SEC LITIGATION AND REGULATORY COMPLIANCE
Crypto Update: Commissioner Peirce Addresses Regulatory Gaps Restricting Token Networks
On February 6, 2020, SEC Commissioner Hester M. Peirce delivered a speech where she announced her plans to address the regulatory gaps that prohibit properly functioning token networks and offered a new solution to foster these networks. Peirce noted that crypto entrepreneurs have tried building decentralized token networks where tokens can trade hands without ever going through a central authority. However, current securities laws potentially cover these token network transactions, and the lack of clarity (coupled with the SEC’s aggressive enforcement) have chilled innovation in the token network space. The SEC has argued that tokens have the same characteristics as a traditional security and should be regulated as such, even if they lack the features of a typical investment contract. As a result, crypto entrepreneurs who offer tokens may unwittingly be engaging in what the SEC determines is an offering of securities, and potentially run afoul of any number of rules. Peirce’s new solution: create a safe harbor for token networks. The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws.
Executive Compensation Update: SEC Settles Proceedings Alleging Failure to Properly Disclose CEO Perquisites and Benefits
The SEC’s focus on perquisite disclosures continues. The SEC’s Philadelphia Regional Office recently provided a reminder to companies of the importance of disclosing compensation paid to named executive officers, including perks and benefits, within their proxy statements, as well as the importance of having robust internal controls in place to ensure shareholders are receiving this information on a timely basis. On June 4, the SEC entered a cease-and-desist order against Argo Group International Holdings, Ltd. (“Argo”), an international underwriter of specialty insurance and reinsurance products (Administrative Proceeding File No. 3-19822), requiring Argo to pay a $900,000 civil monetary penalty for failing to properly disclose $5.3 million in perquisites paid to its former chief executive officer over the five-year period between 2014 and 2018. The SEC’s order states that the definitive proxy statements filed in this time period disclosed an aggregate of $1.22 million worth of perquisites and personal benefits provided to Mark E. Watson III, the chief executive officer, president and a director of Argo from 2000 until his resignation late 2019, consisting of 401(k) and retirement contributions, insurance coverage, supplemental executive retirement plan benefits, housing and home leave allowances, medical premiums and financial planning services. However, Argo failed to disclose an additional $5.3 million in perquisites Watson received over the same time period, including expenses associated with personal use of corporate aircraft; rent and other housing costs; personal use of corporate automobiles; helicopter trips; other personal travel costs; use of a car service by family members; club and concierge service memberships; tickets and transportation to sporting, fashion and other entertainment events; personal services provided by Argo employees; and watercraft-related costs.
The SEC stated that “Argo incorrectly recorded payments for the benefit of, and reimbursements to, Watson as business expenses, and not compensation. As a result, its books, records, and accounts did not, in reasonable detail, accurately and fairly reflect its disposition of assets.” In addition, Argo failed to maintain internal accounting controls to ensure that transactions were properly recorded and to provide accurate documentation of and controls related to expense reimbursements.
The SEC cited, among other applicable federal securities law provisions, violations of Section 14(a) of the Exchange Act, which makes it unlawful to solicit any proxy in respect of any security registered under Section 12 of the Exchange Act in contravention of the SEC’s rules and regulations, along with Rules 14a-3 and 14a-9, and Item 402 of Regulation S-K, which requires that companies disclose the total value of all perquisites and other personal benefits provided to named executive officers who receive at least $10,000 worth of such items in a given year.
The Argo order provides a stark reminder that companies should conduct ongoing assessments of the perquisites provided to named executive officers and internal controls currently in place to ensure accurate reporting of this information to shareholders.
Corporate Disclosure Update: SEC Discusses Additional COVID-19 Disclosure Considerations
On June 23, 2020 the SEC’s Division of Corporation Finance published CF Disclosure Guidance: Topic No. 9A, in which the SEC staff encouraged companies to discuss management’s assessment of COVID-19’s impact so that investors can evaluate the current and expected effects on the company’s operations, both within earnings releases and, to the extent material to the business, in the MD&A section of the company’s periodic reports. Companies have had to make a broad range of operational and financial adjustments in response to COVID-19 (such as suspension of operations, supply chain adjustments, and actions relating to short- and long-term funding). Where COVID-19-related adjustments may affect a company in a way that would be material to an investment or voting decision, the company should carefully consider disclosure of this information to investors. As always, any forward-looking information carries risks and should be carefully assessed and cautioned when included in SEC filings.
