President Trump’s Two for One Regulatory Reduction Is Headed to Court

It seems like just a week ago that President Donald Trump signed an Executive Order requiring two regulations be repealed for every new one adopted.  It was. And this week a lawsuit has been filed challenging that executive order.

The lawsuit was filed by Public Citizen, the Natural Resources Defense Council and the Communications Workers of America. In addition to President Trump, the lawsuit tags the Acting Director of the OMB and the current or acting secretaries and directors of many government agencies.

The Securities and Exchange Commission is noticeably absent from the list of defendants. I guess the plaintiffs concluded that the SEC is independent and not subject to the Executive Order.

The plaintiffs are asking the court to prevent the agencies from implementing the order and to kill the executive order because it cannot be lawfully implemented.

According to the complaint, the executive order to repeal two regulations for the purpose of adopting one new one, based solely on a directive to impose zero net costs and without any consideration of benefits, is “arbitrary, capricious, an abuse of discretion, and not in accordance with law.” The complaint spells out the three big reasons the plaintiffs think so:

There is no statute that tells agencies to withhold regulations because of cost. Of course there is the cost-benefit requirement for some regulations. But that is different than saying there are no costs imposed by the regulation.

Second, the Executive Order forces agencies to repeal regulations that have gone through the administrative process and concluded that they comply with the enabling statute and advance the purpose of the statute. The complaint stops short, but in my view the argument is that the Executive Order is trying overturn legislation passed by Congress authorizing regulation.

Third, no governing statute authorizes an executive agency to base its decision making on there being zero net cost across multiple regulations.

The second argument is certainly applicable to many of the financial regulations imposed by Dodd-Frank. The SEC is taking steps to rollback the Extraction Disclosure Rule.  A rule that was specificaly required by Dodd-Frank.  (Of course, the SEC is not specifically subject to the Executive Order.)

The two big problems with the lawsuit are standing and ripeness.

Two of the causes of action are violations of the constitution, violating the separation of powers and the Take Care Clause. That last one is new one for me. Under Article II, Section 3, the President has duty to “Take Care that the Laws be faithfully executed.” I’m skeptical that individual citizens have standing under these provisions. Congress is not about to bring suit.

The other causes of action would seem to not be ripe for suit until an agency actually starts trying to repeal regulations because of this order.

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The Five Most Frequent Compliance Topics in SEC Exams

The SEC’s Office of Compliance Inspections and Examinations published a list of the five compliance topics most frequently identified in deficiency letters that were sent to SEC-registered investment advisers.

The five are actually the bulk of advisor compliance requirements. It’s the examples in the five topics that are the most useful indicators.

Compliance Rule

  • Compliance manuals are not reasonably tailored to the adviser’s business practices.
  • Annual reviews are not performed or did not address the adequacy of the adviser’s policies and procedures.
  • Adviser does not follow compliance policies and procedures.
  • Compliance manuals are not current.

Regulatory Filings

  • Inaccurate disclosures
  • Untimely amendments to Form ADVs
  • Incorrect and untimely Form PF filings
  • Incorrect and untimely Form D filings

Custody Rule

  • Advisers did not recognize that they may have custody due to online access to client accounts.
  • Advisers with custody obtained surprise examinations that do not meet the requirements of the Custody Rule.
  • Advisers did not recognize that they may have custody as a result of certain authority over client
    accounts.

Code of Ethics Rule

  • Access persons not identified
  • Codes of ethics missing required information
  • Untimely submission of transactions and holdings.
  • No description of code of ethics in Form ADVs

Books and Records Rule

  • Did not maintain all required records.
  • Books and records are inaccurate or not updated.
  • Inconsistent recordkeeping.

The only thing surprising about this publication is that conflicts are not mentioned.  I had assumed that undisclosed conflicts or improperly managed conflicts was the biggest problem found in SEC exams. This list makes it seem like ministerial missteps and sloppy paperwork are the most common problems.

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The SEC Is Making Room For A New Regulation

Although is questionable whether the Securities and Exchange Commission is subject to President Trump’s executive order calling for a reduction in the number of regulations, the SEC seems to be taking it to heart.

Last week, Congress started the push to roll back the Extraction Disclosure Rule. This week, the SEC is looking to roll back the pay ratio disclosure rule.

The SEC is short-handed. Acting SEC Chair Michael Piwowar asked SEC staff to reconsider implementation of the rule. The pay-ratio rule mandates companies to disclose median worker pay and compare it with CEO compensation. This product of Dodd-Frank is supposed to put pressure on corporate boards to slow pay increases for CEOs.

