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

Co-authored by Robert J. Wild

On August 25, the Securities and Exchange Commission adopted final rules, effective 60 days following publication in the Federal Register, permitting shareholders or groups of shareholders to access the proxy statements of public companies for the purpose of nominating directors.

Under new Rule 14a-11, the holder or holders of 3% or more of the shares of the company entitled to vote on the election of directors, who continuously owned such shares for at least three years, will be permitted to nominate, and have included in the company’s proxy statement, the greater of one nominee or nominees representing 25% of the company’s board of directors.

The Rule requires that the nominating shareholder(s) file with the company and the SEC a new Schedule 14N in which the nominating shareholder(s) must make several representations and disclosures regarding its background and intentions and provide detailed information with respect to its nominees. There also are provisions permitting the company to challenge the qualifications under the Rule of either the nominating shareholder(s) or its nominees.

In addition, the SEC has amended Rule 14a-8(i)(8) to require companies to include in company proxy materials shareholder proposals that would amend, or request an amendment of, the company’s governing documents regarding nominating procedures related to shareholder nominations, provided that those proposals may not conflict with new Rule 14a-11. Permitted amendments would be those that, for example, seek to reduce the minimum ownership or holding requirements provided under Rule 14a-11 or otherwise lessen its requirements for nominating shareholders.

Smaller reporting companies (filers which have a pubic equity float of $75 million or less) are not subject to Rule 14a-11 until three years following its effective date.

Click here to read a Katten Client Advisory providing a more detailed analysis of the new rules.
Click here to access the SEC’s final Rule.

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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%.

Read more.

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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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Co-authored by Jessica M. Garrett

Shareholder Westland Police & Fire Retirement System brought an action under Section 220 of the Delaware General Corporate Law to review the books and records of Axcelis Technologies, Inc., a manufacturer of ion implantation and semi-conductor equipment. In 2008, Sumitomo Heavy Industries, Ltd. (SHI) made an unsolicited proposal to acquire Axcelis for $5.20 per share, later increasing the offer to $6.00 per share. The Axcelis board rejected both offers as inadequate, but agreed to meet with SHI to explore whether the parties could reach an agreement on a transaction. After the parties executed a confidentiality agreement and conducted diligence, SHI requested additional time to consider a further acquisition proposal. Axcelis rejected this request and SHI then put all discussions “on hold.” Axcelis’ share price declined significantly following the “on hold” development.

During the negotiation period, Axcelis held its annual shareholder meeting at which three members of Axcelis’ classified board were up for election. Previously, Axcelis had adopted by board resolution a “plurality plus” rule providing that any director who received a plurality but not a majority of shareholder votes must submit a resignation letter, which the board then could in its discretion either accept or reject. At the 2008 meeting, three directors received less than a majority of votes and submitted their resignation letters. The Axcelis board declined to accept the resignations on the ground that it was not in the company’s best interest to do so at that time.

After SHI put its acquisition effort on hold, Westland submitted a books and records request for the purpose of investigating whether the Axcelis board members breached their fiduciary duties by (a) rejecting the SHI acquisition proposals (a possible Unocal violation), and (b) declining to accept the director resignations submitted pursuant to the plurality plus policy (a possible Blasius violation). The Chancery Court found that investigating possible management wrongdoing was a “proper purpose” for a Section 220 books and records inspection, but that Westland had failed to provide evidence establishing a “credible basis” to infer corporate wrongdoing. Specifically, the Chancery Court found that the mere rejection of an acquisition proposal is not a defensive measure under Unocal and that the plurality plus provision expressly provided the board with discretion to accept or reject any resignations.

