Investment Management

Posted on Thursday, August 17 2017 at 8:39 am by

DOL Proposes an Extension of the Fiduciary Rule Transition Period

By Paul Foley and John I. Sanders

When the DOL Fiduciary Rule became effective on June 9th, it marked the start of a transition period that was scheduled to end on January 1, 2018 (the “Transition Period”).[i]  During the Transition Period, compliance burdens under the Fiduciary Rule are relaxed.  For example, those seeking to rely on the Best Interest Contract Exemption (the “BIC Exemption”) will face less stringent requirements.[ii]  Also, the DOL stated that it would not bring enforcement actions during the Transition Period against “fiduciaries who are working diligently and in good faith to comply with the new rule and exemptions.”[iii]

Last week, the DOL submitted proposed amendments to the BIC Exemption and certain other exemptions to the Fiduciary Rule.[iv]  We learned of this development through a 2-page filing the DOL made in relation to ongoing litigation.[v]  Unfortunately, the filing provided little detail, and the full text of the proposed amendments will not be available to the public until the conclusion of an interagency review.[vi]  However, what seems apparent, based upon the title of the proposed amendments in the filing, is that the proposed amendments include an extension of the Transition Period from January 1, 2018 to July 1, 2019.[vii]

In the long term, we believe that the DOL’s proposed amendments foreshadow either significant modifications to or a full repeal of the Fiduciary Rule and its exemptions.  In the near term, we believe the extension of the Transition Period, coupled with the temporary non-enforcement policy, provides fiduciaries with a reason to breathe easier.

Please contact us if you have any questions about this article or the DOL Fiduciary Rule generally.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[i] Department of Labor, Conflict of Interest FAQs (Transition Period) (May 2017), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-transition-period-1.pdf.

[ii] Id.

[iii] Id.

[iv] Thrivent Financial for Lutherans v. Acosta, et al., No. 0:16-cv-03289 (D. Minn. Sept. 29, 2016), available at http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0ahUKEwjTqJP_utzVAhWI7CYKHdKTDrcQFggrMAE&url=http%3A%2F%2Fmedia.thinkadvisor.com%2Fthinkadvisor%2Farticle%2F2017%2F08%2F09%2Fthriventvdolnotice8-9-2017.pdf&usg=AFQjCNFWeSsTSR6C69Z17yHF1q1a7bkDpg.

[v] Id.

[vi] Id.

[vii] Id.

Posted on Wednesday, July 26 2017 at 8:58 am by

Six Ways to Improve Cybersecurity Policies and Procedures

By Paul Foley and John I. Sanders

The SEC has declared cybersecurity to be an examination priority for financial institutions (i.e., broker-dealers, investment advisers, and registered investment companies) in each of the past four years.[1]  While the SEC’s comments in these examination priority releases are helpful for financial institutions, we believe that the SEC may have provided more useful guidance concerning cybersecurity practices through investor bulletins designed to help investors avoid online fraud.[2]  This guidance reveals helpful insights into the SEC’s evolving approach to cybersecurity.  Accordingly, based on the SEC’s most recently issued guidance to investors, we identify six ways financial institutions could improve their cybersecurity policies and procedures below.[3]

1. Passwords. The SEC has recommended that investors choose a strong password (e., one that includes symbols, numbers, and both capital and lowercase letters) for online access, keep their password secure, and change it regularly.[4]  Consistent with this recommendation, financial institutions may want to consider requiring clients to choose strong passwords and change them regularly.

2.  Biometric Safeguards. The SEC has recommended that investors contact their financial institutions to determine whether they offer biometric safeguards (g., fingerprinting, facial and voice recognition, and retina scans) for mobile device access.[5]  Although biometric safeguards are not currently a standard security feature, financial institutions may want to consider ways they can add biometric safeguards as a feature of mobile device access for their clients.

3.  Public Computers. The SEC has recommended that investors avoid using public computers to access investment accounts.[6]  When an investor does use a public computer, the SEC recommends investors take the following precautions:  disable password saving; delete files, caches, and cookies; and log out of accounts completely when finished.[7]  Financial institutions could help investors follow the SEC’s helpful, but often forgotten, advice by, for example, requiring them to proactively check a box to enable password saving on each new device and automatically logging users out of their online accounts after relatively short periods of inactivity.

