Insights from Winston & Strawn
In a closely watched decision, last week the Supreme Court dealt a blow to the government’s aggressive efforts to prosecute insider trading by refusing to hear an appeal from the Second Circuit’s decision in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), reh’g denied, Nos. 13-1837, 13-1917 (2d Cir. Apr. 3, 2015), which overturned the convictions of Todd Newman and Anthony Chiasson, two hedge fund managers. Newmaninvolved trading by Newman and Chiasson in shares of Dell and Nvidia based on material, non-public information obtained in advance of quarterly earnings announcements. In each instance, the defendants were three or four levels removed from the insider tipper.
Because neither Section 10(b) of the Securities Exchange Act nor the regulations issued pursuant to it (including Rule 10b-5) explicitly address insider trading, the contours of insider trading liability have largely been left to the courts. In the classic tipper-tippee case, a corporate insider (the tipper) discloses material, non-public information to an outsider (the tippee) who then trades on that information before it is publicly disclosed. In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court held that “[t]he tippee’s duty to disclose or abstain [from trading] is derivative from that of the insider’s duty,” thus a tippee may be found liable “only when the insider has breached his fiduciary duty…and the tippee knows or should know that there has been a breach” (659, 662). Further, in determining whether the insider has breached his fiduciary duty, the test “is whether the insider personally will benefit, directly or indirectly, from his disclosure” (Id. 662).
Nevertheless, relying on dicta in Dirks and subsequent cases, the government began asserting insider trading liability based on a loosening definition of what constitutes a “personal benefit” to the insider tipper and targeted tippees increasingly remote from the original tipper. Newman, and the Supreme Court’s decision to let it stand, should reverse that trend. In Newman, the Second Circuit held that a tippee’s criminal liability for insider trading requires the government to prove beyond a reasonable doubt that: “(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.”
With respect to the defendants specifically, the Court held that the district court’s jury instruction was erroneous because it failed to instruct the jury that the government must prove that the defendants knew the tippers received a personal benefit in exchange for disclosing confidential information. Moreover, irrespective of the errant jury instruction, the Court held there was insufficient evidence that any personal benefit was received by the tippers or that the defendants knew they were trading on information obtained from a breach of an insider’s fiduciary duties.
Newman, however, still leaves unanswered questions. While making clear that a personal benefit must be “objective, consequential, and [represent] at least a potential gain of a pecuniary or similarly valuable nature,” practitioners and judges will be fleshing out its precise meaning for the foreseeable future. Further, although the Court found no such permissible inference against the defendants in Newman, it left open the possibility of inferring knowledge about the source (and potentially the motive of the source) of information based on its detail and specificity.
Despite leaving some room for prosecutorial inventiveness, Newman has acted and, with the Supreme Court’s denial of certiorari, will continue to act as a check on the government’s efforts to target remote tippees for insider trading. Practitioners and legal scholars will be closely monitoring prosecutors’ next moves and, of course, whether Congress may step into the fray to bring some statutory clarity to insider trading liability.
Feature: The Dodd-Frank Act: Five Years In, and the Reviews Are Mixed
This summer marked the five-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Recent commentary suggests that regulators, policymakers, and industry analysts remain divided over the relative success and failure of the Dodd-Frank Act in shielding financial markets from another collapse without curtailing the growth of financial markets under increased regulatory burdens and compliance costs.
Securities and Exchange Commission (“SEC”) Commissioner Daniel Gallagher marked the Dodd-Frank Act’s milestone in a speech entitled, “Dodd-Frank at Five: A Capital Markets Swan Song.” In his remarks, Gallagher did not mince words, blaming the Dodd-Frank Act for “strangling our economy, increasing the fragility of the financial system, and politicizing our independent financial regulators.” Gallagher lamented the effect of the Dodd-Frank Act on the work of the SEC, noting the increased political atmosphere within the agency as it works to adopt rules to fulfill Dodd-Frank mandates and the diminished voice of the agency, which has been placed at a “decided disadvantage” to prudential regulators. In leveling his criticism of the Dodd-Frank Act, Gallagher focused on the incongruity of applying the principles of prudential regulation to capital markets, criticizing attempts by prudential regulators to “de-risk the U.S. capital markets” and the asset management industry by applying “prudential regulatory tools like capital requirements” as counterproductive and “an attack on U.S. competitiveness.” Gallagher Speech.
