establish for managing material risk exposures that arise from their business activities, including market, credit, and liquidity risks. The Commission also amended its notification rule to require a broker-dealer to notify the SEC whenever the total amount of money payable against all securities loaned or subject to a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds 2,500 percent of tentative net capital (excluding government securities from the threshold). Release No. 34-70072 is reported at ¶80,338.

SEC adopts rules to strengthen oversight of broker-dealer custody practices. The SEC has adopted amendments to the broker-dealer reporting, audit, and notification requirements. The amendments require that broker-dealer audits be conducted in accordance with the standards of the PCAOB, which was given oversight authority for broker-dealer audits by the Dodd-Frank Act. Broker-dealers that clear transactions or carry customer accounts must agree to allow the SEC or their designated examining authorities to review documentation associated with certain reports of their independent public accountants and must allow their accountants to discuss their findings with respect to the reports. Broker-dealers also must file a new Form Custody quarterly to describe their custody practices with respect to securities and funds. Release No. 34-70073 is reported at ¶80,339.

Federal agencies’ repropose credit risk retention rules. The SEC and five other federal agencies have reproposed their joint proposal from April 2011 revising the risk retention requirements as required by the Dodd-Frank Act. The risk retention rules require securitizers to retain no less than 5 percent of the credit risk of any asset they transfer, sell, or convey to a third party. The reproposal redefines qualified residential mortgages (QRM), whose securitizations are exempt from the risk retention rules, to have the same meaning as the term qualified mortgage (QM) as defined by the Consumer Financial Protection Bureau. Both Commissioners Daniel Gallagher and Michael Piwowar issued dissents in response to the issuance of the reproposal. Release No. 34-70277 will be reported at ¶80,351.

Dismissal of Madoff-linked fraud claims upheld. The Second Circuit has upheld the dismissal of fraud claims brought by limited partner investors against Family Management Corporation (FMC) over investments one of its funds made on their behalf in Madoff-linked hedge funds. The district court had dismissed federal securities claims and related New York state law claims because the plaintiffs did not allege scienter. The Second Circuit’s nonprecedential summary order also upheld the district court’s decision not to let the plaintiffs amend the complaint.

The Second Circuit found that the plaintiffs failed to allege a material misrepresentation. The plaintiffs first argued that they had been misled about FMC’s FM Low Volatility Fund’s (FMLVF’s) strategy, diversification, and allocation goals. According to the plaintiffs, FMLVF was to invest in no fewer than three investment vehicles that would each fall below 35 percent of the funds’ net asset value. By contrast, FMLVF allegedly gave the plaintiffs a nearly 60 percent indirect exposure to the Madoff Ponzi scheme.

The Second Circuit, however, said that FMLVF’s offering materials made a few key disclosures: (1) "investment vehicle" means private investment funds and hedge fund-of-funds; (2) FMLVF lacked control over choices by the investment vehicles’ mangers; (3) FMLVF had a diversification limit; and (4) FMLVF said that it would pursue a strategy that echoed Madoff’s.

As a result, the Second Circuit found that FMLVF’s disclosures bespoke caution and that the plaintiffs could not have been misled. The plaintiffs, said the court, had not alleged that FMC disobeyed FMLVF’s investment strategy. The court also noted that even after learning from FMC soon after they were fully invested that they had a 60 percent indirect Madoff exposure, the plaintiffs failed to redeem their shares or object to FMC ahead of public revelations that the Madoff funds were a Ponzi scheme.

The plaintiffs also claimed that FMC failed to exercise the due diligence it cited in its Form ADV because it failed to monitor FMLVF’s investments in the Madoff funds. Here, the Second Circuit noted that the complaint failed to allege facts showing that FMC failed to exercise any level of due diligence. Red flags cited in the complaint were too speculative. According to the court, the plaintiffs’ allegations fell short of the PSLRA’s and FRCP 9(b)’s heightened pleading standards and the much lower notice pleading standard that applies generally to federal suits.

According to the plaintiffs’ complaint, FMC committed fraud because it ignored red flags about the Madoff funds. The district court, however, dismissed the case because the plaintiffs failed to allege scienter. The district court had found that the inference of FMC’s nonfraudulent intent was more compelling than the fraudulent one urged by the plaintiffs.