The Delaware Supreme Court affirmed the Chancery Court’s rulings. Notably, however, the Court’s opinion went on to make clear that Westland’s books and records request for information regarding the directors’ resignations would have been appropriate if Westland had argued that its “proper purpose” was to investigate “director suitability” rather than corporate wrongdoing. The Court found that “[w]here, as here, the board confers on itself the power to override an exercised shareholder voting right without prior shareholder approval”, the board must be accountable. Specifically, where stockholders withhold sufficient votes to trigger a corporation’s plurality plus policy, a credible basis to infer director unsuitability is established and shareholders are entitled under Section 220 to the documents and other records that the board relied on in declining to accept the resignations. (City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., No. 594,2009 (Del. August 11, 2010))

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Co-authored by Jessica M. Garrett

In a recent case filed by the Securities and Exchange Commission, the agency asserts that Donald McKelvey, as President of Telco-Technology, Inc., engaged in an illegal kickback scheme involving “sham” consulting agreements. According to the SEC, Mr. McKelvey directed Telco to issue millions of shares of its penny stock to Wall Street Communications, Inc. under cover of Forms S-8 purportedly as compensation for consulting services performed by Howard Scala, the owner of Wall Street. The SEC contends that Mr. Scala never performed any valid consulting services for Telco. Instead, the SEC alleges that Wall Street sold its Telco shares at Mr. Scala’s direction soon after obtaining them from Telco, and then funneled half of the proceeds back to Mr. McKelvey purportedly as compensation for separate consulting services that Mr. McKelvey performed for Mr. Scala’s affiliate through Donalson Capital Partners, a separate entity controlled by Mr. McKelvey.

The SEC moved for summary judgment on its claims against Mr. McKelvey, alleging violations of Sections 5(a), 5(c) and 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Mr. McKelvey likewise moved for summary judgment, arguing: (1) that there was no evidence supporting the SEC’s claims that he and Mr. Scala were involved in an illegal kickback scheme; (2) that the Form S-8 registration statements were proper; and (3) that the consulting arrangements between Mr. Scala and Telco, on the one hand, and Donalson and Mr. Scala, on the other, were valid.

In denying both parties’ respective motions for summary judgment, the court concluded that there are genuine issues of fact regarding whether the Form S-8 stock was issued for an improper purpose. Specifically, the court determined that there are disputed facts regarding whether the Forms S-8 were proper when filed and whether the stock was issued under a proper consultant compensation plan. Mr. McKelvey testified that the stock was issued pursuant to the consulting agreement between Telco and Wall Street and Mr. Scala. However, in the court’s view, a jury could conclude based on all of the relevant facts that a scheme existed whereby Wall Street agreed to sell the Telco shares soon after obtaining them in order to funnel half of the proceeds back to Mr. McKelvey through Donalson. Moreover, the court found that there was a genuine issue of fact as to whether Wall Street was the “alter ego” of Mr. Scala, a finding which would be required in order to permit Telco to issue shares registered under a Form S-8 to Wall Street, a corporate entity, rather than to Mr. Scala directly. (SEC v. Wall Street Communications, Inc., 2010 WL 3189976 (M.D.Fla. Aug. 10, 2010))

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On August 16, the Board of Governors of the Federal Reserve System (the Federal Reserve) released a number of rules (both final and interim) related to consumers and their mortgage transactions.

In the first issuance, the Federal Reserve issued final rules to require that consumers receive a notice when their mortgage loan has been sold or transferred. Under this rule, the purchaser or its assignee must provide written notice to a consumer that it has acquired the loan within 30 days of the acquisition. The mandatory compliance date for this final rule is January 1, 2011. Read more.

In the second issuance, the Federal Reserve announced final rules that prevent a loan originator from receiving compensation that is based on the consumer’s interest rate or other loan terms. Loan originators may, however, continue to receive compensation that is based on a percentage of the loan amount. This rule also prohibits a loan originator who receives compensation directly from a consumer from also receiving compensation from the lender or another third party and prohibits such originators from directing a consumer to accept a mortgage loan that is not in the consumer’s best interest in order to increase the originator’s compensation. This rule is effective April 1, 2011. Read more.

The Federal Reserve also released an interim rule that requires lenders to disclose how consumers’ mortgage payments may change over time. Lenders must comply with this rule with respect to applications they receive on or after January 30, 2011. The Federal Reserve is also soliciting comments on the interim rule for 60 days after publication in the Federal Register. Read more.

