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 Monday, May 8 2017 at 10:38 am by

General Solicitations of Certain Regulation D “Private” Securities Offerings:  SEC Affirms Zero-Tolerance Policy.

By Paul Foley and John I. Sanders

On March 29, 2017, the Securities and Exchange Commission (the “SEC”) issued a noteworthy opinion in In re KCD Financial Inc.,[i] a review of a FINRA disciplinary action.[ii]  While the opinion affirmed FINRA’s disciplinary action,[iii] it also affirmed the SEC’s zero-tolerance policy regarding general solicitations made in the course of certain Regulation D offerings.  Those relying on or contemplating relying on Regulation D exemptions from registration should review the SEC’s opinion.

Factual Background

KCD Financial, Inc. (“KCD”) is an independent broker-dealer.[iv]  In 2011, KCD signed an agreement with one of its affiliates (“Westmount”) under which it would solicit accredited investors for a particular private fund (the “Fund”) sponsored by Westmount.[v]  Westmount did not plan to register the offering.  Westmount instead planned to rely on a Rule 506(b) exemption from registration.[vi]

Prior to KCD selling any interest in the Fund, Westmount issued a press release describing the Fund.[vii]  Two Dallas newspapers published articles based on the press release and made the articles available on their respective public websites.[viii]  One of those newspaper articles was then posted on a public website belonging to a Westmount affiliate.[ix]  Westmount’s outside counsel informed Westmount that the newspaper articles constituted general solicitations, which are prohibited in Rule 506(b) offerings.[x]

After KCD and Westmount officers were told that the articles were general solicitations prohibited under Rule 506(b), they did not end the offering, register the securities, or seek to rely on an alternative exemption.  Instead, KCD’s CCO and Westmount’s Vice President of Capital Markets instructed the representatives to sell interests in the Fund only to (i) those with an existing relationship to KCD or Westmount and (ii) accredited investors who had not learned of the offering through the general solicitations.[xi]  Under those guidelines, at least one person was refused an opportunity to purchase interests in the Fund.[xii]

During a FINRA examination of KCD, the examiner found that the newspaper article about the offering had not been removed from a Westmount-affiliated website.[xiii]  Subsequently, FINRA filed a complaint against KCD alleging that the firm’s registered representatives sold securities that were unregistered and not qualified for an exemption from registration, thereby violating FINRA Rule 2010.[xiv]  FINRA also alleged that KCD failed to reasonably supervise the offering, thereby violating FINRA Rule 3010.[xv]  FINRA’s Hearing Panel found that KCD violated those rules.[xvi]  FINRA censured KCD and imposed a fine of $73,000.[xvii]  The National Adjudicatory Counsel affirmed FINRA’s decision.[xviii]  KCD then requested an SEC review.[xix]

SEC Review

KCD admitted that the Fund interests it offered were not registered, but argued that offers were made pursuant to Rule 506(b).[xx]  The SEC rejected KCD’s contention,[xxi] finding that where a party relying on the Rule 506(b) exemption makes a general solicitation, the exemption then is unavailable “regardless of the number of accredited investors or the knowledge and experience of the purchasers who were not accredited investors.”[xxii]  In this context, whether purchasers were accredited or had prior relationships with KCD and Westmount was “irrelevant to whether or not the newspaper articles constituted a general solicitation” and precluded reliance on Rule 506(b).[xxiii]

KCD also argued, assuming the newspaper articles constituted general solicitations, it could still rely on a Rule 506(b) exemption because “KCD did not generally solicit any of the actual investors in the [Westmount] Fund.”[xxiv]  This argument confused the notion of what is prohibited under Rule 506(b).  It is making an offer by general solicitation which precludes reliance on a Rule 506(b) exemption.[xxv]  Whether a sale results directly from the general solicitation is irrelevant.[xxvi]

Practical Implications

The SEC’s opinion affirms its view that exemptions from registration in securities offerings are narrowly construed and must be adhered to strictly.[xxvii]  Where, as here, the exemption prohibits a general solicitation, any general solicitation forever forfeits the issuer’s ability to rely on the exemption in making the offering (i.e., the toothpaste cannot go back into the tube).

Those making exempt offerings in reliance on Rule 504,[xxviii] Rule 505,[xxix] and Rule 506(b)[xxx] should review their sales practices in light of the KCD opinion.  In reviewing practices, issuers should look beyond the obvious means of making a general solicitation (e.g., a press release that is published by a widely-circulated newspaper).  Websites and social media accounts of those participating in the offerings are equally capable of precluding use of a valuable registration exemption.