Erik Gerding, a Professor of Law at the University of Colorado Law School, has also examined the intersection of prudential regulation and securities regulation under the Dodd-Frank Act in a recent blog post for The Conglomerate, which focuses on the Volcker Rule’s covered fund provisions. Gerding noted that, in drafting the covered fund statutory provisions and final rule, Congress and federal regulators reference securities laws (specifically exemptions under the Investment Company Act) to define the entities to which the covered funds rule would apply, a process Gerding termed “trans-statutory cross reference.” Gerding pointed out that using a securities law to define elements of a banking law allowed Congress and regulators to target risky investments such as private equity and hedge funds, but has also resulted in unanticipated consequences. According to Gerding, “the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC),” a transfer of powers that places a portion of systemic risk regulation in the hands of the SEC and injects increased interest by banks and the securitization industry in SEC rulemaking with respect to Investment Company Act exemptions.
In addition to the potential implications of the Dodd-Frank Act for regulators, critics of the Act continue to point to the burdens of compliance. Wulf Kaal, writing for The CLS Blue Sky Blog, recently examined the cost of compliance for private investment funds, which face increased disclosure requirements as well as mandatory registration under SEC rules implementing Title IV of the Dodd-Frank Act. Kaal, an Associate Professor at the University of St. Thomas School of Law, analyzed compliance cost estimates collected after mandatory registration requirements for private funds became effective to determine if, as some policymakers have argued, these costs are driving smaller private investment fund advisers out of the market. Kaal concluded that smaller firms do, in fact, have greater compliance costs than larger funds because the number of funds managed by private fund advisers, rather than the amount of assets under management, is associated with Dodd-Frank compliance cost. Kaal noted that, in addition to driving smaller funds out of the market, the implications of increased Title IV compliance costs may be the consolidation of the private fund industry, which could increase the systemic risk that the Dodd-Frank Act seeks to counteract. View the blog post here.
In another blog post, Kaal examined the effect of the Dodd-Frank Act on the profitability of the private fund industry. Kaal analyzed data on monthly private fund earnings for over 10,000 private funds and private fund advisers. Kaal found that the mandates of the Dodd-Frank Act requiring increased disclosure and supervision of private funds does, in fact, appear to impact private fund revenue negatively. Noting the lack of sufficient data to support theoretical explanations for his findings, Kaal speculated that concerns regarding SEC supervision could lead to managers altering their investment portfolios to avoid certain strategies. Kaal rejected industry claims that compliance costs or the focus by managers on legal and disclosure requirements at the expense of their other core duties accounts for the impact on private fund earnings.
While critics are quick to blame the Dodd-Frank Act for many of the problems facing the financial sector, a recent article in The Wall Street Journal suggests that small community banks are holding strong in spite of the increased regulatory burdens and compliance costs associated with Dodd-Frank. The article explains that while the number of community banks has fallen, small banks have expanded their lending at almost twice the rate of larger banks and have closed the profitability margin with larger banks since the enactment of the Dodd-Frank Act. The article cites banking consultants and analysts, who suggest that smaller banks face a greater challenge from low interest rates than from Dodd-Frank compliance costs.
The long-term implications of the Dodd-Frank Act for the financial sector are still unclear, as regulators continue to finalize rules to fulfill their Dodd-Frank mandates. What is clear, however, is the fact that stakeholders will continue to agree to disagree over the Act’s benefits and burdens.