The argument against is that is a costly to implement and not valuable to shareholders.

Unlike the Extraction Disclosure Rule, the Pay Ratio Rule was not implemented in the window subject to the Congressional Review Act. The SEC cannot rely on Congress to repeal the rule for them.

For the SEC to make changes, it has to create a new rule-making process and open to comments on changing the rule. Repealing the rule would put the SEC at odds with the Congressional mandate in Dodd-Frank to create the rule. That seems an untenable position to take.

Since the SEC is currently subject to three vacancies, it’s unlikely that anything will happen until Jay Clayton is approved by the Senate as the new Chair. That would likely mean two votes in favor of killing or maiming the rule, to one likely opposed.

According to the President’s executive order, the SEC has identified two rules to be repealed. That means it can now roll out a new regulation. Wonder what it will be?

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Comeback

It’s tough thinking about compliance this morning after staying up to watch the greatest comeback in Super Bowl history by one of the greatest quarterbacks, orchestrated by one of the greatest coaches.

I reflect back humbly. I grew up with the red-uniformed Patsies. I remember the 1 and 2 win seasons. I remember the years of not being able to beat Miami in Miami.

At halftime of this game, I remembered the Patriots’ first Super Bowl when the team was steamrolled by the great ’85 Bears in what, at the time, was the most lopsided loss in Super Bowl history.

I remember the Patriots with one foot out the door to St. Louis and again with an aborted move to Hartford.

I know that the painting in Tom Brady’s attic will not hold back time forever, that Belichick will retire someday, and that Mr. Kraft will pass on the team to someone else to run. This dynasty will come to end some day.

But not today.

I’ll leave with a picture of my good friend holding the Lombardi Trophy last night.

Congress Disapproving The SEC Rule That Congress Made The SEC Make

Dodd-Frank made the Securities and Exchange Commission create a rule on the disclosure of payments by resource extraction issuers. The SEC finally got the rule out this fall. Now Congress is threatening to abolish the rule.

Section 1504 of the Dodd-Frank Act directed the Securities and Exchange Commission to

“issue final rules that require each resource extraction issuer to include in an annual report . . . information relating to any payment made by the resource extraction issuer, a subsidiary of the resource extraction issuer, or an entity under the control of the resource extraction issuer to a foreign government or the Federal Government for the purpose of the commercial development of oil, natural gas, or minerals..”

SEC finished the rule and finally adopted the Rules for Resource Extraction Issuers Under Dodd-Frank Act in September.

The strategy is not to pass a law removing section 1504. That would require getting the supermajority in the Senate to overcome the filibuster obstacle. That is hard and unlikely.

The plan is to use the Congressional Review Act to repeal the rule. That Act was part of Newt Gingrich’s Contract with America.

Under the law, Congress can stop a regulation passed within the last 60 legislative days. That counting is a bit fuzzy, but seems to stretch all the way back to the middle of June 2016.

I have little doubt that the rule will be rolled back. My question is whether this repeal counts towards the two repealed rules it takes to get a new one enacted under the Executive Order.

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The New Supreme Court Pick and Private Funds

Justice Scalia died last year and replacing his position has been held up by partisan politics ever since. President Trump has made his pick, federal appeals court judge Neil Gorsuch from the 10th Circuit, and the confirmation battle has begun.

Being very liberal on social issues, I’m disappointed that the Senate chose not consider President Obama’s pick for the vacancy. We’re now faced with a justice who is likely to cause an erosion of some of the liberal gains we have seen on social issues.

But Compliance Building is about compliance so I quickly looked for some of judge Gorsuch’s opinions involving the Securities and Exchange Commission or private funds. I didn’t find much.

In ACAP Financial v. US SEC (2015), Judge Gorsuch wrote the opinion upholding an SEC penalty levied against the appellants for failing to take sufficient steps to guard against the firm’s involvement in the unlawful trading of unregistered shares. I found the writing to be very clear and easy to read. It lacks the ponderous rhetoric of many court opinion.

The decision is an easy one to find in favor of the SEC, so it does not offer much insight. The appellants did not argue their liability, but merely disputed the remedy imposed. The remedy was one proscribed for “egregious” behavior and they argued that their behavior was not “egregious.” The judge goes on for ten pages shooting down the appellants’ arguments, none of which even come close.