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Co-authored by Michael R. Durnwald

The Securities and Exchange Commission has proposed amendments to multiple rules under the Securities Act of 1933 and the Investment Company Act of 1940 regarding the marketing of target date retirement funds. In general, a target date retirement fund is a fund designed to hold a diversified portfolio of assets that is automatically rebalanced among asset classes over time without the need for the investor to rebalance the assets.

Since their inception during the 1990s, target date retirement funds have exploded in popularity and are frequently an investment option offered under 401(k) retirement plans. This increased popularity, combined with market losses in 2008, has caused federal regulatory agencies to examine target date retirement funds more closely. For example, the Department of Labor and the SEC held a joint hearing in June 2009 regarding target date retirement funds. As part of its scrutiny, the SEC identified concerns with how such funds are marketed to investors and learned that investors often misunderstand how such funds operate. Consequently, the SEC has proposed rule changes to help alleviate misunderstandings and prevent misleading marketing materials.

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Internal Claims/Appeals

Effective for plan years beginning on or after September 23 (January 1, 2011, for calendar year plans and policies), non-grandfathered group health plans (including non-Employee Retirement Income Security Act plans such as governmental and church plans) and health insurance issuers will be required under the Patient Protection and Affordable Care Act (PPACA) to comply with federal rules for administering health plan claims and appeals. ERISA plans already are required to adhere to existing Department of Labor (DOL) claim and appeal regulations, but interim final regulations issued jointly by the Department of the Treasury, the DOL and the Department of Health and Human Services (75 Fed. Reg. 43330) extend those requirements to non-ERISA group health plans and health insurance policies and also impose new requirements for all group health plans and insurers.

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Co-authored by Jonathan D. Weiner

On August 11, the Securities and Exchange Commission’s Division of Corporation Finance issued new Compliance and Disclosure Interpretations (C&DIs) on topics including the availability of Form S-3 for issuers filing shelf registration statements in reliance on General Instruction I.B.6 (limited primary offerings) of that form, the incorporation of information required by Part III of Form 10-K from proxy statements and foreign private issuer status.

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Co-authored by Ross Pazzol

On August 11, the Chairman of the Securities and Exchange Commission announced that additional measures in response to the May 6 market plunge are being considered. The SEC has undertaken two policy responses already.

First, the SEC approved new rules that require the exchanges and the Financial Industry Regulatory Authority to pause trading in S&P 500 stocks if price fluctuations reach 10% within five minutes. In June, the SEC published for comment proposals to expand these rules beyond the S&P 500 to stocks listed in the Russell 1000 Index and another 344 exchange traded funds.

Second, the SEC published for public comment proposed rules from self-regulatory organizations setting clearer standards for breaking clearly erroneous trades. The SEC is currently reviewing the comments and hopes to approve these rules soon.

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On August 6, the Financial Industry Regulatory Authority proposed an expansion of its Order Audit Trail System (OATS) to include the trading of all national market system securities (NMS stocks) on all national securities exchanges. Currently, FINRA requires all of its members to record in electronic form and report to OATS on a daily basis order, trade and quote information for all over-the-counter trades and NMS stocks listed on NASDAQ. From this information OATS creates a time-sequenced record of orders and transactions, which is then used by the Securities and Exchange Commission and the national exchanges and securities associations (SROs) to conduct surveillance and investigations for potential violations of federal securities laws and exchange/association rules.

On May 26, the SEC announced a rule proposal which would require the SROs to develop a consolidated audit trail system. Under the proposal, the SROs are to work together to implement a consolidated order tracking system with respect to NMS stocks and listed equity options.

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Co-authored by Vanessa Friedman and Kevin Foley

The Commodity Futures Trading Commission has reissued its proposal to amend CFTC Regulations 1.20, 1.26 and 30.7, relating to the acknowledgment letters that futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) are required to obtain from depositories that hold customer segregated and/or secured amount funds.