4.  Secure Websites. The SEC has recommended that investors not log in to an account unless the relevant financial institution’s website has a secure “https” address.[8]  Many financial institutions have a secure website already, but those that do not may want to consider implementing one.

5.  Links. The SEC has recommended that clients never click on links sent to them by financial institutions with which they do not have a relationship, and to confirm the legitimacy of links sent to them by their financial institutions by calling or emailing the purported sender.[9]  In response to this advice, financial institutions may want to use links judiciously, and ensure that those who will receive calls and emails from clients know what links have been sent to which clients and under what circumstances.  Without such knowledge, financial institution employees may be unable to confirm or deny the legitimacy of the link, undermining client confidence in the financial institution’s cybersecurity policies and procedures.

6.  Review Account Statements. The SEC has recommended that investors regularly review statements and trade confirmations for suspicious activity and contact their financial institution with a written complaint if there is suspicious activity.[10]  In response, financial institutions may want to evaluate their security procedures with respect to redemptions and distributions.  Adopting reliable technological innovations can help prevent suspicious activity and create a business advantage (g., using biometric safeguards or two-factor authentication may be more reliable and less time-consuming than requiring signature guarantees).

Please contact us if you have any questions about this article or the SEC’s cybersecurity guidance.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] SEC, Examination Priorities for 2014 (Jan. 9, 2014), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf; SEC, Examination Priorities for 2015 (Jan. 13, 2015), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2015.pdf; SEC, Examination Priorities for 2016 (Jan. 11, 2016), available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf;  SEC, Examination Priorities for 2017 (Jan. 12, 2017), available at https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf.

[2] SEC, Cybersecurity, the SEC and You (last visited July 25, 2017), available at https://www.sec.gov/spotlight/cybersecurity (containing a library of resources of both investors and securities industry professionals related to cybersecurity).

[3] SEC, Updated Investor Bulletin:  Protecting Your Online Investment Accounts from Fraud (April 26, 2017), available at https://investor.gov/additional-resources/news-alerts/alerts-bulletins/updated-investor-bulletin-protecting-your-online.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

Posted on Monday, July 24 2017 at 2:41 pm by

Wyoming Mid-Sized Advisers Can No Longer Register with the SEC

By Paul Foley and John I. Sanders

Wyoming required investment advisers to register with the state for the first time on July 1, 2017.[i]  Wyoming’s decision primarily affects those Wyoming-based advisers with between $25 million and $100 million in assets under management (“Mid-Sized Advisers”).  Generally, Mid-Sized Advisers may not register with the SEC.[ii]  However, Wyoming-based Mid-Sized Advisers were required to register with the SEC pursuant to an exception to the general rule.[iii]  That exception requires a Mid-Sized Adviser to register with the SEC if its principal office or place of business is in a state that does not require it to register.[iv]  Wyoming’s lack of a registration requirement for Mid-Sized Advisers and the SEC’s exception made Wyoming a destination for Mid-Sized Advisers who wanted to tout SEC registration.[v]  Some Mid-Sized Advisers went as far as to fraudulently claim to be based in Wyoming so that they could boast SEC registration.[vi]  Wyoming’s decision to require investment advisers to register with the state means that Wyoming-based Mid-Sized Advisers (real and fictitious) are no longer permitted to register with the SEC.  Instead, they must register with Wyoming and comply with its new regulatory regime.[vii]  This continues a shift, which we first noted in 2011, of primary responsibility for the regulatory oversight of Mid-Sized Advisers to the states.[viii]

Please contact us if you have any questions about the new law or its potential impact on your investment advisory business.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[i] Wyoming Secretary of State, FAQs (March 14, 2017), available at http://soswy.state.wy.us/Investing/Docs/investment_faq_final.pdf.

[ii] 15 USC 80b-3a (2017); see also SEC, Division of Investment Management: Frequently Asked Questions Regarding Mid-Sized Advisers, available at https://www.sec.gov/divisions/investment/midsizedadviserinfo.htm (providing additional commentary related to the effect of certain Dodd-Frank Act provisions on Mid-Sized Advisers).

