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

Co-authored by David S. Kravitz

On April 18, the NASDAQ Stock Market LLC filed a proposed rule change with the Securities and Exchange Commission to adopt additional listing requirements for companies that have become public through transactions in which unlisted private operating companies merge into publicly traded shell companies, commonly known as reverse mergers. According to NASDAQ, proposed Rule 5110(c) was promulgated in response to widespread concerns of fraudulent behavior by, and unreliable financial statements of, reverse merger companies.

Proposed Rule 5110(c) would permit a company formed through such a reverse merger to submit an application for initial listing on a NASDAQ market only after that company has (1) traded for no less than six months in the over-the-counter market or on another national securities exchange or listed foreign market following the filing with the SEC or other regulatory authority of audited financial statements for the combined company, and (2) maintained a bid price of at least $4 per share on at least 30 of the 60 trading days immediately preceding the filing of the initial listing application.

The proposed rule also provides that a reverse merger company would only be approved for listing if, following the reverse merger transaction, it has timely filed (1) in the case of a domestic issuer, at least two periodic financial reports with the SEC or other regulatory authority, or (2) in the case of a foreign private issuer, one or more reports including financial statements for a period of not less than six months.

Proposed Rule 5110(c) would not apply to reverse merger companies applying for listing on NASDAQ in connection with a firm commitment underwritten public offering.

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Section 989G(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act required the Securities and Exchange Commission to conduct a study to determine how the SEC could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act (the auditor attestation requirement) for companies whose market capitalization is between $75 and $250 million, while at the same time maintaining investor protection. The SEC was also required to consider whether an exemption for such companies from Section 404(b) compliance would encourage the U.S. listing of initial public offerings (IPOs).

In a 113-page study published on April 22, the SEC concluded that the existing requirements for issuers with a $75-$250 million public float to comply with the auditor attestation provisions of Section 404(b) should be maintained and that no new exemptions should be granted. Specifically, the SEC found that over time the costs and burdens of Section 404(b) compliance have declined and that eliminating them would not "justify the loss of investor protections and benefits to issuers...". It also found that "the evidence does not suggest that granting an exemption to issuers that would expect to have $75-$250 million in public float following an IPO would, by itself, encourage companies in the United States or abroad to list their IPOs in the United States". In sum, the SEC, noting that the Dodd-Frank Act already exempts approximately 60% of reporting issuers from Section 404(b) compliance, does not recommend further extending this exemption.

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Co-authored by Natalya S. Zelensky

The Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Commodity Exchange Act to provide that a U.S. financial institution for which there is a federal regulatory agency could not enter into retail foreign exchange (retail forex) transactions except pursuant to a rule or regulation of a federal regulatory agency allowing such transactions. The Office of the Comptroller of the Currency (OCC) has proposed a rule authorizing national banks, federal branches or agencies of foreign banks, and their operating subsidiaries (national banks) to engage in retail forex transactions. In addition, the proposed rule describes various requirements that national banks must comply with in order to engage in such transactions. The proposed rule is modeled on the Commodity Futures Trading Commission's retail forex rule in order to promote consistent treatment of retail forex transactions regardless of whether a retail forex customer's dealer is a national bank or a CFTC registrant. Comments on the OCC's proposed retail forex rule must be received by May 23.

Click here to read the OCC's proposal in the Federal Register.

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Co-authored by Natalya S. Zelensky

The Securities and Exchange Commission has approved the Financial Industry Regulatory Authority's proposal to adopt consolidated rules governing books and records. The effective date for the new rules is December 5. The new rules, modeled after NASD Rule 3110, New York Stock Exchange Rule 440 and NYSE Rule Interpretations 410/01 and 410/02, will require member firms to make and preserve certain books and records to show their compliance with securities laws, rules and regulations. New FINRA Rule 4511, based on the general recordkeeping requirements of NASD Rule 3110(a) and NYSE Rule 440, clarifies that member firms must: (1) make and preserve books and records as required by FINRA rules, the Securities Exchange Act of 1934 (Exchange Act) and applicable Exchange Act rules; and (2) preserve books and records required by FINRA rules in a format and media that complies with Exchange Act Rule 17a-4. In addition, FINRA Rule 4511 requires member firms to preserve for at least six years those FINRA books and records for which there is no specified retention period under FINRA rules or applicable Exchange Act rules. The new books and records rules also address records of written customer complaints, authorization records for negotiable instruments, changes in account name or designation, predispute arbitration agreements, order audit trail system recordkeeping requirements, and pre-time stamping.

Click here to read FINRA Regulatory Notice 11-19.

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Co-authored by Kevin M. Foley and Vanessa L. Colman

The Commodity Futures Trading Commission has published its fourteenth series of proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act. These proposals include capital requirements for swap dealers (SDs) and major swap participants (MSPs), interpretive guidance regarding various proposed definitions and the regulation of mixed swaps, proposed rules concerning the bankruptcy protection of cleared swaps customer contracts and collateral, and amendments to adapt certain CFTC regulations to Dodd-Frank Act requirements.

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Co-authored by Jonathan Rotenberg

The U.S. District Court for the Southern District of New York granted defendant United States' motion to dismiss a complaint brought by former investors in the investment advisory firm Bernard L. Madoff Investment Securities LLC (BMIS) seeking money damages under the Federal Tort Claims Act (FTCA) for losses suffered by plaintiffs in connection with the Ponzi scheme perpetrated by Mr. Madoff and BMIS.