On appeal, the Second Circuit never reached the scienter issue because it upheld the district court’s dismissal on the ground that the plaintiffs failed to allege a material misrepresentation. The Second Circuit first applied Delaware’s Tooley test in finding that the plaintiffs’ state law claims are derivative ones. Delaware law governed this issue because FMLVF was a Delaware limited partnership. The plaintiffs also said they did not make a demand on FMC’s board because this would be futile. But under Delaware’s Levine/Aronson test, the Second Circuit found that the plaintiffs failed to show that FMC’s general partner was not disinterested and independent. Newman v. Family Management Corporation. (2ndCir) is reported at ¶97,562.

Investor cannot sue SEC over “Flash Crash.” An investor who said he lost over $106,000 in the May 6, 2010 "Flash Crash" may not sue the SEC for breach of implied contract or of fiduciary duty for allegedly not ensuring fair and orderly markets, said the U.S. Court of Federal Claims. The court agreed with the SEC that it lacked subject matter jurisdiction over the investor’s claims. Likewise, the court did not take up the SEC’s allied motion to dismiss for failure to state a claim because its jurisdictional ruling ended the suit.

The claims court said that while the Tucker Act gave the court jurisdiction over money damages claims, plaintiff Clyde C. Grady failed to show that another law gave him a substantive right to money damages. Mr. Grady had argued that the Exchange Act’s language about fair and orderly markets implied a contract between the SEC and investors. Specifically, Mr. Grady said that investors put money into U.S. markets because the SEC has a duty to ensure fair and orderly markets.

The claims court, however, found that the relevant Exchange Act text did not create a contractual relationship between the SEC and investors. The Act, said the claims court, states a goal with no guarantee of SEC success. In contract law terms, the statutory relationship between the SEC and investors lacks the indicia of a formal contract.

Moreover, the claims court said in a footnote that the SEC’s mission statement is not a contractually binding promise, as Mr. Grady had argued. Citing the Federal Circuit’s 2011 opinion in Chattler, the claims court said the SEC showed its lack of intent to be contractually bound by phrasing its mission statement in the passive rather than the active voice.

Mr. Grady had argued that the Tucker Act let him bring breach of fiduciary duty claims against the SEC. The claims court, however, again noted that the Tucker Act is merely jurisdictional and that Mr. Grady had not demonstrated a trust relationship between the SEC and investors under another law.

The claims court also noted that the Supreme Court has said that government fiduciary duties can arise only when the government has taken on those duties under its governing laws or regulations. The Supreme Court found government fiduciary duties existed in White Mountain Apache Tribe and Mitchell II (Mr. Grady relied on Mitchell II) because the applicable laws and regulations required the government to exercise "elaborate control" over land for the "needs and best interests" of the Native American beneficiaries.

Here, the SEC enforces laws and regulations in the public interest, but it does not act for the benefit of investors as a fiduciary. The claims court analogized the SEC’s role to that of a sports referee who ensures that the players abide by the rules of the game, but does not tell the coaches and players which plays to run. As a result, Mr. Grady could not pursue his contract and fiduciary duty claims under the Tucker Act because the Exchange Act is not a money-mandating law. Grady v. U.S. (Ct Cls) is reported at ¶97,587.

Court upholds fund late trading violation, vacates penalty. A 2nd Circuit panel generally upheld an SEC enforcement action against investment advisers that engaged in fraudulent late trading of mutual fund shares but, in a bow to the Supreme Court’s Gabelli opinion, vacated and remanded the civil penalty imposed on the advisers. The basis for the district court’s imposition of fraud liability on the advisers was the practice of late trading in the mutual fund market. Late trading occurs when, after the price of a mutual fund becomes fixed each day, an order is placed and executed as though it occurred at or before the time the price was determined, thereby allowing the purchaser to take advantage of information released after the price becomes fixed but before it can be adjusted the following day.

Deceitful intent is inherent in the act of late trading, said the appeals panel. The late trader places an order after the daily mutual fund price is set, but receives the benefit of additional information that the earlier price does not reflect. The advisers engaged in deceitful behavior, the court found, noting that they sought out brokers who would engage in late trading and knew that the trade sheets were time-stamped before 4 p.m., even though they had no intention of trading before that time. They also issued a false and deceitful letter of assurance that they were not engaging in late trading. The advisers orchestrated the late trading program carried out by their brokers and were liable under securities antifraud provisions because their actions caused the misrepresentations as to the time of the trades and led to their concomitant deception.