[iii] Id.

[iv] Id.

[v] See Danielle Andrus, ThinkAdvisor, Wyoming to Begin Registering RIAs (July 13, 2016), available at http://www.thinkadvisor.com/2016/07/13/wyoming-to-begin-registering-rias; see also Christine Idzelis, Investment News, Wyoming poised to scrutinize its RIA industry for the first time (July 6, 2016), available at http://www.investmentnews.com/article/20160706/FREE/160709978/wyoming-poised-to-scrutinize-its-ria-industry-for-the-first-time.

[vi] See In re Matter of New Line Capital, LLC and David A Nagler, IA-4017 (February 4, 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4017.pdf; and In the matter of Wyoming Investment Services, LLC and Criag M. Scariot, IA-4014 (February 4, 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4014.pdf.

[vii] Wyoming Secretary of State, Proposed Rules, available at http://soswy.state.wy.us/Investing/Docs/WyomingProposedRulesforIA.pdf.

[viii] Paul Foley, Kilpatrick Townsend & Stockton, LLP Investment Management Blog, Deadline for Meeting the New Investment Adviser Regulatory Requirements Under the Dodd-Frank Act is Quickly Approaching (Sept. 20, 2011), available at http://www.kilpatricktownsend.com/en/Knowledge_Center/Alerts_and_Podcasts/Legal_Alerts/2011/09/Deadline_for_Meeting_the_New_Investment_Adviser_Regulatory_Requirements.aspx.

Posted on Monday, June 12 2017 at 11:00 am by

Fiduciary Rule Creates Breach of Contract Claim, But No Private Right of Action

By Paul Foley and John I. Sanders

The first part of the DOL’s Conflict of Interest Rule (the “Fiduciary Rule”) went into effect on Friday, June 9th.  A large group of newly-defined “fiduciaries” are now subject to certain requirements of the Best Interest Contract (“BIC”) exemption,[1] a portion of the Fiduciary Rule that according to some commentators creates a private right of action for investors.

The creation of a private right of action is one of the investment industry’s chief concerns with the Fiduciary Rule.  Industry leaders claim that the BIC exemption creates a private right of action because it enables investors to bring breach of contract claims and class actions against the fiduciaries with whom they contract.  However, a federal judge from the Northern District of Texas flatly rejected this claim in Chamber of Commerce of the United States of America v. Hugler.[1]

The plaintiff in Hugler claimed, among other things, that the BIC exemption created a private right of action in violation of Alexander v. Sandoval, a Supreme Court case holding that only Congress, not an administrative agency, can create a private right of action under federal law.[2]  But the judge in Hugler sided with the DOL, finding that the BIC exemption does not create a private right of action, and so does not violate Sandoval.[3]  The judge reasoned that any lawsuit resulting from the breach of a BIC exemption contract would be brought under state contract law rather than federal ERISA law.[4]  The judge also noted that it is not a new concept for federal regulations to require entities to enter into written contracts with mandatory provisions; annuity owners already have enforceable contract rights against insurers, and multiple other agencies require that their regulated entities enter into written agreements with mandatory terms.[5]

Yet articles from leaders in the legal and investment industries continue to label the BIC exemption’s litigation risk as a private right of action for investors.  Fiduciaries reading these articles should keep in mind that a private right of action cannot exist under the BIC exemption because the Supreme Court’s ruling in Sandoval only allows a private right of action to be created by Congress.  Also, it is unlikely that any court will block the Fiduciary Rule on the grounds that the BIC exemption impermissibly creates a private right of action because, as pointed out by the judge in Hugler, any claims brought as a result of BIC exemption contracts would be brought under state law rather than federal law.  However, fiduciaries should be aware that the Fiduciary Rule still exposes them to litigation risk as investors can use BIC exemption contracts (which are not required to be used until January 1, 2018) to file state breach of contract claims and, potentially, class actions.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] For more information on current Fiduciary Rule and BIC Exemption requirements, see Paul Foley & John Sanders, DOL Puts Advisors on Notice: Fiduciary Rule Will be Effective June 9th, Kilpatrick Townsend: Inv. Mgmt. Blog (May 25, 2017, 9:32 PM), http://blogs.kilpatricktownsend.com/investmentmanagement/?p=321.[1] Chamber of Commerce of the United States of Am. v. Hugler, 3:16-CV-1476-M, 2017 WL 514424 (N.D. Tex. Feb. 8, 2017).