The complaint, derived substantially from the Securities and Exchange Commission Office of Inspector General's 457-page report, entitled "Investigation of Failure of the SEC to Uncover Bernard Madoff's Ponzi Scheme," alleged that the SEC was grossly negligent in carrying out its supervisory duties over the securities industry when it failed to uncover Mr. Madoff's Ponzi scheme despite numerous credible and detailed warnings between 1992 and 2008, and several investigations undertaken by the SEC into Mr. Madoff's and BMIS's trading activity.

In granting the United States' motion, the district court found that plaintiffs' claims were within the FTCA's discretionary function exception and barred by sovereign immunity. The court reasoned that the scope, manner and results of investigative activity undertaken by the SEC is "inherently discretionary and policy-driven," and the complaint failed to sufficiently allege any relevant statutory obligations that required the SEC to undertake a more thorough investigation into BMIS. (Molchatsky v. United States, 2011 WL 1471798 (S.D.N.Y. Apr. 19, 2011))

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Co-authored by Jonathan Rotenberg

The U.S. District Court for the District of Nevada dismissed a claim for securities fraud brought under Section 10(b) of the Securities Exchange Act on the ground that plaintiff lacked standing because he had never purchased or sold the securities in question.

Plaintiff was a doctor who worked at defendant Laboratory Medical Consultants (LMC) for 31 years and retired in 2006. LMC redeemed all of plaintiff's stock in accordance with the parties' 2001 Stockholders' Agreement at that time. Under the 2001 Stockholders' Agreement, a portion of plaintiff's deferred compensation benefits was to be secured by an escrow of plaintiff's stock. Plaintiff alleged that his shares were not properly placed in escrow and defendants conspired to defraud him of the value of his shares during the sale of LMC in 2007.

In granting defendant's motion to dismiss, the district court ruled that under Section 10(b), a claim for securities fraud must be made in connection with the purchase or sale of a security. Plaintiff did not allege that he was forced to sell his stock or even that it was sold. He alleged harm based on defendant's action in not placing the stock in escrow, or alternatively, based on defendant's placing the stock in escrow and then converting it. In dismissing the complaint, the court held that "the mere involvement of shares of stock does not bring a transaction within [Section 10(b)]." (Slaughter v. Laboratory Medical Consultants, 2011 WL 1486228 (D.Nev. Apr. 19, 2011))

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On April 14, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the National Credit Union Administration, the Securities and Exchange Commission, and the Federal Housing Finance Agency, published a notice of proposed rulemaking in the Federal Register to implement the incentive-based compensation provisions of Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

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Co-authored by Natalya S. Zelensky

The Securities and Exchange Commission has approved the Financial Industry Regulatory Authority's proposal to delay the implementation date for know-your-customer (FINRA Rule 2090) and suitability rules (FINRA Rule 2111) until July 9, 2012. The previous implementation date was October 7, 2011. Following SEC approval of these rules, many firms requested that the implementation date be delayed to allow firms additional time to determine the types of systems and procedural changes they need to make, implement those changes, and educate associated persons and supervisors regarding compliance with the rules.

Click here to read SEC Release No. 34-64260.
Click here for information on previous guidance from FINRA regarding the new rules, as reported in the January 14 edition of Corporate and Financial Weekly Digest.

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Co-authored by Kevin M. Foley, Christian B. Hennion and Vanessa L. Colman

The Office of the Inspector General (OIG) for the Commodity Futures Trading Commission has issued a report summarizing its investigation into the CFTC's cost-benefit analyses for four rulemakings promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The OIG investigation, which was conducted at the request of Reps. Frank Lucas (R-OK) and K. Michael Conway (R-TX), reviewed how the CFTC formulated its cost-benefit analyses for its rulemakings regarding (1) definitions of "swap dealer," "major swap participant" and other key terms from Title VII of the Dodd-Frank Act; (2) confirmation, portfolio reconciliation and compression requirements for swap dealers and major swap participants; (3) core principles for designated contract markets; and (4) duties of swap dealers and major swap participants.

In its report, OIG concludes that, to a varying extent for the various rulemakings examined, the CFTC's Office of General Counsel (OGC) appeared to have a more dominant role in formulating the cost-benefit analysis than did the CFTC's Office of the Chief Economist (OCE), at times overriding the latter's input into the process. OIG further stated that the OGC's methodology for formulating cost-benefit analyses utilized a historic and "somewhat stripped down" analytical approach, and recommended that a "more robust" approach, with greater OCE input, be implemented.

A copy of the OIG report is available here.

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Co-authored by Kevin M. Foley, Christian B. Hennion and Vanessa L. Colman

The Commodity Futures Trading Commission announced that it will hold an open meeting on the fourteenth series of rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act on April 27. At the meeting, the CFTC will consider, among other things, proposed rulemakings regarding capital requirements for swap dealers and major swap participants, bankruptcy protections for cleared swaps and associated collateral, product definitions under Title VII of the Dodd-Frank Act and other conforming amendments to CFTC regulations.

Information about the meeting is available here.