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 out of the firm’s Winston-Salem office.

[i] In re KCD Financial, Inc., SEC Release No. 34-80340 (March 29, 2017), available at www.sec.gov/litigation/opinions/2017/34-80340.pdf (hereinafter, SEC Opinion).

[ii] In re KCD Financial, Inc., FINRA Complaint No. 2011025851501 (Aug. 3, 2016), available at http:www.finra.com (hereinafter, FINRA Opinion).

[iii] SEC Opinion, supra note 1, at p. 1.

[iv] Id., at p. 2.

[v] Id.

[vi] Id.

[vii] Id, at p. 3.

[viii] Id.

[ix] Id. at p. 4.

[x] Id.

[xi] Id.

[xii] Id.

[xiii] Id.

[xiv] Id.

[xv] Id.

[xvi] FINRA Opinion, supra note 2, at p. 4.

[xvii] Id.

[xviii] Id.

[xix] Id.

[xx] SEC Opinion, supra note 1, at 2.

[xxi] Id.

[xxii] Id. at 7.

[xxiii] Id. at 9.

[xxiv] Id at 10.

[xxv] Id.

[xxvi] Id. at 11

[xxvii] Id. at 7.

[xxviii] 17 CFR 230.504 (2017).

[xxix] 17 CFR 230.505 (2017).

[xxx] 17 CFR 230.506(b) (2017).

Posted on Wednesday, April 19 2017 at 8:48 am by

SEC Issues Guidance to Robo-Advisers

Robo-advisers are a fast-growing segment of the investment advisory industry.  In fact, they now account for an estimated $71.5 billion in assets under management.[1]  In response to their explosive growth, the SEC has made robo-advisers an examination priority[2] and has issued regulatory guidance to them.[3]  The SEC’s guidance is summarized below.

  • Disclosures to potential clients should explain the: (i) robo-adviser’s business model and how it differs from traditional investment adviser models; and (ii) limitations in the scope of the robo-adviser’s services.[4]  The robo-adviser should also consider whether its delivery of the disclosures is clear and conspicuous enough to be effective in the context of the relationship, which may be entirely web-based.[5]
  • Questionnaires used to gather client information should be designed to obtain sufficient information to support the robo-adviser’s suitability obligation.[6] Where the client can select investments other than those the adviser recommends, the robo-adviser should provide commentary supporting its recommendations.[7]
  • Internal compliance programs should address the unique aspects of the robo-adviser business model, including limited human interaction and heightened cybersecurity risks.[8]

Advisers who have replaced or supplemented their advisory services with robo-adviser technology in recent years may have questions after reviewing the SEC’s guidance.  Please feel free to contact us with any questions you may have.

Paul J. 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] Daisy Maxey, Spotlight on Robo Advisers’ Returns, Wall Street Journal (Nov. 1, 2016), https://www.wsj.com/articles/spotlight-on-robo-advisers-returns-1478018429.

[2] SEC, National Exam Program Examination Priorities for 2017 (Jan. 13, 2017), www.sec.gov/about/offices/ocie/national-examination-program-priorities-2017.pdf.

[3] SEC, IM Guidance Update No. 2017-02 (Feb. 2017), www.sec.gov/im-guidance-2017-02.pdf.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

Posted on Wednesday, March 8 2017 at 10:41 am by

SEC Issues Guidance to Ease Fund Implementation of “Clean Shares”

By Andrew Sachs and John I Sanders

In January, we authored a post[i] discussing an SEC no-action letter, dated January 11, 2017, to Capital Group (the “Capital Group Letter”), the parent company of American Funds.[ii]  In the Capital Group Letter, the SEC agreed 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 so-called “Clean Shares”.[iii]

Clean shares are mutual fund 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.[iv]  We noted in January that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by a broker would give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally, and we anticipated that many mutual fund companies would explore the concept of Clean Shares.

On February 15, 2017, just a month after publication of the Capital Group Letter, the SEC was compelled to issue guidance (the “FAQ”) addressing some of the questions it had received from mutual fund companies to-date.[v]  Below, we summarize FAQ as it relates to Funds seeking to implement Clean Shares.