[2] Alexander v. Sandoval, 532 U.S. 275, 286 (2001) (citing Touche Ross & Co. v. Reddington, 442 U.S. 560, 578 (1979)).

[3] Hugler, 3:16-CV-1476-M, 2017 WL 514424, at *20.

[4] Id..

[5] Id..

Posted on Tuesday, June 6 2017 at 12:13 pm by

Kokesh v. SEC:  The U.S. Supreme Court Limits SEC Disgorgement Powers

By Paul Foley and John I. Sanders

Since the 1970s, courts have regularly ordered disgorgement of ill-gotten gains in SEC enforcement proceedings.[1]  According to the SEC, this was done as a means to both “deprive . . . defendants of their profits in order to remove any monetary reward for violating” securities laws and “protect the investing public by providing an effective deterrent to future violations.”[2]  Disgorgement has been one of the SEC’s most powerful tools in recent years.[3]  Yesterday, the Supreme Court issued an opinion that significantly limits the SEC’s ability to disgorge ill-gotten gains.[4]

The question before the Supreme Court in Kokesh v. SEC was whether disgorgement, as it has been used by the SEC, constitutes a “penalty.”[5]  Under federal law, a 5-year statute of limitations applies to any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise.”[6]  The SEC has long argued that disgorgement does not constitute a “penalty” and, therefore, is not subject to a 5-year statute of limitations.  The Supreme Court unanimously rejected the SEC’s position by holding that disgorgement constitutes a “penalty.”[7]  As a result, the SEC will be precluded from collecting ill-gotten gains obtained by the defendant more than five years before the date on which the SEC files its complaint.[8]

In the Kokesh case, the Supreme Court’s decision means that the defendant may retain $29.9 million of the $34.9 million of allegedly ill-gotten gains because that amount was received outside of the 5-year state of limitations.[9]  The Kokesh decision is also likely to have a significant long-term impact on SEC enforcement proceedings by reducing the leverage the SEC can apply while negotiating settlements.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 91 (SDNY 1970), aff ’d in part and rev’d in part, 446 F. 2d 1301 (CA2 1971).

[2] Id. at 92.

[3] SEC, SEC Announces Enforcement Results for FY 2016 (Oct. 11, 2016), available at https://www.sec.gov/news/pressrelease/2016-212.html (illustrating that the SEC has obtained more than $4 billion in disgorgements and penalties in each of the three most recent fiscal years).

[4] Kokesh v. SEC, available at www.supremecourt.gov.

[5] Id. (“This case presents the question whether [28 U.S.C.] §2462 applies to claims for disgorgement imposed as a sanction for violating a federal securities law.”).

[6] 28 U.S.C. §2462 (2017).

[7] Kokesh v. SEC, supra note 4, available at www.supremecourt.gov.  (“SEC disgorgement thus bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and it is intended to deter, not to compensate.”).

[8] Id.

[9] Id.

Posted on Thursday, May 25 2017 at 9:32 pm by

DOL Puts Advisers on Notice:  Fiduciary Rule Will Be Effective June 9th

By Paul Foley and John I. Sanders

On March 2, 2017, the DOL extended the applicability date of the Conflict of Interest Rule (the “Fiduciary Rule”) from April 10, 2017 to June 9, 2017.[1]  This week, with the extension drawing to a close, Secretary of Labor Alexander Acosta has reported that the DOL “found no principled legal basis” to delay the applicability date beyond June 9.[2]  It is now a near-certainty that the Fiduciary Rule will “go live” on that date.