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Co-authored by Elizabeth D. Langdale

Jepsco, Ltd., a shareholder of Rich Realty Inc. (RRI) requested that all papers filed under seal in an action brought by B.F. Rich Co., Inc. against RRI in the Delaware Chancery Court be opened for review pursuant to Court of Chancery Rule 5(g)(6). Jepsco, which was not a party to the action against RRI, asserted a concern that the sealed documents would reveal that RRI sold assets without providing notice to shareholders, or distributing the proceeds of the transaction. RRI objected to Jepsco's request on the basis that Jepsco was not a party to the action and that the text of Rule 5(g)(6) limited this right to parties.

The Court of Chancery did not determine whether Jepsco had standing under Rule 5(g)(6). Instead, it found a clear basis for Jepsco to intervene in the action under Court of Chancery Rule 24, which delineates the circumstances under which a nonparty may intervene in a pending case either as of right or as permitted by the Court. Under Rule 24, a party has standing either where the party can claim an interest in the subject of the litigation or where the applicant's claim and the main action have a common question of fact or law.

The Chancery Court found that Jepsco's motion met both of the standards. Thus, it granted intervention in the underlying litigation for the limited purpose of obtaining access to documents filed under seal. (B.F. Rich Co., Inc. v. Richard E. Gray, Sr. and Rich Realty, Inc., C.A. No. 1896-VCP (Del. Ch. Apr. 8, 2011))

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Co-authored by Elizabeth D. Langdale

Plaintiffs entered into a Funding Agreement with defendant Gary Hall that directed the parties to create lending entities to facilitate real estate investments. The Funding Agreement provided that the parties would divide profits received by the lending entities. Defendant Bentley Investments of Nevada LLC was a lending entity Mr. Hall created pursuant to the Funding Agreement. Plaintiffs asserted that defendants failed to advance the profits contractually allocated to them, and thereby breached the Funding Agreement.

Defendant Bentley moved to dismiss plaintiffs' complaint on the basis that it failed to plead a breach of contract claim, because Bentley was not a party to the Funding Agreement. Plaintiffs contended that Bentley should be held liable under a "reverse alter ego theory" because it was responsible for Mr. Hall's breaches.

The U.S. District Court for the District of Kansas granted defendants' motion to dismiss, rejecting plaintiffs' argument that Bentley was liable on a reverse alter ego liability theory. Citing Tenth Circuit precedent, the district court noted that absent a clear statement under state law that reverse alter ego liability is appropriate, federal courts should not hold a corporation liable for the acts of an individual. Because Kansas has not clearly adopted reverse alter ego liability, plaintiffs could not predicate a claim on this theory to hold defendant Bentley liable. (Bettis v. Hall, No. 10-2457-JAR, 2011 WL 1430327 (D. Kan. Apr. 14, 2011))

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Co-authored by Ann M. Kim

The U.S. Department of Labor (DOL) recently indicated that it may update the rules governing electronic disclosure of benefit plan information (e.g., summary plan descriptions, benefit statements, administrative forms, annual notices, etc.). DOL rules generally require disclosure procedures that are reasonably intended to ensure actual receipt of the relevant documents by plan participants and beneficiaries. In 2002, the DOL adopted a safe harbor rule that allowed for electronic disclosure—usually through a website or email. If the safe harbor rule is followed, the plan sponsor/administrator will be deemed to have satisfied the disclosure requirements.

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Co-authored by James B. Anderson

On April 8, the Securities and Exchange Commission updated its planned schedule for adopting rules and taking other actions to implement the corporate governance and disclosure provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As reported in the September 24, 2010, edition of Corporate and Financial Weekly Digest, the SEC had previously announced its planned rulemaking schedule to implement provisions of the Dodd-Frank Act. The updated schedule delays implementation of some of these provisions by as much as six months. Below are updated time periods set forth in the SEC's revised rulemaking schedule for governance and disclosure rules to be adopted during such time periods, as well as certain related actions. Section references are to the Dodd-Frank Act.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The Commodity Futures Trading Commission has published its thirteenth series of proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposals relate to the establishment of initial and variation margin requirements for uncleared swaps and to recordkeeping and reporting requirements for existing swaps.

Margin Requirements for Uncleared Swaps

The CFTC has proposed rules to implement Section 731 of the Dodd-Frank Act, which requires the CFTC to adopt rules imposing initial and variation margin requirements on all swaps that are not cleared by a derivatives clearing organization (DCO). The margin requirements would apply to uncleared swaps entered into after the effective date of the rules.

The proposed rules would apply to swap dealers (SDs) and major swap participants (MSPs) that are not subject to oversight by a regulator other than the CFTC. Margin requirements would vary by counterparty, depending on whether the counterparty is a "financial entity," as defined under Section 2(h)(7)(C) of the Commodity Exchange Act. The proposed rules would require initial and variation margin to be paid on all uncleared swaps that are entered into between an SD or MSP with an SD or MSP. Initial margin posted for swaps between SDs and MSPs would have to be deposited with a third-party custodian and could not be rehypothecated.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The Commodity Futures Trading Commission and the Securities and Exchange Commission will jointly conduct a public roundtable discussion to address the schedule for implementing final rules for swaps and security-based swaps under the Dodd-Frank Wall Street Reform and Consumer Protection Act, including whether to phase in the implementation of the new requirements. The roundtable will take place on May 2 and 3 at the CFTC headquarters in Washington, D.C. Further information about the public roundtable, including how to submit advance comments to the CFTC and SEC, is available here.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The Commodity Futures Trading Commission and the Federal Trade Commission (FTC) have signed a Memorandum of Understanding (MOU) to facilitate the sharing of non-public information between the agencies in connection with investigations into possible market manipulation. In its press release announcing the MOU, the CFTC focused on information sharing related to investigations into fraud-based manipulation of the oil and gasoline markets. The MOU states that "[u]nless applicable law requires otherwise, the [CFTC and the FTC] shall take all actions reasonably necessary to preserve, protect and maintain all privileges and claims of confidentiality related to all nonpublic information provided pursuant to this MOU."