In the June Guidance, the SEC staff provides a list of questions for companies to consider as they assess materiality of specific facts and circumstances on company operations, broadly covering the following topics:
In each of these areas, the SEC staff asks companies to consider whether any of these new developments have or may have a material impact on a company’s balance sheet, statement of cash flows or short- and long-term liquidity, and if so, how? The SEC staff notes that companies that have received COVID-19 government assistance under the CARES Act should consider whether that should be disclosed. If COVID-19 has impacted management’s assessment about the company’s ability to continue as a going concern (that is, COVID-19 effects have raised substantial doubt about the company’s ability to meet obligations as they become due within one year after financial statements are issued), additional disclosures should be made within the MD&A about the conditions and events that led to this conclusion and any plans management has to address these challenges.
Advertising Update: Marketing and Solicitation Reforms Under the Investment Advisers Act
On December 22, 2020 the Securities and Exchange Commission announced it had finalized reforms under the Investment Advisers Act to modernize rules that govern investment adviser advertisements and payments to solicitors. The amendments create a single rule that replaces the current advertising and cash solicitation rules. The final marketing rule addresses, among other things, testimonials, endorsements, performance advertising and third-party ratings, and allows them as long as they comply with anti-fraud protections and other conditions. In his statement about the modernization, Clayton said that “The marketing rule reflects important updates to the traditional advertising and solicitation regimes, which have not been amended for decades, despite our evolving financial markets and technology,” Clayton further said in a statement. “This comprehensive framework for regulating advisers’ marketing communications recognizes the increasing use of electronic media and mobile communications and will serve to improve the quality of information available to investors. The new rule provides for an extended compliance period intended to provide advisers with a sufficient transition period, including to enable consultation with the Commission’s expert staff.” https://www.sec.gov/news/
Reg BI Update:
The SEC’s Reg BI has been in effect since June 2020. Firms are starting to work through the details and requirements with an eye on examinations. A lot of emphasis will be placed on proper disclosures to customers.
Also, there has been some talk that some in the new Administration may try to reverse Reg BI and try for a standard fiduciary rule despite the many technical issues. Maxine Waters urges Biden administration to overturn Reg BI.
For the latest BI news, check out SEC REG BI Resources Page to find up to date information on Regulation Best Interest, Form CRS and Related Interpretations.
Litigation Update: Supreme Court Rules on Liu Et Al. v. Securities and Exchange Commission
As highlighted in the April 2020 edition of Securities Quarterly, many have been patiently awaiting a ruling from the U.S. Supreme Court after oral arguments were held on March 3 in the case Liu Et. Al. v. Securities and Exchange Commission, No. 18-1501, in which the Court was faced with the question of whether Section 21 of the Exchange Act, which governs available remedies in the context of a federal SEC enforcement proceeding, properly includes disgorgement of ill-gotten gains within the meaning of “equitable relief that may be appropriate or necessary for the benefit of investors.” (See 15 U. S. C. §78u(d)(5)).
Working against the backdrop of Kokesh v. SEC, a 2017 case in which the Supreme Court stated that for purposes of the applicable statute of limitations for proceedings seeking to enforce civil penalties, disgorgement constitutes a penalty, on June 22 the Court in Liu ultimately maintained, in an 8-1 opinion, that disgorgement does, in fact, constitute equitable relief in civil proceedings and therefore would not constitute punitive sanctions that are normally excluded from equitable relief. However, the Court added two limiting factors in its opinion by requiring that the disgorgement “does not exceed a wrongdoer’s net profits” and is awarded for the victims of the subject securities fraud claim. The Court reasoned that, although “[e]quity practice has long authorized courts to strip wrongdoers of their ill-gotten gains,” to keep disgorgement within the bounds of “a traditional form of equitable relief,” the relief granted should be limited to the “fair compensation of the person wronged” (in other words, the net profit realized from the defendant’s unlawful activity, after deducting “legitimate” business expenses).