In response to comments on its previous proposal, the CFTC’s amended proposal includes a required form of acknowledgment letter. FCMs and DCOs would be required to update the acknowledgment letters within 60 days of any change in the name of the FCM or DCO, of the bank, trust company, FCM or DCO that has received the funds, or of any change in the account number. Finally, the CFTC has proposed to create an electronic filing system for the required acknowledgement letters.

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Co-authored by Gregory Johnson

An investment company’s representation that certain energy bonds were backed by the State of Georgia—when they were in fact guarantied by Lehman Brothers Holdings, Inc.—could subject the firm to liability for securities fraud.

Investor Paul Prager contacted FMS Bonds, Inc. in April 2008 to pursue conservative investment opportunities. An FMS advisor recommended that he purchase a recent issue of natural gas bonds, which the advisor described as municipal bonds that were backed by the State of Georgia. The bonds were actually guarantied by Lehman, however, and Mr. Prager lost $112,000 of his $200,000 investment after the investment bank filed for bankruptcy.

Mr. Prager sued FMS for violations of Securities and Exchange Commission Rule 10b-5 and the Securities Exchange Act of 1934. FMS sought dismissal of the securities claims, arguing that Mr. Prager had not alleged particularized facts about how FMS had misled the plaintiff or about Mr. Prager’s reliance on the misstatements. The U.S. District Court for the Southern District of Florida rejected these arguments, holding that the allegation that FMS described the bonds as “safe” investments backed by Georgia provided sufficient details about FMS’s alleged deception and about the factual assertions that Mr. Prager relied upon. (Prager v. FMS Bonds, Inc., 2010 WL 2950065 (S.D. Fla. July 26, 2010))

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Co-authored by Gregory Johnson

The managing partner of a mining venture cannot pursue federal securities claims against his estranged partners because he exerted substantial control over the enterprise.

Marc Nunez formed Sand Specialties and Aggregates, LLC (SSA) with five other partners, four of whom promised to commit $800,000 to the project. Mr. Nunez oversaw certain financial operations of SSA while an operational partner, who was not an investor, handled SSA’s mining activities. When the other four investors failed to contribute their share of the funds, disclosed that they could not fulfill this obligation, and began to utilize SSA property for their own benefit, Mr. Nunez sued them and SSA for securities fraud under the Securities Exchange Act of 1934.

The defendants sought dismissal of the securities claim, arguing that Mr. Nunez’s financial contribution to SSA could not be considered an investment contract because he exercised substantial control over the business. Mr. Nunez contended that he was induced into purchasing an interest in SSA by promises of like contribution, and that his reliance on the expertise of the operational partner showed that he qualified as a passive investor under the Exchange Act. The U.S. District Court for the Eastern District of Louisiana ruled that Mr. Nunez’s control over SSA’s finances ensured that he could protect his financial interests in the company, thus his contribution could not be considered an investment contract under federal law. (Nunez v. Robin, 2010 WL 3021618 (E.D. La. July 29, 2010))

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The Federal Reserve Board on July 11 announced its approval of an interim final rule implementing recent legislation modifying the effective date of certain disclosure requirements applicable to gift cards under the Credit Card Accountability Responsibility and Disclosure Act of 2009. For gift certificates, store gift cards, and general-use prepaid cards produced prior to April 1, the legislation and interim final rule delay the August 22 effective date of these disclosures until January 31, 2011, provided that several conditions are met. While the Gift Card Amendment delays the effective date for certain disclosure requirements set forth in the Credit Card Act, the Gift Card Amendment does not address the status of additional requirements adopted in the Board’s final gift card rule. As a result, persons seeking to take advantage of the relief afforded by the Gift Card Amendment may be unable to do so if certain of these additional provisions were to apply after August 22. For example, Section 205.20(e)(1) prohibits any person from selling or issuing a certificate or card unless the consumer has had a reasonable opportunity to purchase a certificate or card with at least five years remaining until the certificate or card expiration date. Thus, a card produced prior to April 1 that has a card expiration date of less than five years could not be sold under the final gift card rule, notwithstanding the provisions of the Gift Card Amendment. Therefore, in order to carry out the intended purpose of the Gift Card Amendment, this interim final rule also delays the effective date of certain of these supplemental requirements. This interim final rule revises Sections 205.20(c) and (g) of the final gift card rule (“Form of Disclosures” and “Compliance Dates,” respectively) and adds a new Section 205.20(h) (“Temporary Exemption”).