The MOU is available here. The CFTC press release about the MOU can be found here.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The National Futures Association (NFA) has amended the Self-Examination Questionnaire required to be reviewed annually by NFA members in order to identify and correct any supervisory deficiencies. Specifically, NFA has added a section to the Questionnaire for Forex Dealer Members (FDMs), updated other sections of the Questionnaire to assist non-FDM members in reviewing their forex operations, and made general updates to the Questionnaire.

In connection with the amendments to the Questionnaire, NFA has amended the related Interpretive Notice 9020 to require FDMs to complete the Questionnaire and to require non-FDM members who engage in forex transactions to use the Questionnaire to review their forex operations.

The amended Questionnaire can be found here.
NFA's letter to the Commodity Futures Trading Commission regarding the amendments to Interpretive Notice 9020 can be found here.

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Co-authored by Natalya S. Zelensky

On March 30, in Wiener v. Eaton Vance Distributors, Inc., the U.S. District Court for the District of Massachusetts dismissed an Eaton Vance Municipals Trust shareholder derivative suit involving Eaton Vance Distributors, Inc. and the Trust's nine trustees, alleging that the asset-based Rule 12b-1 fees paid by the Trust to Distributors and selling broker-dealers who distribute Trust mutual fund shares violated the Investment Advisers Act of 1940 since neither Distributors nor the selling broker-dealers were registered under the Advisers Act. The plaintiff sought, among other things, the rescission of the distribution agreement between the Trust and Distributors under Section 47(b) of the Investment Company Act of 1940 (1940 Act).

Section 47(b) creates a private right of action for a party to void a contract that involves a violation of the 1940 Act or any rules thereunder. The plaintiff argued that the alleged violations of the Advisers Act constitute violations of Section 36(a) of the 1940 Act (allowing the Securities and Exchange Commission to bring enforcement actions against, among others, fund trustees and principal underwriters for breaches of fiduciary duties) and SEC Rule 38a-1 (requiring investment companies to establish and maintain adequate compliance policies and procedures) as grounds to rescind the distribution agreement. The court rejected these arguments, stating that Section 47(b) covered violations of the 1940 Act, not of the Advisers Act, and declined to create a private right of action under Section 36(a). The court also stated that the complaint failed to allege a violation of Rule 38a-1 and declined to imply any general duties arising out of the rule.

The Wiener case dismissal follows the October 2010 dismissal of a virtually identical complaint filed in the U.S. District Court for the Northern District of California against Franklin/Templeton Distributors, Inc.

Click here to read the Massachusetts federal court's opinion dismissing the case.

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Co-authored by Brian Schmidt

The U.S. Court of Appeals for the Ninth Circuit upheld a lower court's approval of a settlement agreement entered into by The Facebook, Inc. and individual litigants, Cameron and Tyler Winklevoss and Divya Narendra (the Winklevosses), who claimed that the idea for the popular social networking site had been stolen from them. The Winklevosses and their own social networking site sued Facebook and its founder Mark Zuckerberg in Massachusetts and Facebook countersued in California. The California court eventually dismissed the Winklevosses for lack of personal jurisdiction and the parties were ordered to mediate.

During the course of the mediation, the parties signed a handwritten, one-and-a-third page term sheet and settlement agreement. However, after the agreement was signed, a dispute arose during negotiations over the final details, and Facebook moved for an order enforcing the handwritten settlement agreement. The lower court found the agreement enforceable and the Winklevosses appealed. Facebook also sought an order from the lower court requiring the Winklevosses to sign more than 130 pages of documents to effect the settlement, including a stock purchase agreement and other papers, which the court refused to grant.

The Winklevosses argued that the handwritten agreement was unenforceable because it lacked material terms, such as those in the 130 pages of deal documents the parties were negotiating after the agreement was signed. The Ninth Circuit disagreed, distinguishing between material terms that are necessary, "without which there can be no contract," and terms that are "important" and that affect "the value of the bargain." A contract that omits the latter type of terms is "enforceable under California law, so long as the terms it does include are sufficiently definite for a court to determine whether a breach has occurred, order specific performance or award damages." Under this test, the handwritten settlement agreement easily passed muster, as it provided that Facebook would acquire the Winklevosses' site, the Winklevosses would get a cash payment and an interest in Facebook, and that both sides would cease litigation.