The Court was careful to note that Kokesh declined to address the question of whether disgorgement was an available remedy at equity and therefore could be used by courts within SEC enforcement proceedings. After ruling that the SEC may continue to seek the equitable disgorgement remedy in civil cases, the Court remanded to the District Court for the Ninth Circuit to determine net profits from the defendants’ wrongdoing. Notably, the Supreme Court declined to rule on the defendants’ narrower arguments that disgorgement should be limited to cases only in which fraud victims can be identified and disgorgement liability should not be imposed by the SEC on a wrongdoer’s affiliates through joint and several liability, stating that the lower courts should evaluate these questions in the context of equitable principles
FINRA LITIGATION AND REGULATORY COMPLIANCE
Effective in June 2020 FINRA Amends Its Suitability, Non-Cash Compensation and Capital Acquisition Broker (CAB) Rules in Response to Regulation Best Interest. https://www.finra.org/sites/
On June 10, the Financial Industry Regulatory Authority (FINRA) released its Artificial Intelligence (AI) in the Securities Industry Report (Report), a culmination of a two-year review by FINRA’s Office of Financial Innovation to learn about the emerging challenges confronted by broker-dealers (Firms) and other market participants as they introduce AI-based applications into their businesses. The Report provides an overview of AI technology, explores its diverse, multifaceted applications in the securities industry and identifies the challenges and legal considerations with leveraging this technology.
Operational Update: FINRA Board of Directors Projects 2021 Regulatory Focuses
During a December meeting, FINRA staff discussed operational updates on several topics, including the implementation of the Securities and Exchange Commission’s (SEC’s) Regulation Best Interest, the status of FINRA’s 529 plan self-reporting initiative and ongoing zero-commission "sweep" examinations, and the progress of the Consolidated Audit Trail (CAT). These operational initiatives along with continued regulatory focus on FINRA rules related to outside business activities, direct market access and COVID-19 related BCP and Supervisory Processes will likely continue into 2021.
Proposed Rule Update: What’s Next from FINRA
FINRA approved the following three rule proposals to move forward in 2021:
1. Proposed Amendments to Enhance the Continuing Education Program – The Board approved filing with the SEC proposed amendments to FINRA Rules 1210 and 1240 to enhance FINRA's continuing education (CE) program. The amendments would, among other things, require registered persons to complete the Regulatory Element of the CE program every year rather than every three years, and would allow individuals who terminate their registrations to reregister for an extended period without retaking the required examinations if they maintain their CE requirements during this period.
2. Proposed Amendments to FINRA Rules Regarding Security-Based Swaps – The Board approved filing with the SEC proposed amendments relating to the application of FINRA rules to members’ activities and positions in security-based swaps, in light of SEC rules for security-based swap dealers, including business conduct, margin, and financial and operational requirements.
3. Proposal to Establish a Process to Appeal Staff Statutory Disqualification Determinations – The Board approved the filing with the SEC proposed amendments to the FINRA Rule 9000 Series to establish a process to appeal statutory disqualification determinations made by FINRA staff. The new process would provide individuals with the ability to challenge a FINRA decision that the person is subject to a statutory disqualification, without needing the support of a firm to do so.
Litigation Update: Coronavirus Impact on Arbitration Hearings and Enforcement Transparency Efforts
In response to the evolving coronavirus disease 2019 (COVID-19), FINRA decided to administratively postpone all in-person arbitration and mediation proceedings scheduled through April 2, 2021 unless the parties stipulate to proceed telephonically or by Zoom or the panel orders that the hearings will take place telephonically or by Zoom. Note that if all parties and arbitrators agree to proceed in-person based on their own assessment of public health conditions, the case may proceed provided that the in-person hearing participants comply with all applicable state and local orders related to the COVID-19 pandemic. In addition, Regulatory Notice 20-42 FINRA also seeks comment on lessons learned from the COVID-19 pandemic, comment period expires on February 16, 2021.
In 2020, FINRA enforcement leaders identified increased transparency as a key component of their enforcement programs. For instance, EVP Hopper noted FINRA Enforcement’s efforts to improve its settlement documents to provide more clarity to the industry regarding why FINRA brought a case, what the facts were in that case, and how the facts led to the specific sanctions against the member. EVP Hopper highlighted a recent settlement from 2019, involving unit investment trusts as an example of the kind of guidance FINRA Enforcement hopes to provide in its settlement documents. One element of that settlement stated that the member received credit for cooperation in light of its substantial assistance to the investigation, identifying the customers eligible for restitution, and voluntarily implemented corrective measures. EVP Hopper also discussed FINRA Enforcement’s expectations for cooperation under Regulatory Notice 19-23, stating that FINRA Enforcement expected “complete and total cooperation.” In EVP Hopper’s view, that cooperation included sharing the results of an internal investigation, though EVP Hopper also emphasized that the enforcement staff would be mindful of privilege issues inherent in such disclosure.
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