Despite DOL statements about a “transition period” and a “phased approach to implementation,” the heart of the Fiduciary Rule will be effective in just two weeks.[3]  Most importantly, “investment advice providers to retirement savers will become fiduciaries.”[4]  As fiduciaries, they must provide impartial advice in the customer’s best interest and cannot accept payments creating conflicts of interest (i.e., commissions and 12b-1 fees) unless they qualify for an exemption.[5]  Among exemptions, the Best Interest Contract Exemption is especially enticing before more stringent requirements for its use go into effect on January 1, 2018.[6]  Until January 1, 2018, the only conditions for the BIC Exemption are:  (i) investment advice is in the “best interest” of the retirement investor, meaning that it is both prudent and the advice is based on the interest of the investor rather than the adviser; (ii) no more than reasonable compensation is charged; and (iii) no misleading statements are made about the transaction, compensation or conflicts of interest.[7]  After January 1, 2018, an actual contract with particular terms will be required.[8]

For many investment advisers (as opposed to broker-dealers and their registered representatives), the impending applicability of the Fiduciary Rule is not a significant concern.  The DOL has stated that a fee based on assets under management (i.e., flat asset based fees or traditional wrap fee arrangements)  typically would not raise any issues under the Fiduciary Rule.[9]  However, for investment advisers not currently employing such fee arrangements, the Fiduciary Rule likely will require changes.[10]

In an effort to calm would-be fiduciaries that will not be able to meet the June 9th deadline for compliance with the Fiduciary Rule, the DOL issued a temporary enforcement policy on May 22nd stating that it would not take any enforcement action against “fiduciaries who are working diligently and in good faith to comply with the new rule and exemptions” until January 1, 2018.[11]  The DOL also promised an enforcement approach prior to January 1, 2018 “marked by an emphasis on compliance assistance (rather than citing violations and imposing penalties).”[12]  This policy only applies to DOL enforcement actions.  Investors may still bring private actions (i.e., fraud or breach of contract claims) against those who breach their fiduciary duties, and the IRS may still impose excise taxes or seek civil penalties.[13]

With applicability of the Fiduciary Rule just two weeks away, all investment advisers should assess its applicability to them and prepare accordingly.  At a minimum, this means working with compliance staff and legal counsel to determine whether all advice given to retirement investors is:  (i) in the client’s best interest (which investment advisers, as fiduciaries should already be doing), (ii) is impartial, and (iii) does not generate payments to the investment adviser giving rise to a conflict of interest.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[1] Department of Labor,  Conflict of Interest Rule – Retirement Investment Advice; Proposed Rule; Extension of Applicability Date (March 1, 2017), available at https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[2] Id.

[3] Department of Labor, Conflict of Interest FAQs (Transition Period) (May 2017), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-transition-period.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Conflict of Interest Rule, 81 Fed. Reg. 20946, 20992 (April 8, 2016) (to be codified at 29 CFR Parts 2509, 2510, and 2550) (The DOL has stated that if an investment adviser using a flat fee or wrap fee compensation model makes recommendations that would generate additional compensation for the adviser (e.g., adviser recommends rolling an IRA into an annuity that will generate fees for the adviser), then the adviser would need to rely on an exception.)

[10] Id.

[11] Department of Labor, Conflict of Interest FAQs (Transition Period) (May 2017), available at https://www.dol.gov/sites/default/files/ebsa/about-ebsa/our-activities/resource-center/faqs/coi-transition-period.pdf .

[12] Id.

[13] Conflict of Interest Rule, 81 Fed. Reg. 20946, 20653 (April 8, 2016) (to be codified at 29 CFR Parts 2509, 2510, and 2550).

Posted on Friday, January 27 2017 at 10:34 am by

Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry

By Andrew Sachs and John I. Sanders

The Department of Labor finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[i]  Since the finalization of the Fiduciary Rule, the annuities,[ii] brokerage,[iii] and advisory industries[iv] have all seen substantial changes to products or fee structures.  Now, the effects of the rule have reached the mutual fund industry as well, with the SEC’s recent approval of American Funds’ “Clean Shares” – shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[v]

On January 11th, the SEC issued a no-action letter to Capital Group, the parent company of American Funds.[vi]  The no-action letter stated that the SEC concurred with Capital Group’s view that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus,” does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in Clean Shares.[vii]

At least one publication predicts that thousands of mutual funds will create similar classes of shares.[viii]  We believe that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by the broker will give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally.  For those wishing to more fully understand the costs and benefits of adopting a similar share class, we are here to help.