Moreover, the handwritten settlement agreement also specified that material terms would be determined later by Facebook "consistent with a stock and cash for stock acquisition." The court read this provision to mean that the parties intended to be bound by the handwritten agreement even though certain material aspects would be finalized later. The Ninth Circuit also rejected the Winklevosses' claim for rescission of the settlement agreement based on purported securities laws violations, finding that they had released all such claims when they signed the settlement agreement. (The Facebook, Inc. v. Pacific Northwest Software, Inc., Nos. 08-16745; 08-16873, 09-15021, 2011 WL 1346951 (9th Cir. Apr. 11, 2011))

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Co-authored by Brian Schmidt

Deciding an issue of first impression, the Superior Court of Delaware recently authorized the assertion of claims based on a new theory of tortious interference with contract, but ruled that the plaintiff failed to state a claim under that theory. Allen Family Foods, Inc. operates a poultry processing facility and had contracted with Capital Carbonic Corporation to supply dry ice for the facility. In September 2010, Allen, believing that its contract with Carbonic had been terminated by its terms, entered into a contract with Praxair Distribution, Inc. to supply dry ice. Thereafter, Carbonic sent a letter to Praxair threatening litigation, after which Allen ceased performance of its contract with Praxair and, instead, continued to purchase dry ice pursuant to its previous agreement with Carbonic.

Allen then sued Carbonic, alleging that Carbonic tortiously interfered with its agreement with Praxair. Traditionally, to assert a tortious interference with contract claim, the plaintiff must allege that the defendant's conduct "induce[d] a third party to terminate a contract with the plaintiff unlawfully." Under the Restatement (Second) of Torts, there is an additional basis for a tortious interference claim where, rather than induce a third party to breach a contract, the alleged wrongdoer "intentionally and improperly interferes with the performance of a contract... between [the plaintiff] and a third person, by preventing the [plaintiff] from performing the contract or causing his performance to be more expensive or burdensome."

No Delaware court had reviewed this theory of tortious interference before, and the court examined opinions from other jurisdictions before holding that it was a valid expansion of the law of tortious interference of contract. In so holding, the court noted that "it seems irrational to recognize a cause of action for a party's conduct directed at a third party designed to prevent that third party from performing a contract with [the plaintiff] and not recognize a similar cause of action for [the plaintiff] where the actor's conduct is instead directed at the [plaintiff] to prevent them (sic) from performing."

Nevertheless, the court held that Allen failed to state a claim under the new theory because the letter that Carbonic sent that formed the basis for Allen's claims was directed to Praxair, not Allen. Moreover, the claim failed because Allen failed to allege that it was prevented from performing the agreement with Praxair or that its performance of that agreement was made more expensive by Carbonic's actions. Nor did Allen allege a breach of contract by Praxair, a requirement to state a claim under the traditional theory of tortious interference. Instead, Allen merely alleged that it was damaged because it continued to accept shipments of dry ice from Carbonic, an allegation that is insufficient to state a claim for tortious interference with contract under any theory. (Allen Family Foods, Inc., v. Capital Carbonic Corp., No. N10C-10-313 (Sup. Ct. Del. Mar. 31, 2011))

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On April 12, federal banking regulators (Agencies) proposed regulations, pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, requiring certain large participants in the OTC swaps market (“covered swaps entities”) to collect margin from other covered swaps entities. This proposed regulations would impose initial margin and variation margin requirements on covered swaps entities for uncleared swaps. This would require covered swaps entities to calculate and collect initial margin and variation margin from all swap counterparties. The amount of margin that would be required would vary based on the relative risk of the counterparty and the swap. The proposed regulations would also impose existing regulatory capital rules on covered swaps entities. These initial margin, variation margin and capital standards are intended, according to the Agencies, to offset the risk to swap entities and the financial system arising from the use of swaps that are not cleared.

The proposed regulations would require commercial end users to comply with the margin requirements noted above only if their exposure is above a predefined level calculated by the seller of the swap; commercial end users of derivatives would not be required to post margin unless their activity exceeds the risk limits of the entity with which they are transacting. According to the Agencies, low-risk financial end users, including most community banks, would not be required to post margin unless their activity exceeds substantial thresholds or the risk limits of the entity with which they are transacting.

The proposal establishes minimum quality standards for acceptable margin collateral. It also establishes minimum safekeeping standards for collateral posted by covered swap entities to ensure that collateral is available to support the trades and not housed in a jurisdiction where it is not available if defaults occur.

Comments to these proposed rules are being solicited through June 24. New trades would not be subject to the proposed requirements until after the proposed effective date, which is currently planned for six months after the federal banking regulators issue the final version of these proposed requirements.

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Co-authored by Edward Black

On April 11, the Independent Commission on Banking (ICB), established by the UK Government in July 2010, published for consultation its interim report on potential reforms to the UK banking sector. Its proposals have the twin aims of financial stability and competition.