Initial Implementation of Clean Shares

A mutual fund company issuing Clean Shares must, of course, amend its registration statement to include disclosure of the new share class.  Such an amendment might be affected through a Rule 485(a) filing or through a Rule 485(b) filing, depending on whether the amendment is “material”.[vi]  Typically, funds prefer Rule 485(b) filings because they become effective immediately,[vii] while Rule 485(a) filings are subject to a 60 day review.[viii]

In the FAQ, the SEC confirmed that “Funds should create these new Clean Shares, like any new class, by making a filing under Rule 485(a).”  To minimize the burdens of filing under Rule 485(a), if the only disclosures being amended are those describing the new share class, we advise mutual fund companies to seek selective review of the Rule 485(a) filing.  The request for a selective review should be made in the cover letter accompanying the 485(a) filing and must include (i) a statement as to whether the disclosure in the filing has been reviewed by the staff in another context; (ii) a statement identifying prior filings that the registrant considers similar to, or intends as precedent for, the current filing; (iii) a summary of the material changes made in the current filing from the previous filings; and (iv) any specific areas that the registrant believes warrant the SEC staff’s particular attention.[ix]

Adding Clean Shares to Multiple Funds

A mutual fund family adding Clean Shares to multiple funds need not file Rule 485(a) filings for each fund.  Instead, the FAQ confirms that mutual funds companies introducing Clean Shares across multiple funds can request Template Filing Relief pursuant to Rule 485(b)(i)(vii).  A registrant requesting Template Filing Relief would make a single Rule 485(a) filing with a Template Filing Relief request for all other funds with “substantially identical disclosure”.[x]

We note, however, that a request for Template Filing Relief must include (i) the reason for making the post-effective amendment; (ii) the identity of the Template filing;[xi] (iii) the identity of the registration statements that intend to rely on the relief (“Replicate filings”).[xii]  Additionally, the registrant must represent to the SEC that (i) the disclosure changes in the template filing are substantially identical to disclosure changes that will be made in the replicate filings; (ii) the replicate filings will incorporate changes made to the disclosure included in the Template filing to resolve any staff comments thereon; and (iii) the replicate filings will not include any other changes that would otherwise render them ineligible for filing under rule 485(b).[xiii]  Selective Review and Template Filing Relief can save registrants adding Clean Shares to existing funds time and money.

Existing Share Classes Qualify as Clean Shares

One of the more interesting aspects of the FAQ was the acknowledgement by the SEC that certain existing share classes of funds (such as institutional class shares) might already meet the requirements of Clean Shares, thereby offering a path to offering Clean Shares to many registrants without a Rule 485(a) filing.[xiv] In such a case, the SEC noted that a 485(a) filing would not be necessary “solely to add the prospectus disclosure described in the [Capital Group Letter]”[xv] where the fund already offers a share class that meets the requirements of the Capital Group Letter.[xvi]  Instead, a Rule 485(b) or Rule 497 filing will suffice.

Conclusion

The introduction of Clean Shares to the mutual fund industry presents an opportunity for mutual fund companies to improve the competitive position of their products, and we anticipate that there will be continued interest in Clean Shares even if the Department of Labor’s Conflict of Interest Rule does not become effective.[xvii]  If you have questions about Clean Shares of the SEC’s recent guidance, we encourage you to contact us.

 

[i] Andrew Sachs and John I. Sanders, Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry, Kilpatrick Townsend: Investment Management News and Notes (Jan. 27, 2017), http://blogs.kilpatricktownsend.com/investmentmanagement/.

[ii] 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 (“Capital Group Letter”).

[iii] Id.

[iv] 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.

[v] SEC, Frequently Asked Questions on IM Guidance Update 2016-06 (Mutual Fund Fee Structures, available at https://www.sec.gov/divisions/investment/guidance/frequently-asked-questions-mutual-fund-fee-structures.htm (“FAQ”).

[vi] 17 CFR 230.485(a)-(b) (2017).

[vii] 17 CFR 230.485(b) (2017).

[viii] 17 CFR 230.485(a) (2017).

[ix] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[x] Id.

[xi] This identifying information should include the name of the Fund and the registrant, the Securities Act file number, and the filing date of the rule 485(a) filing.

[xii] This identifying information should include the name of the registrant, the Securities Act file number, and the series and class name for each of the Funds that intend to rely on the relief.

[xiii] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[xiv] FAQ, supra note 7.

[xv] Id. at Question 5.