Gorsuch’s 10th Circuit is responsible for the Bandimere decision that recently struck down the SEC’s current system of administrative law judges. That put the 10th Circuit in opposition to other appeals courts, setting up a potential clash at the Supreme Court. However, Judge Gorsuch was not one of the appellate judges on the Bandimere case.

Let me know if you find any other cases from Judge Gorsuch that are relevant to private funds, compliance or the SEC.

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Add One, Take Two Away

Prior to his inauguration, President Trump promised a 75% reduction in regulations. I was left scratching my head about what he meant. Did he want the Code of Federal Regulation to be 75% shorter? How do you decide where one regulation begins and another starts? What about statutes enacted by Congress that specifically mandate the promulgation of new regulations? Isn’t repealing a regulation itself a new rule-making?

President Trump followed up on the promise and issued a new executive order. Whenever an agency publicly proposes a new regulation, it must identify at least two existing regulations to be repealed.

Additionally, the order requires the net incremental cost for fiscal 2017 to “be no greater than zero.” The cost of new regulations should be offset by existing rules that will be rescinded. I assume this add one, take away two is being put in place to achieve his 75% promise.

It looks like Dodd-Frank is the biggest target. I’m not sure the executive order will do it. Dodd-Frank mandated many new regulations. Repealing those regulations would seem to require an act of Congress.

I focus on the Securities and Exchange Commission, so I decided to take a closer look at the executive order. First up is what was meant by regulation.

“For purposes of this order the term “regulation” or “rule” means an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or to describe
the procedure or practice requirements of an agency…”

Wow.

I think this executive order could affect not only the promulgation of new rules, but could also affect staff guidance. I think a rule-making is general applicability and guidance is particular applicability. That could affect information updates and staff guidance. Could it even affect no-action letters? I think you can read it that way. Ultimately, it will be the SEC commissioners interpretation of the executive order that matters.

Of course, there is the argument that the SEC is an independent agency and not subject to the executive order. The order itself states that it applies to each “executive department or agency.”

Regardless of whether the order applies, President Trump has lesser power to fire the commissioners on the SEC so they may chose to ignore the executive order. Or they may embrace the concept and begin de-regulating.

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The Trump Organization’s Compliance Program Begins

Last week, the Trump Organization kicked off its compliance program by making two appointments.

Bobby Burchfield will be independent ethics adviser. He’ll be responsible for signing off on transactions that could raise ethics or conflicts of interest concerns.

George Sorial will become chief compliance counsel.

In the January 11 press conference, Sheri Dillon announced:

[T]o ensure the Trump Organization continues to operate in accordance with the highest and legal ethics standards, an ethics adviser will be appointed to the management team. The written approval of the ethics adviser will be required for new deals, actions, and transactions that could potentially raise ethics or conflicts of interest concerns.

…

“Another step that President-elect Trump has taken is he created a new position at the Trump Organization: the position of chief compliance counsel, whose responsibility will be to ensure that the Trump businesses, again, are operating at the highest levels of integrity and not taking any actions that could be perceived as exploiting the office of the presidency.”

I admit that I was skeptical that the Trump Organization would even make the appointments to these two positions and I did not expect that it would happen this quickly. Of course, it would have been better to have a compliance program in place before the inauguration.

It would seem that the Trump Organization did not have an existing compliance program. The obvious person to deal with the compliance issues related to his political office would have been the compliance head.

Mr. Burchfield is a partner in the Washington office of King & Spalding and a well respected lawyer for the Republican party. He represented George W. Bush in the 2000 Florida recount. Mr. Burchfield previously challenged the McCain-Feingold Campaign Finance Law on behalf of the Republican National Committee. He was general counsel to George H.W. Bush’s 1992 reelection campaign. He is on the board of Crossroads GPS, the Republican advocacy group started by Karl Rove.

Mr. Sorial has worked at the company since 2007 and served most recently as executive vice president and counsel. He has had roles in Trump’s international development efforts, including the building of his golf course in Aberdeen, Scotland.

As I wrote last week, Mr. Trump is currently one of the most powerful men in the world and therefore the compliance program for his business empire is one of the most important in the world.

Mr Burchfield is very experienced lawyer who does tremendous work for his clients. I’m disappointed that the ethics advisor is such a partisan attorney for the Republican party.

As for Mr. Sorial, I will have to state my bias. Like him, I came from a real estate background. I also went to law school with him. However, he is stepping into an extremely difficult position with no background in compliance.

Hopefully, compliance professionals will learn more the compliance program so we can see how one is put in place to protect one of the most powerful people in the world. Obviously, the American people deserve to know more about the program to know whether the President is directly benefiting financially from his government actions.