Banking Agency Developments
OCC Compliance and Credit Risk Workshops
On October 8th, the Office of the Comptroller of the Currency (“OCC”) announced it will host two workshops in St. Louis for directors of national community banks and federal savings associations. The Compliance Workshop will be held on November 17 and will focus on the essential elements of an effective risk management program, major compliance risks, and critical regulations. The Credit Workshop will be held on November 18 and will focus on issues surrounding credit risk within the loan portfolio. OCC Press Release.
OCC Hosts Bank Directors Workshop
On October 7th, the OCC announced it will hold its Building Blocks for Directors workshop in New Orleans on November 16, 17, and 18 for directors of national community banks and federal savings associations. The workshop provides an introduction to the OCC’s approach to supervision, focusing on directors’ duties and responsibilities, major laws and regulations, and the exam process. OCC Press Release.
Updated Interagency Examination Procedures for Regulation P
On October 5th, the FRB published revised interagency examination procedures for Regulation P, which governs the disclosure of nonpublic information about consumers by financial institutions to unaffiliated third parties and the distribution of privacy policies to consumers. The examination procedures were developed by the Federal Financial Institutions Examination Council’s (“FFIEC”) Task Force on Consumer Compliance and supersede the examination procedures from 2011. FRB Consumer Affairs Letter 15-7.
OCC Releases Mortgage Metrics Report for the Second Quarter
On October 2nd, the OCC published its quarterly report on mortgage performance for the second quarter of 2015. The report indicated that the number of current and performing mortgages increased compared to the previous year, while the number of delinquent mortgages and foreclosures declined. OCC Press Release.
Treasury Department Developments
CFPB Offers Guidance to Mortgage Industry on Potential Pitfalls of Marketing Service Agreements
On October 8th, the Consumer Financial Protection Bureau (“CFPB”) published a bulletin containing guidance regarding marketing service agreements for the mortgage industry. The bulletin provides an overview of the federal prohibition on mortgage kickbacks and referral fees, which are often disguised in marketing service agreements as payments for advertising and promotional services. The bulletin also provides examples of legal violations the agency has uncovered during the investigation and enforcement process. CFPB Press Release.
OFR Publishes Paper on the Challenges of Interpreting the Liquidity Coverage Ratio
On October 7th, the Treasury Department’s Office of Financial Research (“OFR”) published a working paper that illustrates some of the complexities in interpreting the Liquidity Coverage Ratio (“LCR”) under both international and U.S. standards. Under LCR standards, banks are required to retain sufficient high-quality liquid assets to survive a significant stress scenario lasting 30 days. The report examines complexities in calculating and interpreting LCR under the international standard developed by the Basel Committee on Banking Supervision and under the U.S. standard. OFR Press Release.
CFPB Outlines Proposals for Potential Rulemaking Banning Arbitration Clauses that Prohibit Class Action Lawsuits
On October 7th, the CFPB announced that it is considering new rules that would prevent consumer financial companies from including arbitration clauses that prohibit consumers from pursuing class action lawsuits to obtain relief from companies’ wrongdoing. The proposals under consideration include requiring arbitration clauses to specify that they are not applicable to class action lawsuits unless class certification is denied or class claims are dismissed by a court, requiring companies that use arbitration clauses to report arbitration claims filed and awards issued to the CFPB, and increasing transparency by publishing claims and awards on the CFPB website for public monitoring. CFPB Press Release.
CFPB Prepares Mortgage Industry for Know Before You Owe Compliance
On October 2nd, the CFPB sent a letter to mortgage industry trade groups preparing them for compliance examinations under the Know Before You Owe mortgage disclosure rule, which became effective on October 3, 2015. The agency explained that during initial examinations for compliance with the rule it will take into consideration an institution’s efforts to develop a compliance management system, its good faith efforts to meet compliance requirements in a timely fashion, and its management of early technical problems and other challenges. CFPB Press Release.
