Corporate & Financial Weekly Digest : Corporate Finance Lawyers & Attorneys for Legal Developments in Business & Financial Services

Co-authored by Ross Pazzol and James D. Van De Graaff

On August 13, the Securities and Exchange Commission published a notice that the Financial Industry Regulatory Authority proposes to adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability) as part of the Consolidated FINRA Rulebook. The proposed Know Your Customer and Suitability rules are based largely on the following:

• Incorporated NYSE Rule 405(1) (Diligence as to Accounts);
• NASD Rule 2310 (Recommendations to Customers (Suitability)); and 
• both rules’ related interpretative materials (together, the Existing Rules).

The proposed rules would delete the Existing Rules; however, the proposed rules seek to clarify and strengthen the core features of the Existing Rules.

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Co-authored by Ross Pazzol and James D. Van De Graaff

On August 20, the Securities and Exchange Commission published a notice that the Financial Industry Regulatory Authority proposes to adopt rule changes to its trade reporting and Order Audit Trail System (OATS) in response to recent amendments to SEC Regulation SHO. Among other things, the amendments:

1. implement a “short sale circuit breaker” for National Market System stocks that once triggered prohibits the execution or display of short sale orders at a price less than or equal to the current national best bid for the remainder of the day and the following day; and
2. reinstitute a “short sale exempt” marking category, which allows broker-dealers to mark certain sell orders as “short exempt” once the short sale circuit breaker has been triggered.

The short sale circuit breaker described above is triggered by a 10% or more decrease in the price of the security from such security’s closing price at the end of the regular trading hours on the prior trading day.

Trade Reporting

In response to the reinstitution of the short sale exempt marking category, FINRA proposes to change its trade reporting rules. Specifically, under the proposed rule changes, FINRA members would have to indicate on trade reports if a transaction is short sale exempt.

OATS

Likewise, FINRA’s proposed rule changes would require FINRA members to record the designation of an order as short sale exempt when an order is received or originated.

To read the text of the text of the amendment to Regulation SHO, click here.
To read the text of FINRA’s proposed rule change, click here.

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Co-authored by Joshua A. Penner

The Commodity Futures Trading Commission has signed a Statement of Intent (SOI) Concerning Cooperation, Consultation and the Exchange of Information with the Ministry of Economy, Trade and Industry of Japan (METI) and the Ministry of Agriculture, Forestry and Fisheries of Japan (MAFF).

The SOI establishes a framework for information sharing and facilitates cooperation in cross-border investigations of potential violations of commodity futures laws. The SOI is supported by a diplomatic Note Verbale exchanged by the governments of the United States and Japan. The Note confirms that information obtained under the SOI can be used by each country’s criminal authorities.

METI has oversight over trading in precious metals, base metals, rubber and energy related products, and MAFF has jurisdiction over agricultural commodity trading.

The CFTC press release concerning the SOI can be found here.
The text of the SOI can be found here.

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Co-authored by Joshua A. Penner

The Commodity Futures Trading Commission has published a Federal Register notice seeking public input on the CFTC’s proposed rulemaking areas to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act.

On July 21, the CFTC released the list of 30 areas of rulemaking for over-the-counter derivatives to implement the Act. The CFTC has made separate electronic mailboxes available for comments with respect to 29 of the 30 individual areas, as well as a general comment mailbox (the addresses for which mailboxes can be found in the Federal Register notice). The CFTC has indicated that the views of interested parties may be considered in the pre-proposal process but will not be treated as official comments on specific proposed rules.

The CFTC will accept submissions on each rulemaking topic until such time as it publishes a proposed rule for that topic in the Federal Register. Thereafter, it will accept official comments on such proposed rules until the close of the proposed rule’s official comment period. All submissions provided to the CFTC will be published on the CFTC’s website. The submissions will not be subject to pre-publication review, and personally identifying information will not be removed.

The CFTC press release regarding the Federal Register release can be found here.
The Federal Register release can be found here.

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Co-authored by Jonathan Rotenberg

Plaintiff brought a claim for securities fraud against a medical device corporation and certain employees, officers and board members of the corporation. Several defendants (the moving defendants) filed motions to dismiss the plaintiff’s complaint on February 11, 2009. On September 4, 2009, the motions were granted in part and denied in part.

One defendant, Budimir Drakulic, was not served with the complaint until September 2, 2009. Mr. Drakulic moved to dismiss the complaint on October 8, 2009. In June 2010, while Mr. Drakulic’s motion to dismiss was pending, plaintiff served him, as well as several co-defendants who had made the original motion to dismiss, with requests for production of documents and a notice of deposition. The moving defendants moved to quash the document requests and notice of deposition on the ground that automatic discovery stay provision of the Private Securities Litigation Reform Act (PSLRA) remained in effect as to all defendants while Mr. Drakulic’s motion to dismiss was pending.