[xvi] See, Capital Group Letter, supra note 2 (Listing the registrant’s representations to the SEC:  The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares; The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker; The fund’s prospectus will disclose that an investor transacting in Clean Shares may be required to pay a commission to a broker, and if applicable, that shares of the fund are available in other share classes that have different fees and expenses; The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and Department of Labor rules; and Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before imposition of a commission).

[xvii] Paul Foley and John I. Sanders, Department of Labor Set to Eliminate the Fiduciary Rule, JD SUPRA (March 3, 2017), http://www.jdsupra.com/legalnews/department-of-labor-set-to-eliminate-92801/.

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 Friday, December 16 2016 at 11:51 am by

7 Securities Law and Regulatory Changes Likely to be Considered During the Trump Administration

By Paul Foley and John Sanders

On November 8, 2016, political power in United States shifted in an unexpected and unprecedented way.  As of January 20, 2017, Republicans will hold the White House and both Houses of Congress.[1]  President-elect Donald Trump will also have the opportunity to appoint two SEC Commissioners and a new Chair.[2]  He and his party will have the ability to reshape securities law and regulation.  As this was unanticipated, there was little discussion before the election as to what it would mean for securities law and regulation.  We believe the following seven issues are likely to be part of the discussion in the weeks and months ahead.

1. Dodd-Frank Act – Volcker Rule

The Volcker Rule, a 900-plus-page rule adopted in December 2013, was intended to limit proprietary trading by banks.[3]  Championed by former Federal Reserve Chairman Paul Volcker, the rule was a last-minute addition to the 2010 Dodd-Frank Act.  For years, it stalled as regulators and commentators tried to distinguish between speculation (deemed bad) from investment (deemed good).  Few believe that the regulators were successful in properly drawing this distinction.[4]  Making the rule more susceptible to criticism, many experts have determined the rule “would have done nothing to mitigate [the Great Recession,] the worst financial crisis since the Great Depression.”[5]

President-elect Trump’s nominee for Secretary of the Treasury has promised “strip back” elements of the Dodd-Frank Act, including the Volcker Rule.[6]  If the new administration is dedicated to repealing the Volcker Rule, something that isn’t quite clear,[7] repealing it won’t be easy.  Legislative action would likely require bipartisan support in the Senate.[8]  Eliminating the rule through agency rule making, like adopting the rule, would require coordination between multiple independent agencies,[9] an opportunity for public comment,[10] and time.[11]  The easier (but less permanent) solution is for the new President to appoint agency heads who will interpret the rule differently or deemphasize its enforcement.[12]  The discussion of whether, and how, to repeal the Volcker Rule should be followed closely.

2. Delegated Authority for Enforcement

In 2009, the SEC delegated authority to the Director of Enforcement to open formal orders of investigation of persons and entities.[13]  The Director of Enforcement then took the unprecedented step of sub-delegating authority to Regional Directors, Associate Directors, and Specialized Unit Chiefs.[14]  The delegation supports Chair White’s “broken windows” approach by which deficiencies and misconduct of every size and nature are addressed.[15]  This approach has resulted in a record number of enforcement proceedings.[16]  However, many commentators have raised concerns about the ease with which proceedings can be brought and subpoenas issued and whether enforcement is now less effective because it is uncoordinated.[17]  If the new administration wishes to end the delegation, it can appoint SEC Commissioners and a Chair that will withdraw the delegation with an order[18] not subject to the lengthy formal rule making process.[19]

3. Fiduciary Rule

The Department of Labor (the “DOL”) finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[20]  According to the DOL, investors lose billions of dollars in fees each year because their advisors are not acting in their best interests.[21]  The goal of the Fiduciary Rule, therefore, is to “stop advisers from putting their own interests in earning high commissions and fees over clients’ interests in obtaining the best investments at the lowest prices.”[22]  However, the net effect of the rule is unclear.  Among the potential negative effects of the rule are investors losing access to competent advice,[23] skyrocketing costs for affected accounts,[24] decreases of 25 to 50% in annuities sales,[25] and unnecessary corporate restructuring.[26]

If lawsuits aimed at preventing the rule from going into effect fail, those who advocate repealing the rule will find the job challenging.  First, the rule isn’t within the reach of the Congressional Review Act[27] and isn’t likely to be suspended by the Secretary of Labor who oversaw its creation.[28]  That means a lengthy formal rule making process would be required to repeal the rule.[29]  It is uncertain whether this is an effort the investment advisory industry would welcome after spending the past year working toward compliance, which included spinning off business units[30] changing long-standing pricing models,[31] and jettisoning certain clients.[32]