The ICB stresses that it has not yet reached any final conclusions. Its key interim proposals are:

1. As expected, the ICB has stopped short of realizing the banks' worst fears—recommending a British version of the repealed U.S. Glass-Steagall Act and forcing a separation of ownership between investment and commercial/retail banking. However, it is recommending a form of "Glass-Steagall light"; retail banking operations can be owned by a combined, or "universal", bank, but must be ring-fenced into a separate subsidiary of the investment or combined bank.
2. Systemically important banks should hold equity capital of at least 10% (up from the 7% recommended by new EU regulations). Investment and wholesale banking operations in the UK will only have to maintain capital reserves in accordance with international norms. The criteria for qualifying as a "systemically" important bank are not yet defined.
3. Universal banking groups would be able to move capital between their investment and retail banking subsidiaries provided that each subsidiary meets its distinct capital reserve requirements at all times.
4. The ICB does not at present recommend the adoption of a UK equivalent of the "Volcker Rule."
5. Banks should issue debt which suffers some of the loss if the bank gets into trouble; the report is sketchy on the detail here but the principle is that the bank's bondholders, as well as its equity, should suffer at least some of the pain if a bank runs into trouble. The report also floats the idea of bank depositors' money ranking ahead of other debt on bankruptcy (as is already the case in a number of countries).
6. The role of the proposed organizations which will replace the UK Financial Services Authority (FSA) in due course (see the June 18, 2010, and July 30, 2010, editions of Corporate and Financial Weekly Digest) is clarified. The Financial Conduct Authority, which will be responsible for prudential and conduct supervision of banks, investment firms and exchanges, is clarified. The other regulator replacing the FSA will be the Prudential Regulatory Authority, which will have primary responsibility for monitoring banks' balance sheets and financial soundness. 
7. The UK retail banking market is perceived to suffer from a lack of competition. As it has over 30% of the UK retail market, ICB's preliminary recommendation is that Lloyds will almost certainly be ordered to sell off several hundred more branches. Other large retail banks may also be ordered to divest branches in order to promote competition.
8. The ICB notes with approval proposals to standardize and clear OTC derivatives.

The consultation stage lasts until July 4. The ICB is due to issue its final report and recommendations to the UK Government in September 2011.

Read more.

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On April 5, the Securities and Exchange Commission announced that the national securities exchanges and the Financial Industry Regulatory Authority filed proposals to establish "limit up-limit down" requirements (Limit Rules) to address extraordinary market volatility in the U.S. equity markets. The Limit Rules would replace the existing single stock circuit breaker pilot program established in response to the market events of May 6, 2010.

The proposed Limit Rules would prevent trades in listed equity securities from occurring outside set price ranges (i.e., a certain percentage above and below the average price of a security over the preceding five minutes). The following percentage limits would apply:

1. 5% for stocks subject to the current circuit breaker pilot (i.e., stocks in the S&P 500 Index, the Russell 1000 Index and certain exchange-traded funds);
2. 10% for stocks not currently subject to the circuit breaker pilot; and
3. double the applicable percentage during opening and closing periods.

Moreover, the proposed Limit Rules would pause trading in a particular stock for five minutes if trading is unable to occur within the acceptable price range for more than 15 seconds.

The national exchanges and FINRA have requested that the SEC approve the proposed Limit Rules as a one-year pilot program.

To read the SEC release, click here.

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Co-authored by Kevin M. Foley and Vanessa L. Colman

The Commodity Futures Trading Commission announced that it will hold an open meeting on the thirteenth series of rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act on April 12. At the meeting, the CFTC will consider, among other things, proposed rulemakings regarding the imposition of margin requirements for uncleared swaps on swap dealers and major swap participants.

Information about the meeting is available here.

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Co-authored by Gregory C. Johnson

The U.S. Court of Appeals for the Fifth Circuit held that a corporate fiduciary who exercises substantial control over a limited partnership managed by a corporation can owe fiduciary obligations to the partnership itself.

David Harwood was a Director and the Chief Operating Officer of B&W Finance Co., Inc., which was the sole general partner of FNFS, Ltd., a limited partnership engaged in consumer lending operations. Mr. Harwood, who managed B&W's daily affairs, exercised substantial control over FNFS, and withdrew more than $800,000 of FNFS funds as personal loans that he allegedly neglected to properly record. The B&W board terminated Mr. Harwood, who filed for Chapter 7 bankruptcy, and B&W challenged Mr. Harwood's ability to discharge his debts to FNFS because he accrued this debt through defalcation while acting as a fiduciary.

The bankruptcy court ruled the debts were not dischargeable and Mr. Harwood appealed. He argued that while he owed a duty to B&W as an officer and director, this duty did not transfer to FNFS, the limited partnership managed by B&W. The Fifth Circuit disagreed, ruling that the status of a fiduciary was based on the trust conferred on Mr. Harwood and the control he exercised over FNFS. Accordingly, his debts to the partnership were not dischargeable. (In re Harwood, No. 10–40406, 2011 WL 1239810 (5th Cir. April 5, 2011))

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Co-authored by Gregory C. Johnson

Allegations that a medical device manufacturer knowingly overbilled insurance companies and reported these unrecoverable accounts as income were sufficient to support security fraud claims.

According to plaintiffs, Zynex Inc. deliberately overbilled insurance companies and reported this inflated income on its financial statements even though top officers knew that the company would not be able to collect this amount. Zynex announced on April 1, 2009, that it was revising its financial reports for the first three quarters of 2008, telling investors that the reduction in earnings was based on "provider discounts" that should have been recognized during that period. Zynex's stock price dropped 56% following the announcement, and plaintiffs sued the company and two officers for securities fraud under Section 10(b) of the Securities Exchange Act of 1934
and Rule 10(b)(5) promulgated thereunder.