Andrew Sachs is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem office. John I. Sanders is an associate in the firm’s Winston-Salem office.

 

[i] Department of Labor, Fact Sheet: Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle Class Families Billions of Dollars Every Year, https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest.

[ii] Greg Iacurci, Insurers Developing Fee-Based Fixed-Index Annuities Post-DOL Fiduciary Rule, INVESTMENT NEWS (July 14, 2016), http://www.investmentnews.com/article/20160714/FREE/160719964/insurers-developing-fee-based-fixed-indexed-annuities-post-dol.

[iii] Katherine Chiglinsky and Margaret Collins, AIG CEO Blames Obama Retirement Rule for Broker-Dealer Exit, BLOOMBERG (Jan. 27, 2016), http://www.bloomberg.com/news/articles/2016-01-27/aig-broker-dealer-exit-fueled-by-obama-retirement-rule-ceo-says.

[iv] Darla Mercado, How the New “Fiduciary” Rule Will Actually Affect You, CNBC (Oct. 13, 2016), http://www.cnbc.com/2016/10/13/how-the-new-fiduciary-rule-will-actually-affect-you.html.

[v] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[vi] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm.

[vii] Id.

[viii] Waggoner, supra note 5.

Posted on Tuesday, January 24 2017 at 3:08 pm by

Constitutionality of SEC Judges Questioned

By Paul Foley and John I. Sanders

Among the many provisions of the Dodd-Frank Act were some that gave the SEC greater ability to hear cases and levy punishments in internal administrative courts without resort to ordinary federal courts.[i]  These provisions resulted in alarming results, including a 90% success rate for the SEC in front of its own newly-minted administrative law judges.[ii]  For comparative purposes, the SEC’s previous success rate was below 70%.[iii]

A legal challenge brought against the SEC argued that these judges are “inferior officers” that, pursuant to the Appointments Clause of the U.S. Constitution,[iv] must be appointed by an executive branch member and approved by the Senate.  Because such steps were never taken, the judges’ actions would be unconstitutional if they are, in fact, found to be “inferior officers”.  The 10th Circuit has agreed with the plaintiffs, but the SEC is expected to appeal.[v]

If the challenge is ultimately successful, there will be two significant impacts.  First, the cases decided by the SEC’s judges may be void.  Second, the SEC will be forced to use the old, less certain procedure of bringing enforcement actions in federal district court.  If you’d like to know more, I encourage you to read a succinct review of the matter in today’s Wall Street Journal.[vi]

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[i] Giles D. Beal IV, Judge, Jury, and Executioner:  SEC Administrative Law Judges Post-Dodd Frank, 20 N.C. Banking Inst. 413 (2016), available at https://litigation-essentials.lexisnexis.com/webcd/app?action=DocumentDisplay&crawlid=1&doctype=cite&docid=20+N.C.+Banking+Inst.+413&srctype=smi&srcid=3B15&key=e7ef73edd6e64a6ec56e122360340a35.

[ii] Jean Eaglesham, SEC Wins with In-House Judges, Wall St. Journal (May 6, 2015), http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803.

[iii] Id.

[iv] U.S. Const. art. II, sec. 2, cl. 2.

[v] Alison Frankel, 10th Circuit Strikes Down SEC ALJ Regime, Debates Reach to Other Agencies, Reuters (Dec. 28, 2016), http://www.reuters.com/article/otc-sec-idUSKBN14H1S3.

[vi] David B. Rivkin Jr. and Andrew M. Grossman, When is a Judge Not Really a Judge?, Wall St. Journal (Jan. 23, 2017), http://www.wsj.com/articles/when-is-a-judge-not-really-a-judge-1485215998.

Posted on Tuesday, January 17 2017 at 8:39 am by

SEC Announces 2017 Exam Priorities

By Paul Foley and John I. Sanders

Each year, the SEC’s Office of Compliance Inspections and Examinations (the “OCIE”) releases its priorities for the upcoming year.  For regulated entities such as investment companies and investment advisers, the release of the OCIE’s priorities is highly significant.  The reason, simply put, is that your regulator’s priorities must also be your own priorities.