The interim final rule is effective August 22. The Board is, however, seeking public comment on the interim final rule. Comments on the interim final rule must be submitted within 30 days after publication in the Federal Register, which is expected shortly.

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Co-authored by Christina Grigorian

On August 10, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Office of Thrift Supervision (collectively, the Banking Agencies) issued an advanced notice of proposed rulemaking regarding the use of credit ratings in the Banking Agencies’ risk-based capital rules (the Proposal). The issuance is in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires federal agencies to review, no later than one year after enactment, any regulation that requires use of an assessment of creditworthiness of a security or money market instrument and any references to, or requirements in, regulations regarding credit ratings. Where feasible, the Banking Agencies are also required to remove references or requirements to rely on credit ratings and to substitute an alternative standard of creditworthiness.

The Proposal describes where the Banking Agencies rely on credit ratings in their regulations. It also includes an informative table that provides an overview of where credit ratings are referenced in such regulations and used as a basis for capital requirements. The Banking Agencies will use the information they collect in response to the questions set forth in the Proposal to begin to develop an alternative to the use of credit ratings in their respective capital rules.

Comments are due to the Banking Agencies within 60 days after publication in the Federal Register.

For more information, click here.
 

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Co-authored by Christina Grigorian

On August 11, the Federal Deposit Insurance Corporation (FDIC) released proposed guidance affecting all FDIC-supervised institutions regarding automated overdraft payment programs (Proposal). The Proposal focuses on ways for banks to monitor their overdraft programs for chronic or excessive use by consumers. It also addresses compliance and safety and soundness issues related to overdraft programs.

Included in the Proposal is a requirement that the bank’s board and management regularly review their overdraft programs’ features and operation as well as a requirement to impose daily limits on a customer’s costs related to overdrafts.

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On August 10, the Federal Deposit Insurance Corporation Board of Directors adopted a final rule amending its insurance regulations (12 C.F.R. Part 330) and advertising regulations (12 C.F.R. Part 328) to conform with provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which permanently increased the standard maximum deposit insurance amount (SMDIA) from $100,000 to $250,000. This permanent increase in the SMDIA became effective July 22 and is retroactive to January 1, 2008.

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The UK Financial Services Authority (FSA) has recently publicized widespread failings in the marketing of “unregulated collective investment schemes”—a category of fund products which includes almost all private funds including all hedge funds other than those established within the Undertakings for Collective Investment in Transferable Securities (UCITS) framework. This does not mean that such funds cannot be sold in or from the UK but it emphasizes the need for great attention to the details of the relevant regulations before, and while, doing so.

The FSA announced that it had just completed a project examining the promotion and sale of unregulated collective investment schemes to retail customers by financial advisors. The FSA stated that it had uncovered widespread failings by financial advisor firms in understanding the regulatory requirements for the promotion of these funds, a lack of understanding of the market within which these schemes operated and of the risks of investment in these funds. This has resulted in firms marketing and selling these funds to customers who were not eligible to purchase them. The FSA is bringing enforcement proceedings against a number of regulated firms.

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The UK Financial Services Authority (FSA) recently published a report entitled “Assessing possible sources of systemic risk from hedge funds.” It sets out the FSA’s key findings and conclusions from two surveys it conducted in April 2010—the Hedge Funds as Counterparties Survey (HFACS) and the Hedge Fund Survey (HFS). The FSA intends to continue conducting these surveys every six months to help monitor trends in hedge funds. (The results of the October 2009 surveys, published in February 2010, were reported in the February 26 edition of Corporate and Financial Weekly Digest).

The HFACS has been conducted every six months since 2005. It asks some of the largest FSA-authorized banks with exposures to hedge funds about their credit counterparty risks. The HFS was introduced in October 2009 to complement the HFACS. It surveys the 50 largest FSA-authorized investment managers, on this occasion with a combined total of $345 billion in hedge fund assets under management. The survey asks questions about the assets the firms managed and the larger funds for which they undertake management activities.