4. Consolidated Audit Trail

In 2010, as the SEC and CFTC attempted to trace the root cause of the Flash Crash, it became abundantly clear that the financial market regulators were ill-equipped to police modern markets.  Out of this realization came the idea for the Consolidated Audit Trail (the “CAT”).[33]  CAT is conceptualized as a market-wide system that tracks equity and option trades.[34]  It would help in both investigations and monitoring.  Proving manipulation and fraud, as well as identifying systemic risk, should become easier with CAT in place.  However, despite years of work, “a fully baked, centralized trail is still years away.”[35]  Given the benefits of an operational CAT to each of the SEC’s mandates, including maintaining the investor confidence that drives investment into our public markets, getting it up and running may be a priority.  However, many commentators argue that CAT would be a hacker’s dream.[36]  The new administration will signal its where it stands on CAT with its appointment of SEC commissioners and Chair.

5. Pay Ratio Disclosures

The Dodd-Frank Act instructed the SEC to adopt a rule requiring each publicly traded company to disclose “the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees.”[37]  The ratio would appear in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure.[38]  This seemingly simple calculation may “actually entail herculean bookkeeping for large, diverse companies.”[39]

The compliance date for the pay ration rule is January 1, 2017.[40]  Once the new Congress and SEC commissioners are in place, authorities should consider whether the rule serves any of the SEC’s three mandates: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.[41]  If the rule is deemed inappropriate under those mandates, Congress may amend the Dodd-Frank Act and instruct the SEC to engage in a formal rule making process aimed at repealing the rule.  If the rule is deemed appropriate, or the political will to repeal the rule is lacking, it may remain in place with the SEC allowing companies “substantial flexibility in determining the pay ratio.”[42]

6. Political Contributions Disclosures

In 2011, a group of college professors argued that the Supreme Court’s Citizens United[43] ruling necessitated an SEC rule requiring public companies to disclose their political expenditures.[44]  The SEC received more than 1 million public comments – a record.[45]  Yet, the SEC did not act.  Senator Elizabeth Warren, less than a month before the recent election, openly urged President Obama to remove SEC Chair Mary Jo White for refusing “to develop a political spending disclosure rule despite her clear authority to do so.”[46]  This was perhaps a bit unfair.  Not only was the SEC restricted by law from working on the rule at that time,[47] but the rule has faced tremendous opposition.[48]  Business groups and Republicans have long argued that “a company’s political contributions are not related to its financial performance and that the disclosures are unnecessary.”[49]  A Republican Congress or appointments to the SEC may find 2017 is an ideal time to revisit this issue.

7. Liquidity Risk Management

On October 13, 2016, the SEC announced that it had finalized a rule that would require open-ended investment companies to develop liquidity risk management programs and make additional disclosures related to liquidity.[50]  The rule, among other things, requires an investment company’s board of directors to adopt a formal plan for managing liquidity risk and make disclosures classifying fund investments into one of four categories according to liquidity.[51]  In a letter to the SEC supporting the rule, Senator Sherrod Brown cited several sources for the proposition that the fund industry was growing and offering investments in less-liquid assets.[52]  Tellingly, Senator Brown cited widely-available public sources such as Barron’s and Bloomberg articles.[53]  If the public has access to multiple news stories about liquidity risk, risk disclosures in regulatory filings, and lists of fund holdings online, it is fair to ask whether the rule carries a benefit to investors along with its cost.  If the determination is made the costs of this rule substantially outweigh the benefits, then the SEC may engage in a formal rule making process to repeal the rule.

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.

[1] Richard Cowan and Susan Cornwell, Republicans Defend Grip on U.S. Congress as Trump Wins Presidency, Reuters (Nov. 9, 2016), http://www.reuters.com/article/us-usa-election-congress-idUSKBN13317Z.

[2] Mark Shoeff Jr., Where Donald Trump Stands on Top Financial Adviser Issues, Investment News (Nov. 9, 2016), http://www.investmentnews.com/article/20161109/FREE/161109909/where-donald-trump-stands-on-top-financial-adviser-issues.

[3] SEC, Final Rule: Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships With, Hedge Funds and Private Equity Funds (Dec. 10, 2013), https://www.sec.gov/rules/final/2013/bhca-1.pdf.

[4] The Volcker Ambiguity, The Wall Street Journal (Dec. 11, 2013), http://online.wsj.com/news/articles/SB10001424052702304744304579250393935144268.