Among the OEIC’s newly-released examination priorities for 2017 are the following:[i]

  • Never-Before Examined Investment Advisers
  • Cybersecurity compliance procedures and controls
  • Robo-advisors’ marketing, recommendation formulation, and security procedures
  • ETF exemptive relief compliance, sales practices, and risk disclosures
  • Elder abuse detection and prevention practices
  • Money market funds’ compliance with the newly effective rules
  • FINRA oversight

We agree with the OCIE Director who stated earlier this week that the release of examination priorities is an important opportunity for regulated entities to evaluate their own compliance programs and make the necessary enhancements prior to examinations.[ii]  Therefore, we encourage you to read the full text of the SEC announcement, consider your compliance programs in the prioritized areas, and contact us with any questions you may have.

 

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John Sanders is an associate based in the firm’s Winston-Salem office.

[i] SEC, SEC Announces 2017 Examination Priorities (Jan. 13, 2017), https://www.sec.gov/news/pressrelease/2017-7.html.

[ii] Id.

Posted on Thursday, December 15 2016 at 9:28 am by

Supreme Court Confirms Expansive View of Insider Trading

By Paul Foley, Clay Wheeler, and John Sanders

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.”  The allegation alone is enough to derail or end a promising career.  Successful compliance requires an understanding of the law and your obligations under it.  In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading:  The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading.  The basic elements of insider trading are:  (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4]  In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade.  Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information.  Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty.  Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.  Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory.  This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6]  The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan.  In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer.  The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7]  In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan [8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9]  In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10]  Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11]  Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12]  Dirks was held liable for insider trading, but appealed.[13]  The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit.  The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty.  Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure.  Absent an improper purpose, there is no breach of duty to stockholders.  And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware.  In this way, Dirks created a “personal benefit” element related to the tipper.  After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman:  A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years.  Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17]  By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18]  The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on.  Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper.  Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law.  Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari.  This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20]  The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21]  This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman:  The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24]  Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case.  So, some background may be helpful.  Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law.  Thus, Salman was prosecuted as a remote tippee.  He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.[26]  Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27]  Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions.  We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence.  You know these individuals as professionals, former schoolmates, and even friends and family members.  In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you.  Your livelihood and liberty may depend on how well you understand your legal obligations when that happens.  Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

 

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. Clay Wheeler is a partner in Kilpatrick’s Raleigh and Winston-Salem officesJohn Sanders is an associate based in the firm’s Winston-Salem office.

 

[1] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[2] 15 U.S.C. 78j (2016).

[3] 17 CFR 270.10b-5 (2016).

[4] Chiarella v. U.S., 445 U.S. 222 (1980).

[5] U.S. v. O’Hagan, 521 U.S. 642, 643 (1997).

[6] SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012).

[7] O’Hagan, at 642.

[8] Id.

[9] Dirks v. SEC, 463 U.S. 646 (1983).

[10] Id. at 646.

[11] Id.

[12] Id.

[13] Id.

[14] Id. at 647.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[16] U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014)

[17] Id. at 443.

[18] Id.

[19] Id. at 450.

[20] Jon Eisenberg, How the United States v. Newman Changes the Law, Harvard Law School Forum on Corporate Governance and Financial Regulation (May 3, 2015), https://corpgov.law.harvard.edu/2015/05/03/how-united-states-v-newman-changes-the-law/.

[21] Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

[22] Greg Stohr and Patricia Hurtado, The Supreme Court Will Hear Its First Insider-Trading Case in 20 Years, Bloomberg (Oct. 4, 2016), https://www.bloomberg.com/politics/articles/2016-10-04/wall-street-watching-as-u-s-high-court-tackles-insider-trading.

[23] Patricia Hurtado, SAC Capital’s Steinberg Gets Insider Trading Charges Dropped, Bloomberg (Oct. 23, 2015), https://www.bloomberg.com/news/articles/2015-10-22/u-s-drops-charges-against-sac-capital-s-michael-steinberg.

[24] Salman, supra note 21.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

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