Securities and Exchange Commission
Speeches and Testimony
Mary Jo White Delivers Introductory Remarks at National Faith Leaders Conference
On October 2nd, SEC Chair Mary Jo White delivered introductory remarks at the National Faith Leaders Conference, “Protecting Investors Protects You.” Chair White noted the SEC’s objective to bring all wrongdoers to justice and return money to harmed investors. White Remarks.
SEC Investor Advisory Committee Sunshine Act Meeting
On October 8th, the SEC announced that its Investor Advisory Committee will hold a meeting on Thursday, October 15, 2015 in Multi-Purpose Room LL-006 at the SEC’s headquarters. The meeting will begin at 10am Eastern time and will be open to the public. This Sunshine Act notice was issued because a quorum of the SEC may attend the meeting. The agenda for the meeting includes remarks from Commissioners; a discussion of recent market structure developments; a discussion of exchange-traded fund pricing; a report of the Committee chair regarding Committee matters; a discussion of SEC enforcement priorities; and a nonpublic administrative work session during lunch. Sunshine Act Meeting.
SEC Names Michael Liftik Deputy Chief of Staff
On October 5th, the SEC announced that Michael Liftik will become a deputy chief of staff of the agency. Mr. Liftik became Senior Advisor to Chair Mary Jo White in 2013. He served as Chair White’s legal advisor on enforcement policy matters and cases. Mr. Liftik also serves as Chair White’s representative on the Deputies Committee of the Financial Stability Oversight Council. In his legal advisor role, he has worked with SEC staff and senior officials from the Department of Treasury, FRB, and other financial regulators on identifying and addressing developments in the financial sector involving the asset management industry, cybersecurity, and macroeconomic trends. Liftik Announcement.
Deputy Chief of Staff to Leave the SEC
On October 5th, the SEC announced that Erica Williams will be leaving the SEC after serving as Deputy Chief of Staff to the following three Chairs: Mary Jo White, Elisse B. Walter and Mary L. Schapiro. Ms. Williams served as a senior legal advisor to Chair White on all aspects of the SEC’s operations, including enforcement, regulatory policy, compliance exams, strategy, and management of the agency. She also served as Chair White’s representative to the Financial Stability Oversight Board, which oversees the operation of the troubled asset relief program (“TARP”). Williams Announcement.
SEC Names New Associate Director in the Division of Economic and Risk Analysis
On October 2nd, the SEC announced that it has named Chyhe Becker as an Associate Director in the Division of Economic and Risk Analysis. The appointment is effective immediately. Dr. Becker assumes this new position in the division’s Office of Litigation Economics, created to reflect the importance of data-driven economic and statistical analysis in investigations and litigated cases. Becker Appointment.
Commodity Futures Trading Commission
CFTC Market Risk Advisory Committee Meeting
On October 5th, the Commodity Futures Trading Commission (“CFTC”) announced a public meeting of the Market Risk Advisory Committee on November 2, 2015. CFTC Notice.
Federal Rules Effective Dates
Click here to view table.
Exchanges and Self-Regulatory Organizations
SEC Approves Proposed Rule Change to Amend FINRA Rule 2210
On October 9th, the SEC published an order approving a proposed rule change to amend Financial Industry Regulatory Authority (“FINRA”) Rule 2210 (Communications with the Public). SEC Release No 34-76105.
FINRA Announces SEC’s Approval of Proposal to Expand Transparency Initiative
On October 8th, FINRA announced that the SEC approved its proposal to expand its transparency initiative for over-the-counter (“OTC”) equity securities. Under the newly approved rule, FINRA will supplement the alternative trading system (“ATS”) volume it currently publishes with all other equity volume executed over-the-counter by FINRA members. The rule is designed to bring additional transparency to this area of the financial markets, as part of an ongoing effort to help enhance investor confidence. With this initiative. FINRA will expand its volume transparency to all of the OTC market, enabling market participants and investors to better understand a firm's trading volume and market share. FINRA Press Release.