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Co-authored by Natalya S. Zelensky

The Financial Industry Regulatory Authority has issued an information notice reminding member firms of changes to BrokerCheck it will implement on August 23 and the steps firms and individuals may take with respect to these changes prior to implementation. As reported in the June 16 edition of Corporate and Financial Weekly Digest, these changes expand the information released through BrokerCheck and establish a formal process to dispute the accuracy of, or update, information disclosed through BrokerCheck.

Click here to read the FINRA information notice.

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Co-authored by Natalya S. Zelensky

The Financial Industry Regulatory Authority has issued an immediately effective rule change reinforcing its position that it will defer to an exchange’s clearly erroneous determinations with respect to over-the-counter trades in exchange-listed securities when FINRA is deciding which similarly-situated transactions are subject to nullification by FINRA. FINRA states in the release that it believes this clarification is necessary to promote consistency among self-regulatory organizations. Comments are due to the Securities and Exchange Commission on or before August 27.

Click here to read Securities and Exchange Commission Release No. 34-62608.

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Co-authored by Marybeth Sorady, Kathleen H. Moriarty and Gregory E. Xethalis

On July 21, the Securities and Exchange Commission published a rulemaking proposal that would alter the way mutual funds impose 12b-1 fees and sales loads. The marketing and selling costs involved with running a mutual fund are commonly referred to as a mutual fund’s distribution costs. To cover these costs, mutual funds are permitted to charge fees known as 12b-1 fees that are paid from the mutual fund’s assets. These fees are deducted from a mutual fund to compensate securities professionals for sales efforts and services provided to the mutual fund’s investors. The rule proposal would:

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Plaintiff, a distributor of motors and related products to automotive original equipment manufacturers and suppliers throughout the Midwest, brought claims against defendant, a manufacturer with whom plaintiff had a non-exclusive distribution agreement. Plaintiff claimed that defendant’s direct sale to plaintiff’s customers constituted, among other things, tortious interference with plaintiff’s business relationships.

The lower court granted defendant’s summary judgment motion, and the Sixth Circuit affirmed. The Sixth Circuit found that where, as here, defendant had a “legitimate interest, economic or otherwise, in the contract or expectancy sought to be protected, then the plaintiff must show that the defendant employed improper means in seeking to further only his own interests.” Because the distribution agreement did not preclude defendant from making direct sales to plaintiff’s customers, no liability for tortious interference could arise. (Universal Electric Products Co., Inc. v. Emerson Electric Co., 2010 WL 2925930 (6th Cir. July 27, 2010))

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The U.S. Court of Appeals for the Ninth Circuit affirmed a district court’s partial grant of summary judgment in favor of plaintiff, the Securities and Exchange Commission, finding that defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 by issuing a fraudulent press release.

The SEC alleged that defendants’ press release, which stated that a new technology system was being “unveiled,” was false because at the time the press release was issued, the company had no prototypes for the system built, or even the money to build one. The district court granted summary judgment for the SEC on this claim.

On appeal, defendants contended that the statement was not issued with “reckless scienter” as required under Section 10(b). The Ninth Circuit held that scienter requires either “deliberate recklessness” or “conscious recklessness” that includes “a subjective inquiry” turning on “the defendant’s actual state of mind,” and that evidence showing that the defendants did not appreciate the gravity of the risk of misleading others is relevant. The court also found that a defendant ordinarily will not be able to defeat summary judgment by the mere denial of subjective knowledge of the risk that a statement could be misleading. Though summary judgment is generally inappropriate when mental state is an issue, a defendant with knowledge of the relevant facts cannot manufacture a genuine issue of material fact by denying what a reasonable person would have known.