[5] Ben Steil, Beyond the Volcker Rule: A Better Approach to Financial Reform, Council on Foreign Relations (April 2012), http://www.cfr.org/financial-crises/beyond-volcker-rule-better-approach-financial-reform/p27894.

[6] Jacob M. Schlesinger, Trump Treasury Choice Steven Mnuchin Vows to ‘Strip Back’ Dodd-Frank, The Wall Street Journal (Nov. 30, 2016), http://www.wsj.com/articles/trump-treasury-choice-steven-mnuchin-vows-to-strip-back-dodd-frank-1480513188.

[7] Emily Stephenson, Trump Calls for ‘21st century’ Glass-Steagall Banking Law, Reuters (Oct. 26, 2016), http://www.reuters.com/article/us-usa-election-trump-banks-idUSKCN12Q2WA.

[8] Ryan Tracy and John Carney, How to Kill the Volcker Rule? Don’t Enforce it, The Wall Street Journal (Nov. 28, 2016), http://www.wsj.com/articles/how-to-kill-the-volcker-rule-dont-enforce-it-1480329002.

[9] Id.

[10] 5 U.S.C. 553 (2016), available at https://www.law.cornell.edu/uscode/text/5/553 (Outlining the process for rule making, as defined in 5 U.S.C. 551 (2016)).

[11] Tracy and Carney, supra note 8.

[12] Id.

[13] SEC, Final Rule: Delegation of Authority to Director of Division of Enforcement (Aug. 5, 2009), https://www.sec.gov/rules/final/2009/34-60448.pdf.

[14] Bradley J. Bondi, A Questionable Delegation of Authority: Did the SEC Go Too Far When It Delegated Authority to the Division of Enforcement to Initiate an Investigation?, Center for Financial Stability (Sept. 20, 2016), http://centerforfinancialstability.org/wp/2016/09/20/a-questionable-delegation-of-authority-did-the-sec-go-too-far-when-it-delegated-authority-to-the-division-of-enforcement-to-initiate-an-investigation/

[15] Jean Eaglesham, SEC Breaks Record for Number of Enforcement Cases, The Wall Street Journal (Oct. 11, 2016), http://www.wsj.com/articles/sec-on-track-to-break-record-for-number-of-enforcement-cases-1476198436.

[16] Id.

[17] Bondi, supra note 14.

[18] 17 CFR 200.30-4 (2016), available at https://www.law.cornell.edu/cfr/text/17/200.30-4.

[19] 5 U.S.C. 553(a)(2) (2016), available at https://www.law.cornell.edu/uscode/text/5/553.

[20] Department of Labor, Final Rule: Conflict of Interest Rule (April 8, 2016), https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/completed-rulemaking/1210-AB32-2.

[21] Id.

[22] Liz Skinner, Figuring Out Fiduciary: Now Comes the Hard Part, Investment News (May 9, 2016), http://www.investmentnews.com/article/20160509/FEATURE/160509939/the-dol-fiduciary-rule-will-forever-change-financial-advice-and-the.

[23] Robert Litan & Hal Singer, Obama’s Big Idea for Small Savers: ‘Robo’ Financial Advice, The Wall Street Journal (July 21, 2015), http://www.wsj.com/articles/obamas-big-idea-for-small-savers-robo-financial-advice-1437521976.

[24] Jed Morowitz & Mason Braswell, Exclusive: Merrill to End Commission-Based Retirement Business on Retail Accounts, AdvisorHub (Oct. 6, 2016), http://advisorhub.com/exclusive-merrill-end-commission-based-retirement-business-retail-accounts/.

[25] Skinner, supra note 22.

[26] Christine Idzelis, Sale of AIG Advisor Group May Signal Wave of Mergers Ahead, Investment News (Jan. 29, 2016), http://www.investmentnews.com/article/20160129/FREE/160129906/sale-of-aig-advisor-group-may-signal-wave-of-mergers-ahead.

[27] 5 U.S.C. 801 (2016), available at https://www.law.cornell.edu/uscode/text/5/801.

[28] Aaron Back, Eliminating Obama’s Fiduciary Rule Easier Said Than Done, The Wall Street Journal (Dec. 5, 2016), http://www.wsj.com/articles/eliminating-obamas-fiduciary-rule-easier-said-than-done-1480976385.