The panel rejected the argument that the advisers may not be held liable because they did not communicate directly with the mutual funds. The investment advisers had argued that because they never communicated directly with the mutual funds, they cannot be held liable as makers of any false statements. This argument called into play the 2011 Supreme Court ruling in Janus Capital Group, Inc. v. First Derivative Traders, where the Court held that a mutual fund investment adviser could not be held liable in a private action under Rule 10b-5 for making false statements in mutual fund prospectuses filed by the fund. Because the fund retained ultimate control over the content of the prospectuses, the Supreme Court held that the fund manager could not be liable as a maker of the statement under Rule 10b-5.

To illustrate its point, the Supreme Court used the analogy of the relationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, said the Supreme Court, the content is entirely within the control of the person who delivers it.

To the extent that late trading requires a statement in the form of a transmission to a clearing broker, the Second Circuit panel found that in this case the advisers were as much makers of those statements as were the brokers. While the brokers may have been responsible for the act of communication, said the panel, the advisers retained ultimate control over both the content of the communication and the decision to late trade.

The district court imposed a disgorgement award and a civil penalty. In light of the Supreme Court’s recent decision in Gabelli v. SEC, which was rendered after the district court’s decision, the appeals panel vacated the civil penalty award and remanded it for reconsideration. In Gabelli, the Supreme Court held that the discovery rule, which tolls a statute of limitations for offenses that are difficult to detect, does not toll the five-year statute of limitations for fraud cases in SEC enforcement actions. Thus, reasoned the appeals court, any profit earned through late trading earlier than five years before the SEC instituted its suit against the defendants may not be included as part of the civil penalty.

The panel found no abuse of discretion in the amount of the disgorgement award, which reflected a reasonable approximation of profits causally connected to the late trading violation. SEC v. Pentagon Capital Management (2ndCir) is reported at ¶97,597.

 

CCH Blue Sky Law Reporter  

Purchaser of Mortgage-Backed Securities Stated Claim Against Underwriter for Credit Rating Misrepresentations. In Capital Ventures International v. UBS Securities LLC, a purchaser of residential mortgage-backed securities adequately stated a misrepresentation claim against the underwriter under the Massachusetts Uniform Securities Act (Act). The federal district court (D. Mass.) held that the purchaser adequately alleged that the underwriter did not genuinely believe in the credit ratings assigned to the pass-through certificates at issue because the underwriter knew that the loan-to-value, owner-occupancy, and other data on the loans given to the rating agencies did not reasonably relate to the true nature of the loans being securitized. Moreover, the representations concerning the credit ratings were actionably false because the underwriter allegedly made factual representations as to the processes that would be followed to calculate the ratings. As the inclusion of the ratings in the offering materials thus constituted an actionable misrepresentation under the Act, the court denied the underwriter’s motion to dismiss. The decision will be reported at ¶75,041.

Aspen Federal Securities Publications  

Securities Regulation, by The Late Louis Loss, Joel Seligman, and Troy Paredes. The 2014 Cumulative Supplement, now available online, updates the cornerstone Securities Regulation treatise. The supplement fully incorporates the large number of legislative, regulatory, and case law changes in the past year, including Congressional enactment of the Iran Threat Reduction and Syria Human Rights Act, which added §13(r) to the Securities Exchange Act (Ch. 6.B.1); amendments to 1933 Act Rule 146 to designate securities traded on the BATS Exchange as covered securities under §18 (Ch. 1.B.2.c.(ii)(I)); amendments to transform the Office of Ethics Counsel into a stand-alone office that reports directly to the SEC Chair (Ch. 1.J); adoption of 1940 Act Rule 6a-5 to establish a creditworthiness standard to replace the credit ratings references in §6(a)(5) (Ch. 2.D.2.a); adoption of Rule 10C-1 directing securities exchanges to establish specified compensation committee listing standards (Ch. 2.D.2.k.(v)); approval of an MRSB Interpretative Notice Concerning Application of Rule G-17 to Municipal Securities Underwriters (Ch. 3.B.2.b.(iv)); adoption of Rule 13p-1, the Conflicts Minerals Disclosure Rule, as required by the Dodd-Frank Act (Ch. 3.B.7.b.(iv)); American Petroleum Inst. v. SEC, in which the district court vacated Rule 13q-1 and remanded to the SEC for further proceedings (Ch. 6.B.1); adoption of 1933 Act Rule 506(d) to provide a bad actor disqualification from reliance on Rule 506, substantially similar to the long-standing bad boy disqualification in Rule 262 of Regulation A (Ch. 3.C.7.b); amendments to 1933 Act Rule 506(c) to permit an issuer to engage in general solicitation or general advertising in offering or selling securities under Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors (Ch. 3.C.7.b.(iv)); amendments to 1933 Act Rule 144A to provide that securities sold under Rule 144A may be offered to persons other than QIBs (Ch. 3.D.3); adoption of Regulation NMS Rule 613 to require SROs to submit a National Market System Plan to create a consolidated audit trail (Ch. 7.A.g.(v)); adoption jointly with the CFTC of further definitions of swaps and security-based swaps (Ch. 7.A.5); adoption of Rule 17Ad-22 to establish minimum standards for risk management practices for registered clearing agencies (Ch. 7.A.5); approval of NYSE amendments to its independence standards for the NYSE and related boards (Ch. 7.B.1); the adoption by the Federal Reserve of definitions under the Dodd-Frank Act of (1) predominantly engaged in financial activities and (2) significant nonbank financial company (Ch. 8.A.1.d); approval of FINRA rule changes raising the limits for simplified arbitration to $50,000 and the one arbitrator process to $100,000 (Ch. 11.D.3); adoption jointly with the CFTC of rules to address identity theft under the Fair Credit Reporting Act (Ch. 13.F.2.c); Commission’s and Department of Justice’s jointly published A Resource Guide to the Foreign Corrupt Practices Act (Ch. 2.D.3.a); and Commission’s publishing of a significant report on the Municipal Securities Market (Ch. 3.B.2.b).