Applying this standard, the court found that defendants knew that the company had not produced a complete, field-tested system, and the press release left the “unmistakable impression” that the new system existed. Because no reasonable juror could conclude that defendant was not conscious of the risk that the press release would be misinterpreted, the court held that there was no issue of material fact that the press release was materially misleading and issued with deliberate recklessness. (Securities and Exchange Commission v. Platforms Wireless Int’l Corp., 2010 WL 2902393 (9th Cir. July 27, 2010))

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On July 6, the Employee Benefits Security Administration (EBSA) of the U.S. Department of Labor (DOL) adopted an amendment to Prohibited Transaction Exemption (PTE) 84-14 that permits qualified professional asset managers (QPAMs) to act as QPAMs for their own employee benefit plans, or the plans of an affiliate, if certain additional conditions are met. PTE 84-14 is a class exemption that allows parties related to employee benefit plans to engage in transactions otherwise prohibited by the Employee Retirement Income Security Act of 1974, as amended, if the assets are managed by a QPAM and if certain other conditions are met. PTE 84-14 requires a QPAM managing the assets of a plan it sponsors to adopt policies and procedures designed to ensure compliance with its conditions. The exemption also requires that an independent auditor conduct an annual exemption audit, which is designed to ensure that the conditions of the class exemption have been met. The amendment to PTE 84-14 affects plan participants, beneficiaries, sponsors and persons engaging in the transactions described above. The amendment was published in the July 6 edition of the Federal Register and is effective November 3.

For the DOL release, click here.

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On August 13, the UK Financial Services Authority (FSA) announced that it had fined RBS Plc, NatWest, Ulster Bank and Coutts and Co (RBSG) £5.6 million (approximately $8.9 million) for failing to have in place adequate systems and controls to prevent breaches of UK financial sanctions. This is the biggest fine imposed by the FSA to date in pursuit of its financial crime objective. It is also the first fine imposed by the FSA under the Money Laundering Regulations 2007.

The Regulations require that firms maintain appropriate policies and procedures in order to prevent funds or financial services being made available to those on the HM Treasury Sanctions List. The FSA found that between December 15, 2007, and December 31, 2008, RBSG failed to adequately screen both their customers and the payments they made and received against the List.

The FSA considered that RBSG’s failings in relation to their screening procedures were particularly serious because of the risk posed to the integrity of the UK financial services sector. Specifically, it could have facilitated transactions involving sanctions targets, including terrorist financing.

Margaret Cole, FSA Director of Enforcement and Financial Crime, said: “The scale of the fine shows how seriously the FSA takes this issue and should act as a warning to other firms to ensure that they have adequate screening procedures.”

As RBSG agreed to settle at an early stage of the FSA investigation, it qualified for a 30% reduction in penalty which would otherwise have been £8 million (approximately $12.7 million).

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On July 28, the UK Supreme Court upheld the English Court of Appeal’s judgment that the power of the UK Financial Services Authority (FSA) to prosecute criminal offenses was not limited to the offenses specified in sections 401 and 402 of the Financial Services and Markets Act 2000 (see the October 23, 2009, edition of Corporate and Financial Weekly Digest). In particular, the Supreme Court confirmed that the FSA has the power to prosecute money laundering and other offenses within the ambit of the FSA’s statutory objectives.

To read the UK Supreme Court judgment, click here.

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On August 2, the English Court of Appeal handed down its judgment on the client money directions application made in the Administration of Lehman Brothers International (Europe) (LBIE). The Court of Appeal overturned Mr. Justice Briggs’ High Court decision in part, holding unanimously that:

1. Clients whose money (as opposed to securities and other assets) should have been segregated by LBIE as client money prior to administration but was not are entitled to share in the client money pool.
2. Money held by LBIE (at the time of administration) outside its segregated client money accounts which is “identifiable client money” is to be pooled with the client money held in its segregated accounts.
3. The client money pool will be distributed pro rata to all of LBIE clients entitled to claim against the pool, with the share of each client calculated based on the amount of client money which should have been segregated, as a proportion of the total amount which LBIE should have segregated.

LBIE’s Joint Administrators stated that they were considering the Court of Appeal’s judgment carefully to assess its implications for LBIE’s client money claimants and creditors, including, in particular, on the likely timing and level of any distribution of client money.

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