The defendants moved to dismiss, arguing that plaintiffs' allegations at most showed that accounting mistakes occurred, and that the alleged over-billing did not give rise to a strong inference that the company intended to mislead investors. The U.S. District Court for the District of Colorado disagreed, holding that the alleged insistence of Zynex officers to continue the practice of overbilling—despite being aware that collection was impossible— demonstrated an intent to deceive. The Court also noted that the amount of the earnings reduction was "substantial," which also supported the federal fraud claims. (Mishkin v. Zynex Inc., Civil Action No. 09–cv–00780–REB–KLM, 2011 WL 1158715 (D. Colo.))

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The Federal Reserve Board on April 6 requested comment on a proposed rule to repeal the Board's Regulation Q, which prohibits the payment of interest on demand deposits by institutions that are member banks of the Federal Reserve System. The proposed rule would implement Section 627 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which repeals Section 19(i) of the Federal Reserve Act in its entirety effective July 21. The repeal of that section of the Federal Reserve Act on that date eliminates the statutory authority under which the Board established Regulation Q. The proposed rule would also repeal the Board's published interpretation of Regulation Q and would remove references to Regulation Q found in the Board's other regulations, interpretations and commentary. The Board is seeking comment on whether the repeal of Regulation Q, currently set forth at 12 CFR 217.101, is expected to have implications for balance sheets and income of depository institutions, short-term funding markets such as the overnight federal funds market, the demand for interest-bearing demand deposits, and competitive burden on smaller depository institutions. Some bankers feel that their banks will be compelled to offer accounts that pay interest or lose corporate business, which would either crimp margins or eliminate a source of deposit liabilities.

Technically, the proposal would affect only member banks of the Federal Reserve System. However, other banking agencies are expected to follow suit with similar actions that would apply to their regulatees, regardless of size, that hold demand deposits. The proposal would permit, but not require, member banks to pay interest on demand deposits maintained at those institutions. As such, the Board expects that the proposal would have a positive impact on such entities because it would eliminate an obsolete regulatory provision and because member banks are not obligated to offer interest-bearing demand deposits following the repeal of Regulation Q. The Board promulgated Regulation Q on August 29, 1933, to implement Section 19(i) of the Act. In the past, Regulation Q also contained provisions implementing then-current statutory provisions regulating the rates of interest payable on various types of interest-bearing deposits. The Depository Institutions Deregulation Act of 1982 phased out these statutory interest rate limitations effective in March 1986. After that time, Regulation Q consisted primarily or exclusively of provisions related to implementing Section 19(i)'s prohibition of the payment of interest on demand deposits by member banks.

Read more.

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Co-authored by David S. Kravitz

On March 30, the Securities and Exchange Commission proposed rules directing the national securities exchanges to adopt listing standards related to the compensation committees of listed companies and their consultants and advisers, as required by Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which added Section 10C to the Securities Exchange Act of 1934. As with all listing standards, the exchanges would need the approval of the SEC prior their adoption.

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Co-authored by Christopher T. Shannon

The Financial Industry Regulatory Authority is requesting comment on a proposed new rule clarifying the scope of a member firm's obligations and supervisory responsibilities for functions or activities outsourced to a third-party service provider. According to FINRA, new Rule 3190 (Use of Third-Party Service Providers) addresses continued requests from its member firms for FINRA to identify specific functions that a clearing or carrying member firm may outsource to a third-party service provider and the appropriateness of any member firm outsourcing activities to a third-party service provider that is not registered as a broker-dealer.

Proposed Rule 3190 makes clear that outsourcing functions of a broker-dealer to a third-party service provider does not relieve the member firm of its obligation to comply with applicable securities laws and regulations. Moreover, a member firm cannot delegate its responsibilities for, or control over, any outsourced functions.

The proposed rules also require that a member firm maintain supervisory procedures, including due diligence measures, "reasonably designed" to ensure that third-party service provider arrangements achieve compliance with applicable securities laws and regulations. There are additional restrictions and obligations contained in the proposed rule that apply solely to clearing and carrying member firms and third-party service provider arrangements. Comments on Proposed Rule 3190 are due by May 13.

Click here to read Regulatory Notice 11-14, issued by FINRA in March.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The Financial Stability Oversight Council (FSOC) has released proposed rules regarding the criteria under which it will designate certain financial market utilities (FMUs) as "systemically important."

The Dodd-Frank Wall Street Reform and Consumer Protection Act defines an FMU generally as any person that manages or operates a multilateral system for the purposes of transferring, clearing or settling payments, securities, or other financial transactions among financial institutions or between a financial institution and that person.

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Co-authored by Kevin M. Foley and Joshua A. Penner

The Options Clearing Corporation (OCC) has submitted a petition to the Commodity Futures Trading Commission to permit OCC to operate an internal non-proprietary cross-margining program available to market professionals who trade futures products and securities products that are cleared by OCC in its capacity as a derivatives clearing organization and a securities clearing agency, respectively.

The CFTC requires that cross-margined futures and securities positions that are cleared solely by OCC be cleared by the same clearing member. OCC is requesting a modification to permit internal non-proprietary cross-margining accounts to be maintained at OCC jointly by a pair of affiliated clearing members, each of which is dually registered as a futures commission merchant and a securities broker-dealer.

The CFTC is requesting comments on this proposed change. The comment period will close on April 22.

OCC's request can be found here.