In support of their motion, the moving defendants argued that the PSLRA was unambiguous and that the automatic discovery stay applied “during the pendency of any motion to dismiss.” The district court rejected the moving defendants’ argument and denied their motion. The court reasoned that while the language of the statute appeared plain on its face, the automatic stay provision did not account for situations where there were multiple defendants making multiple motions to dismiss and was therefore ambiguous. The court pointed out that the purpose of the PSLRA’s automatic stay provision is to minimize expensive discovery in frivolous securities class actions by permitting discovery only after the court had sustained the legal sufficiency of the complaint. The court noted that it had already sustained the legal sufficiency of the primary allegations in the complaint when it ruled on the motions to dismiss by the moving defendants. As a result, the purpose underlying the PSLRA’s stay provision would not be undercut by permitting discovery to proceed against the moving defendants during the pendency of Mr. Drakulic’s motion because that discovery would be needed regardless of the outcome of the motion. (Latham v. Stein, Nos. 6:08-2995-RBH and 6:08-3183-RBH, 2010 WL 3294722 (D.S.C. Aug. 20, 2010))
 

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Co-authored by Jonathan Rotenberg

Plaintiffs, former employees of two energy providers, brought a consolidated class action, alleging that the fiduciaries of the companies’ employee savings plans breached their fiduciary duties under the Employee Retirement Income Security Act by maintaining the savings plans’ significant investment in stock of one of the companies, Constellation Energy Group, Inc. Plaintiffs asserted that defendants knew or should have known that the investment was imprudent because Constellation was engaging in risky business practices, such as the trading of large amounts of energy in unregulated markets.

Defendants moved to dismiss the complaint on the grounds that they did not have the discretion to divest the stock, and thus could not be held accountable for the poor plan performance as a result of the decrease in the stock’s value. Defendants further argued that, in any event, they were entitled as fiduciaries to a presumption that they acted prudently by investing the assets in employer stock. Plaintiffs opposed defendants’ motion to dismiss the breach of prudence claim, arguing (1) that the fiduciaries had discretion to divest the Plans of the Stock, and (2) that Fourth Circuit precedent rejected the presumption of prudence that defendants were seeking.

The court granted defendants’ motion to dismiss the breach of prudence claim, holding that, even assuming the fiduciaries had the discretion to divest the stock and that no presumption of prudence was warranted, the plaintiffs’ complaint would still fail to state a cause of action because it lacked any allegation concerning the purported events that allegedly should have triggered the duty of divest. The court pointed out that the alleged risky business practices that plaintiffs argued warranted divestiture had been pursued since 2001, with highly profitable results, and that plaintiffs failed to point to any change in Constellation’s practices at the start of the class period. In so holding, the court noted that investment in high-risk companies cannot be deemed to be “prudent when they succeed and imprudent when they fail.” (In re Constellation Energy Group, Inc. Erisa Litigation, No. CCB-08-2662, 2010 WL 3221821 (D. Md. Aug. 13, 2010))

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On August 24, the UK Financial Services Authority (FSA) announced that it had fined the UK branch of Irish company Zurich Insurance Plc (Zurich UK) £2.275 million (approximately $3.5 million) after 46,000 customers’ confidential information was lost. This is the highest fine imposed to date on a single firm for failings in data protection.

In August 2008, Zurich UK outsourced certain data processing to its South African affiliate Zurich SA. The data losses occurred when Zurich SA transferred data stored on an unencrypted back-up tape to a data storage center as part of a routine transfer. A lack of inter-company communication meant that a year passed before Zurich UK was informed of the incident. The data loss left the customers vulnerable to theft and financial loss.

The FSA found that Zurich UK had not taken reasonable care to ensure that its systems and controls were sufficient to cope with the risks involved in the outsourcing arrangement nor to prevent the customer data being used for financial crime. (It appears that the lost data was not misused and no customers were compromised.)

As Zurich UK settled early, the original fine of £3.25 million (approximately $5 million) was reduced by 30%.

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On August 25, the UK Financial Services Authority (FSA) published a discussion paper (The Prudential Regime for Trading Activities - a Fundamental Review DP10/4) proposing fundamental changes to the regulation of the trading activities of banks and investment firms. The FSA considers that its proposed regulations will address key elements of risks currently posed to the financial system.

The proposals cover three key areas:

1. Valuation—more comprehensive regulation of valuation of trading positions and investigations into valuation uncertainty
2. Coverage, coherence and the capital framework—a restructuring of the capital framework, improving coherence and reducing structural arbitrage in the banking and finance sector
3. Risk management and modelling—measures targeting firms’ risk management and modelling standards, aligning both with regulatory objectives

The closing date for responses is November 26. The FSA anticipates that it will issue a feedback statement and final rules in the first half of 2011.