[29] 5 U.S.C. 553 (2016), available at https://www.law.cornell.edu/uscode/text/5/553 (Outlining the process for rule making, as defined in 5 U.S.C. 551 (2016)).

[30] Greg Iacurci, Insurance Based Broker-Dealers Plan to Use BICE Under DOL Fiduciary Rule, Investment News (July 7, 2016), http://www.investmentnews.com/article/20160707/FREE/160709959/insurance-based-broker-dealers-plan-to-use-bice-under-dol-fiduciary.

[31] Id.

[32] Andrew Welsch, Raymond James follows Morgan’s Lead in Keeping Commissions Under Fiduciary, OnWallStreet (Oct. 27, 2016), http://www.onwallstreet.com/news/raymond-james-follows-morgans-lead-in-keeping-commissions-under-dol; See also Robert Powell, New Rules Force Financial Advisers to do What’s Best for their Clients, USA Today (April 6, 2016), http://www.usatoday.com/story/money/columnist/powell/2016/04/06/investors-new-fiduciary-rule-protection/82661384/.

[33] SEC, Final Rule: Consolidated Trail (July 18, 2012), https://www.sec.gov/rules/final/2012/34-67457.pdf.

[34] Nick Fera, What New Developments in the Consolidated Audit Trail Spell for Broker-Dealer Compliance, The Street (June 13, 2016), https://www.thestreet.com/story/13604582/1/what-new-developments-in-the-consolidated-audit-trail-spell-for-broker-dealer-compliance.html.

[35] Id.

[36] Dave Michaels, SEC Approves Consolidated Audit Trail to Detect Market Manipulation, Wall Street Journal (Nov. 15, 2016), http://www.wsj.com/articles/sec-to-vote-on-consolidated-audit-trail-to-detect-market-manipulation-1479240411.

[37] SEC, SEC Adopts Rule for Pay Ratio Disclosure (Aug. 5, 2015), https://www.sec.gov/news/pressrelease/2015-160.html.

[38] Id.

[39] Richard Levick, The Pay Ratio Rule:  Businesses Face Unprecedented Executive Pay Disclosure Burden (Feb. 9, 2016), http://www.forbes.com/sites/richardlevick/2016/02/09/the-pay-ratio-rule-businesses-face-unprecedented-executive-pay-disclosure-burden/#a044585cf077.

[40] SEC, Final Rule: Pay Ratio Disclosure (Aug. 5, 2015),  https://www.sec.gov/news/pressrelease/2015-160.html.

[41] SEC, What We Do, https://www.sec.gov/about/whatwedo.shtml.

[42] SEC, SEC Adopts Rule for Pay Ratio Disclosure (Aug. 5, 2015), https://www.sec.gov/news/pressrelease/2015-160.html.

[43] Citizens United v. Federal Election Com’n, 558 U.S. 310 (2010).

[44] Committee of Corporate Political Spending, Rulemaking Petition to SEC (Aug 3, 2011), available at https://www.sec.gov/rules/petitions/2011/petn4-637.pdf.

[45] Ranee Merle and Jim Tankersley, Elizabeth Warren Urges President Obama to Remove the Head of the SEC, The Washington Post (Oct. 14, 2016), https://www.washingtonpost.com/news/wonk/wp/2016/10/14/elizabeth-warren-asks-president-obama-to-remove-the-head-of-the-sec/.

[46] Id.

[47] Pub. L. No. 114-113, 129 Stat. 3030 (2016), available at https://www.congress.gov/bill/114th-congress/house-bill/2029/text (stating that no funds made available under the Consolidated Appropriations Act would “be used by the [SEC] to finalize, issue, or implement any rule, regulation, or order regarding the disclosure of political contributions.”)

[48] Andrew Ackerman, Elizabeth Warren to Obama: Fire SEC Chief Mary Jo White, The Wall Street Journal,  (Oct. 14, 2016), http://www.wsj.com/articles/elizabeth-warren-to-obama-fire-sec-chief-mary-jo-white-1476439200.

[49] Merle and Tankersley, supra note 45.

[50] SEC, Final Rule: Investment Company Liquidity Risk Management Programs (Oct. 13, 2016), https://www.sec.gov/rules/final/2016/33-10233.pdf.

[51] Id.

[52] Letter from U.S. Senator Sherrod Brown to SEC Chair Mary Jo White (July 6, 2016), available at https://www.sec.gov/comments/s7-24-15/s72415-247.pdf.

[53] 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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