FINRA Publishes Notice on Dissemination of Qualified Contingent Trades Reported to It
On October 7th, FINRA published a Trade Reporting Notice as to the dissemination of qualified contingent trades (“QCT”) reported to it. According to the notice, effective November 16, 2015, the over-the-counter transactions in NMS stocks that are reported to FINRA as QCTs will be identified as such for purposes of public dissemination. This change affects dissemination only – firms are not required to change the way they report QCTs to FINRA.Trade Reporting Notice.
SEC Publishes Notice of Filing of a Proposed Rule Change to Merge FINRA’s Dispute Resolution Subsidiary Into and With Its Regulatory Subsidiary
On October 6th, the SEC published a notice of filing of FINRA’s proposal to merge its dispute resolution subsidiary, FINRA Dispute Resolution Inc., with and into its regulatory subsidiary, FINRA Regulation Inc. Comments are due within 21 days after publication in the Federal Register. SEC Release No. 34-76082.
SEC Approves Amendments to FINRA Rules on Temporary and Permanent Cease and Desist Orders
On October 2nd, the SEC approved amendments to FINRA rules that lower the evidentiary standard to enforce a temporary cease and desist order (“TCDO”); create a new expedited proceeding for recurring failures to comply with a TCDO or a permanent cease and desist order (“PCDO”); synchronize the provisions governing how documents are served in temporary cease and desist and expedited proceedings; clarify FINRA’s authority to impose a PCDO; and ease FINRA’s administrative burden in temporary cease and desist proceedings. The amendments become effective on November 2, 2015. (10/2/2015) Regulatory Notice 15-35.
IBA Selected as New ISDA SIMM Crowdsourcing Utility
On October 8th, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced that ICE Benchmark Administration Limited (“IBA”) has been selected to build and operate a crowdsourcing utility for the ISDA Standard Initial Margin Model (“ISDA SIMM™”). The ISDA SIMM™ has been developed as part of ISDA’s Working Group on Margining Requirements (“WGMR”) implementation initiative to help market participants meet new margining rules for non-cleared derivatives. By using a common methodology to calculate initial margin, counterparties can avoid the potential for disputes. The ISDA SIMM™ can be used by any party subject to the non-cleared margin requirements. ISDA Press Release.
MSRB Requests Comment on Lengthening Board Member Terms
On October 5th, the Municipal Securities Rulemaking Board (“MSRB”) announced that it is seeking public comment on a proposal to lengthen the term of board member service to four years from three. MSRB Press Release.
SEC Approves NASDAQ’s Proposed Rule Change as to the Listing and Trading of Shares
On October 5th, the SEC granted approval of NASDAQ’s proposed rule change as to the listing and trading of shares of the First Trust SSI Strategic Convertible Securities ETF of First Trust Exchange-Traded Fund IV. SEC Release No. 34-76076.
NASDAQ OMX BX, Inc.
SEC Approves NASDAQ OMX BX, Inc.’s Proposed Rule Change to Adopt a Kill Switch
On October 8th, the SEC published an order approving NASDAQ OMX BX, Inc.’s (the “Exchange”) proposed rule change to adopt a risk protection functionality referred to as a kill switch that will be available to all participants of the Exchange. SEC Release No. 34-76116.
NYSE Arca Inc.
SEC Publishes Notice of Filing of Proposed Rule Change for New Equity Trading Rules
On October 6th, the SEC published notice of filing of a proposed rule change for new equity trading rules relating to auctions for Pillar, NYSE Arca Inc.’s new trading technology platform. Comments are due within 21 days after publication in the Federal Register. SEC Release No. 34-76085.