Fundamentals of Securities Regulation, by The Late Louis Loss, Joel Seligman, and Troy Paredes. The 2014 Cumulative Supplement to the Sixth Edition is now available online. This compendium reviews the most significant aspects of securities regulation and provides essential information covering a wide array of topics concerning securities law. In addition to expanded coverage of securities regulation overall, the Sixth Edition also has been expanded to incorporate extensive discussion and analysis of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The 2014 Cumulative Supplement includes a discussion of American Petroleum Inst. v. SEC where the district court vacated Rule 13q-1 and remanded to the SEC for further proceedings (Ch. 6.B.1); Congressional enactment of the Iran Threat Reduction and Syrian Human Rights Act, which added §13(r) to the Securities Exchange Act (Ch. 6.B.1); amendments to 1933 Act Rule 146 to designate securities traded on the BATS Exchange as covered securities under §18 (Ch. 1.B.2.c.(ii)(I)); adoption of 1940 Act Rule 6a-5 to establish a credit-worthiness standard to replace the credit ratings references in §6(a)(5) (Ch. 2.D.2.a); adoption of Rule 10C-1 directing securities exchanges to establish specified compensation committee listing standards (Ch. 2.D.2.k.(v)); adoption of Rule 13p-1, the Conflicts Minerals Disclosure Rule, required by the Dodd-Frank Act (Ch. 3.B.7.b.(iv)); adoption of 1933 Act Rule 506(d) to provide a bad actor disqualification from reliance on Rule 506 (Ch. 3.C.6.b.(i)); amendments to 1933 Act Rule 506(c) to permit an issuer to engage in general solicitation or general advertising in offering or selling securities under Rule 506, provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors (Ch. 3.C.6.b.(iii)); amendments to 1933 Act Rule 144A to provide that securities sold under Rule 144A may be offered to persons other than QIBs (Ch. 3.D.3); adoption of Regulation NMS Rule 613 to require SROs to submit a National Market System Plan to create a consolidated audit trail (Ch. 7.A.g.(v)); the adoption by the Federal Reserve of definitions under the Dodd-Frank Act of (1) predominantly engaged in financial activities and (2) significant nonbank financial company (Ch. 8.A.1.d); and approval of FINRA rule changes raising the limits for simplified arbitration to $50,000 and the one arbitrator process to $100,000 (Ch. 11.D.3).

 

IPO Vital Signs

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IPO Week in Review, a weekly e-newsletter to keep professionals up to date with recent filing and going public activity, is an important element of the IPO Vital Signs system or is available by separate subscription. Coverage includes a monthly feature article on recent trends in going public in the U.S.

To see how an IPO Vital Sign works click on the Vital Sign title below:

Tip! Click column headings to rank the table in ascending order, pause and click again to rank in descending order. Click on blue numbers to drill down for more information.