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Co-authored by Jessica M. Garrett

Shareholders of The9, Ltd., which operates online video games in China, filed a class action against the company and certain of its current and former officers for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that defendants fraudulently misrepresented facts relating to the likelihood of renewal of the company's most profitable exclusive license. The U.S. District Court for the Southern District of New York held that plaintiffs failed to adequately plead fraud and granted the defendants' motion to dismiss.

Plaintiffs claimed that certain executives made false statements in earnings calls, filings with the Securities and Exchange Commission and press releases regarding the likelihood of renewing an exclusive license to provide and run the networks and servers for the videogame "World of Warcraft" (WoW), which accounted for 90% of the company's revenues. Plaintiffs claimed that the company's executives engaged in a scheme to personally benefit from WoW before the expiration of the WoW license, which was ultimately not renewed, by, among other things, selling their shares of The9 during the class period. However, only one executive sold her shares, under a Rule 10b5-1 plan, and the company's president actually increased his beneficial holdings during the class period.

The court held that plaintiffs failed to sufficiently allege that defendants personally benefitted from the purported fraud. Because the inference that the company made a concerted effort to renew the license was stronger than the inference supporting scienter, the court rejected the plaintiffs' claims and granted the defendants' motion to dismiss. (Glaser v. The9, Ltd., 2011 WL 1106713 (S.D.N.Y. March 28, 2011))

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Co-authored by Jessica M. Garrett

Shareholders of MetroPCS Communications, Inc., the nation's fifth-largest wireless communications provider, filed a federal securities class action against the company and certain of its officers, alleging that defendants made materially false or misleading statements or omissions regarding the company's future prospects that artificially inflated the value of MetroPCS common stock in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The U.S. District Court for the Northern District of Texas held that plaintiffs failed to adequately plead fraud and granted the defendants' motion to dismiss.

The objectionable statements related to: (1) the accuracy of the 2009 earnings guidance issued at the end of 2008; (2) the strength of MetroPCS's business model in a recessionary economy; (3) the impact of increased competition on the wireless communications business; and (4) the relationship between subscriber growth and attrition, particularly in light of a cell phone promotion that may have attracted disloyal customers who were inclined to leave after the promotion ended. Plaintiffs alleged that certain officers sold their shares prior to announcing adjusted corporate financials for 2009, causing the stock price to fall from $18.85 to $6.01 per share.

The court determined that plaintiffs did not adequately allege a strong inference of scienter. The defendants' sale of shares pursuant to preexisting Rule 10b5-1 trading plans undermined any inference of suspiciousness surrounding the timing or amount of the stock sales. In addition, the claim that the defendants had access to information that the cell phone promotion was increasing the rate of customer attrition, and thereby was not accretive to the company, was not alleged with any particularity as to any individual defendant. The court dismissed the plaintiffs' Amended Complaint and ordered plaintiffs to reimburse MetroPCS's court costs.
(Hopson v. MetroPCS Communications, Inc., et al., Civil Action No. 3:09-cv-02392 (N.D. Tex. March 25, 2011))

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The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) approved on March 29 a joint Notice of Proposed Rulemaking (NPR) for covered systemic organizations to file and report resolution plans and credit exposure reports as required in Title I, Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Resolution plans, also known as "living wills," would have to be submitted within 180 days of the effective date of a final regulation, and Credit Exposure Reports would have to be filed 30 days after the end of each calendar quarter. The NPR is to be issued jointly with the Board of Governors of the Federal Reserve System. The regulation would apply to organizations that have $50 billion or more in total consolidated assets.

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Six federal agencies, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission, the Federal Housing Finance Agency, and the Department of Housing and Urban Development, are seeking comment on a proposed rule, approved by the FDIC on March 30, that would require sponsors of asset-backed securities (ABS) to retain at least 5% of the credit risk of the assets underlying the securities and would not permit sponsors to transfer or hedge that credit risk. The proposal, totaling 376 pages in length, would provide sponsors with various options for meeting the risk-retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The options include but are not necessarily limited to: (1) a "vertical" slice of the ABS interests, whereby the sponsor or other entity retains a specified pro rata piece of every class of interests issued in the transaction; (2) a "horizontal" first-loss position, whereby the sponsor or other entity retains a subordinate interest in the issuing entity that bears losses on the assets before any other classes of interests; (3) a "seller's interest" in securitizations structured using a master trust collateralized by revolving assets whereby the sponsor or other entity holds a separate interest that is pari passu with the investors' interest in the pool of receivables (unless and until the occurrence of an early amortization event); or (4) a representative sample, whereby the sponsor retains a representative sample of the assets to be securitized that exposes the sponsor to credit risk that is equivalent to that of the securitized assets. The proposed rules also include disclosure requirements that are an integral part of and specifically tailored to each of the permissible forms of risk retention.

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On March 30, the UK Ministry of Justice published detailed guidance on "adequate procedures" for companies to put in place to prevent infringement of the Bribery Act 2010. It also published a shorter "quick start guide" aimed at smaller businesses.

The Bribery Act, which will come into force on July 1, creates four criminal offenses: (1) bribing another; (2) being bribed; (3) bribing a foreign official; and (4) (for commercial organizations) failing to prevent bribery. If a commercial organization can show that it has adequate procedures in place, this can form the basis of a defense to the offense of failing to prevent bribery.

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