The discussion paper can be found here.

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On August 18, the Securities and Exchange Commission provided notice that at an open meeting on August 25, the Commission will consider whether to adopt changes to the federal proxy and other rules to facilitate director nominations by shareholders.

In June 2009, the SEC proposed proxy access rules, but delayed adopting them pending confirmation, in the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, of its power to implement such rules. Speculation with respect to the new rules centers primarily around the percentage and duration of ownership necessary to require the company to include the stockholder’s nominees in the company’s proxy statement and whether there will be some relief for smaller public companies.

The SEC’s Sunshine Act Notice can be accessed here.
The SEC’s 2009 Proxy Access proposal can be accessed here.

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Co-authored by Blase J. Kornacki

In 2009, New York State adopted amendments to the New York Power of Attorney Law imposing more demanding power of attorney disclosure and execution requirements aimed at reducing the risks of abuse and fraud in elderly care and the financial planning process. The 2009 law required the use of longer, more comprehensive forms, as well as notarization of the signatures on the power of attorney. The 2009 law provided no exceptions for commercial transactions. Because agency relationships are regularly established in the proxy process, real estate transactions, brokerage arrangements and various commercial agreements, the lack of commercial transaction exception in the 2009 law gave rise to much uncertainty among transactional lawyers. On August 13, New York enacted corrective amendments revising the ambiguities and correcting the unintended consequences of the 2009 law.

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Co-authored by Natalya S. Zelensky

The Securities and Exchange Commission recently approved the Financial Industry and Regulatory Authority’s proposal to adopt NASD Rule 3210, with a few changes, as FINRA Rule 4320 in the Consolidated FINRA Rulebook. New FINRA Rule 4320 applies short sale delivery requirements to equity securities not covered by Regulation SHO’s close-out requirements. The Rule, among other things, clarifies the borrowing requirements for clearing agency participants that sell short non-reporting threshold securities for which a fail to deliver position has not been closed out in the requisite time. FINRA will apply all interpretive positions issued by the SEC and its staff regarding the parallel provisions of Regulation SHO to FINRA Rule 4320.

Click here to read the FINRA Regulatory Notice 10-35.

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Co-authored by Vanessa L. Friedman

The Commodity Futures Trading Commission and the Securities and Exchange Commission have issued a joint advance notice of proposed rulemaking (the Joint Notice) seeking public comment regarding the agencies’ mandate to regulate swaps and security-based swaps under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Joint Notice requests public comments on the CFTC’s and SEC’s joint regulation of “mixed swaps” and the adoption of regulations further defining the following terms: (1) “swap”; (2) “security-based swap”; (3) “swap dealer”; (4) “security-based swap dealer”; (5) “major swap participant”; (6) “major security-based swap participant”; (7) “eligible contract participant”; and (8) “security-based swap agreement”. The comment period for the Joint Notice expires on September 20.

A copy of the Federal Register release of the Joint Notice is available here.

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Co-authored by Vanessa L. Friedman

The Commodity Futures Trading Commission has withdrawn its January proposal to establish federal speculative position limits for futures and option contracts on certain energy products. In its withdrawal notice, the CFTC cited the significant revisions to the Commodity Exchange Act (CEA) introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The CFTC plans to issue a notice of rulemaking and propose position limits for exempt and agricultural commodity derivatives, including energy derivatives, in compliance with the CEA as amended by the Dodd-Frank Act (which requires the CFTC to establish limits for exempt and agricultural commodity derivatives within 180 days and 270 days, respectively, of the date of enactment of the Dodd-Frank Act).

The notice of the CFTC withdrawal is available here.

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Co-authored by Vanessa L. Friedman

In connection with the long-running dispute between CME Group, Inc. and ELX Futures regarding so-called “exchange of futures for futures” (EFF) transactions on ELX, the Commodity Futures Trading Commission sent a letter to CME reaffirming the position previously taken by CFTC staff that neither the Commodity Exchange Act (CEA) nor CFTC regulations prohibit such transactions. EFF transactions are designed to permit market participants effectively to move a Treasury futures position from the Chicago Board of Trade (CBOT) to ELX for clearing. The CFTC letter was written in response to CBOT’s October 19, 2009, Market Regulation Advisory Notice stating that CBOT rules do not permit the execution of EFF transactions.

The CFTC also directed its staff to undertake an analysis of whether the CBOT Advisory Notice complies with Core Principle 18 of Section 5(d) of the CEA (antitrust considerations). In connection with this directive, the CFTC Division of Market Oversight sent a second letter requesting from CBOT a written response and the production of records addressing certain related matters.

The CFTC press release regarding its letters to CME, including links to both letters, is available here.

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