RBsource

A new research tool powered by the Securities Redbook (Securities Act Handbook), RBsource offers you securities laws, rules, regulations and forms together with related SEC guidance and interpretations. With RBsource, you will have SEC guidance related to a specific law, regulation or rule at your fingertips without the need of further searching or browsing. RBsource uniquely associates related content, going beyond the limits of standard searching making research more streamlined and productive. This intuitive research tool will drastically reduce your research time and provide the unparalleled confidence expected from the trusted Securities Act Handbook.

SEC Rulemaking Activity

• 34-70073—Broker-Dealer Reports (July 30, 2013).

The SEC adopted final rules that align broker-dealer audits with PCAOB requirements under authorities granted to the SEC by the Dodd-Frank Act. The release and corresponding rules also explain how to file new Form Custody.

• 34-70072—Financial Responsibility Rules for Broker-Dealers (July 30, 2013).

This release amended the broker-dealer financial responsibility rules, including the calculation of net capital under Exchange Act Rule 15c3-1.

• 34-70150—Order Temporarily Exempting Certain Broker-Dealers and Certain Transactions from the Recordkeeping and Reporting Requirements of Rule 13h-1 under the Securities Exchange Act of 1934 (August 8, 2013).

The SEC has provided a temporary exemption for some broker-dealers from Exchange Act Rule 13h-1’s recordkeeping and reporting requirements.

• 34-70277—Credit Risk Retention (August 28, 2013).

The Commission has jointly re-proposed Dodd-Frank Act credit risk retention requirements along with its federal banking regulator counterparts.

The Road Ahead

Upcoming rulemaking activity will continue to reshape the securities regulation landscape. The items below are a selection of expected near-term regulatory actions. The SEC’s schedule is subject to change at any time. RBsource includes daily updates to securities regulations affected by final Commission action.

The SEC’s recent joint re-proposal of credit risk retention rules with federal banking regulators has offered an early glimpse into the thinking of the Commission’s two newest members. Commissioner Michael S. Piwowar issued a public statement criticizing the re-proposal’s lack of economic analysis and the absence of significant discussion of alternatives to risk retention rules. Commissioner Kara M. Stein said in a public statement that she backs the re-proposal but urged her fellow commissioners to pursue related asset-backed securities reforms.

 

Hot Topic of the Month

This month’s hot topic is the forfeiture of bonuses and profits, or clawbacks. The Sarbanes-Oxley Act requires certain officers to forfeit profits realized on company stock sales, or bonuses received from the company while management was misleading the public and regulators about the company's financial condition.

Section 304 of the act provides that, in the case of accounting restatements that result from material non-compliance with SEC financial reporting requirements, the chief executive officer and chief financial officer must disgorge bonuses and other incentive-based compensation and profits on stock sales, if the non-compliance results from misconduct. The required disgorgement applies to amounts received for the 12 months after the first public issuance or filing of a financial document embodying such financial reporting requirement. The SEC may, however, exempt any person from this requirement as it deems necessary and appropriate.

Courts have found that Section 304 does not require personal misconduct. A Texas district court stated that the language of the statute and its legislative history unambiguously requires reimbursement by CEOs and CFOs of qualifying compensation received after a filing and subsequent restatement due to misconduct. There is no requirement of scienter or separate misconduct.

Courts which have addressed the issue have found that Section 304 does not create a private right of action for shareholders and is enforceable only by the SEC. For example in In re iBasis, Inc. Derivative Litigation (DC Mass 2007), the court found that shareholders who filed a derivative action failed to assert a viable federal claim. In determining that there was no private right of action under Section 304, the court found that "the statutory structure of [Sarbanes-Oxley], the nature of the penalty provision, and precedent from other courts" indicated that Congress did not intend to provide for private enforcement of the section.

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

• Federal Securities Law Reporter
• Sarbanes-Oxley Act Section 304, at ¶62,849
• SEC v. Baker (WD Tex) (holding that Section 304 does not require personal misconduct), is reported at ¶97,085
• In re iBasis, Inc. Derivative Litigation (DC Mass), is reported at ¶94,536
• CCH Explanations (e.g., ¶62,991.054)
• SEC Docket 
• Litigation Release No. 21149; AAER No. 3025 (First enforcement action brought solely under Section 304) (7-23-09)
• Insights – Amy L. Goodman (e.g., "2012 Year-End Securities Enforcement Update"(2-28-13) and "2012 Mid-Year Securities Enforcement Update" (8-31-12)
• Securities Regulation – Loss & Seligman (e.g., Chapter 6.F.4)
• Jim Hamilton’s World of Securities Regulation