Stockholders Can't Sue Broker under SEC Rules for Failing to Deliver Physical Certificates of Securities
On October 8th, the U.S. Court of Appeals for the Sixth Circuit affirmed dismissal of a lawsuit brought by stockholders against their broker. Plaintiffs purchased shares of stock through a brokerage account held by TD Ameritrade, Inc. Plaintiffs requested that TD Ameritrade convert some of the “street shares” held by another entity to physical certificates. When TD Ameritrade refused because the depository entity holding the shares placed a “global lock” preventing any activity in the stock, plaintiffs sued under Nebraska’s Uniform Commercial Code and SEC Rule 15c3-3, which require brokers to deliver securities in physical certificates or other available forms at the holder’s request. The district court dismissed the case, holding that the neither the Securities and Exchange Act provision promulgating the rule nor Nebraska law creates a private cause of action for plaintiffs’ claim. The appellate court affirmed. Muriel Harris v. TD Ameritrade, Inc.
Hedge Fund Volatility Strategy May Be Coming to a Close
On October 9th, Bloomberg discussed the analysis of the Chicago Board Option Exchange’s VIX index by the derivatives research division of Société Générale. The VIX index measures the implied volatility of the S&P 500 and is considered by some to be a “fear gauge.” The article notes that many hedge funds have profited during an era of low interest rates by “selling volatility” by shorting the VIX index. According to Société Générale analysts, volatility moves in cycles and signs suggest that the current cycle may be coming to an end. Volatility Cycle.
Survey Finds Increase in Audit Fees for Public Companies
On October 9th, CFO.com reported that audit fees for public companies have increased by 3.4 percent over the last year, according to a survey conducted by Financial Executives International. The survey found that public companies paid external auditors an average of $1.5 million in 2014. The trade group that conducted the survey concluded the change was due in part to completed mergers and acquisitions as well as reviews of manual controls sparked by Public Company Accounting Oversight Board (“PCAOB”) inspections. Audit Fee Increase.
NASDAQ Employs New Software to Monitor Dark Pools
On October 8th, the Financial Times reported that NASDAQ has heightened its examination of “dark pools” through the use of surveillance software to detect manipulative activity in off-exchange trading equities. The article notes that the move by NASDAQ marks the increased scrutiny of dark pools by regulators as a hotbed for potential market abuse, since these trading venues are located off the exchange and therefore are not as strictly regulated. Dark Pools.
SEC’s White under Increased Pressure to Remove Herself from PCAOB Hiring Process
On October 8th, MarketWatch reported that a national coalition of 14 organizations is demanding that SEC Chair Mary Jo White recuse herself from the selection process for the next PCAOB chair, citing a conflict of interest arising from her husband’s position on the PCAOB Standing Advisory Group. Conflict of Interest.
Supreme Court Denies Certiorari in Landmark Insider Trading Case
On October 5th, Bloomberg reported that the U.S. Supreme Court declined to review the U.S. Court of Appeals for the Second Circuit’s decision overturning insider trading convictions against two hedge fund managers. The Second Circuit’s ruling in U.S. v. Newman held that an insider who tips information must receive a clear benefit beyond friendship that is known to the person trading on the information. The article notes that the ruling has already resulted in the dismissal of five insider trading cases, illustrating prosecutors’ concerns that the ruling will prevent them from prosecuting many who engage in illegal tipping of information. Insider Trading.
New York Fed Economists See Ample Liquidity in Corporate Bond Market
On October 5th, Reuters reported on the findings by economists at the New York Federal Reserve, which indicated that there is sufficient liquidity in the corporate bond market. The economists found that despite the fact that the trading volume in corporate bonds has not kept pace with supply, price-based liquidity measures remain low. The findings address concerns that more stringent regulations could hamper the ability of investors in corporate bonds to sell their holdings. Bond Liquidity.
Proposed Loss-Absorbing Capacity Rules May Prove a Boon to Large Banks
On October 5th, Bloomberg discussed the potential implications for U.S. banks if the FRB adopts the requirements proposed by global regulators for banks considered too big to fail. According to the article, the Financial Stability Board (“FSB”) is planning to propose a lower percentage of risk-weighted assets that banks will be required to have available to sustain losses during a crisis, which is already in line with what the largest U.S. banks currently retain in risk-weighted assets. The FSB will present its final rules for ratification by G20 leaders in November. Too Big To Fail.