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Compliance Bricks and Mortar for January 27

These are some of the compliance related stories that recently caught my attention.

Trump Gets Subtle Pre-taliation Warning by Matt Kelly in Radical Compliance

On Wednesday the Office of Special Counsel issued a reminder that any policies about communications from government employees—like, say, telling them to stop talking about climate change; or to stop talking entirely—must include language that those employees are still free to raise alarms about misconduct. [More…]

How Independent Is The SEC And How Independent Should It Be? by Keith Paul Bishop in California Corporate and Securities Law

I have previously argued that the SEC and other independent agencies are the platypodes of the federal government.  If the SEC is truly an independent agency, perhaps it is time to reevaluate its status.

For more on the SEC’s status, or lack thereof, as an independent agency, see this Harvard Law Review note: The SEC is not an Independent Agency. [More…]

Will Yahoo’s Data Breach Reporting Become the Test Case for the SEC’s Cyber Disclosure Guidelines? by Kevin LaCroix in the D&O Diary

Ever since the SEC released its cyber security disclosure guidelines in October 2011, commentators (including me) have been speculating whether the agency might try to nab a company whose disclosure practices the agency might use as sort of a test case on the guidelines’ requirements.  It now appears, at least based on media reports, the SEC is investigating Yahoo in what may yet become the long-anticipated test case. According to a front page January 23, 2017 Wall Street Journal article (here), the SEC has opened an investigation looking into Yahoo, Inc.’s disclosures of two massive data breaches the company reported last year. [more…]

No Coat, No Tie Leads to Rough Start for Accused Insider Trader by Christian Berthelsen for Bloomberg

He refused to bring his expected court attire when U.S. marshals arrested him. When he finally arrived in federal court in Manhattan late Monday, dressed in Under Armour workout gear, he tried to fire his lawyers. On Tuesday, he listened in silence as a prosecutor laid out the evidence against him — wearing a jacket, shirt, tie and pants that his mother brought him.

Thus began one of the more unusual insider-trading trials in recent memory in New York federal court. Afriyie, 29, attended Cornell University and worked as an analyst at Michael Dell’s MSD Capital LP. He’s accused of using confidential information gleaned from MSD’s computer system to score $1.5 million in illegal trading profits last year on Apollo Global Management LLC’s takeover of alarm-manufacturer ADT Security Services. [More…]

There have been just four documented cases of voter fraud in the 2016 election By Philip Bump in The Washington Post

The burden, as we’ve noted before, is on those who say rampant fraud is occurring. I can claim that there’s a burglary epidemic in my city that has gone unnoticed, but you would be justified in pointing out that no one is coming forward to say their houses were broken into. And if I point at a recent spike in sales of crowbars as evidence — voter registration fraud, in this analogy — you would be right to draw a distinction between that and my initial claim. [More…]

 

Affiliated Service Providers and Private Equity

Conflict disclosure and management of the conflicts are central to the Investment Advisers Act. Clients are supposed to come first. That means that conflicts must be disclosed and steps taken to manage the conflict must be put in place. An affiliated service provider is a common conflict.

Centre Partners Management used a service provider for the private equity funds it manages and used it to provide due diligence for potential portfolio investments. The Service Provider provided IT due diligence services with respect to potential portfolio investments for the Funds at a flat fee capped at $25,000 per engagement. Those fees are paid by the funds.

That seems straight forward until you consider that the the Service Provider is owned in part by principals of the firm.

The potential conflict could have been fixed by disclosing the ownership in the fund documents. But Centre Partners did not make that disclosure in the fund PPM or in the Form ADV. It also did not mention the affiliated party payments in the audited financial statements.

The ownership stake was not large. The three principals of Centre Partners only owned 9.6%. But two of them are on the board of directors of the service provider. The founder and majority owner of the service provider is the brother-in-law of one of the principals. (It’s always the brother-in-law that gets you trouble.)

A placement agent for one of the funds raised the conflict during fundraising in 2012. Investors apparently asked about the service provider.

An SEC exam looked at the relationship with the service provider and decided it was worthy of an enforcement action. It cost the firm a $50,000 fine. It also took almost three years to finalize the settlement. The Order states that the exam was completed in early 2014.

There is no statement that the fees paid to the service provider were excessive or above market. That does not matter if the relationship is not disclosed. To fix the problem going forward, the firm added the disclosure to the Form ADV starting in March 2014.

This seems like a good time to check to make sure that none of your fund service providers are owned by employees of the firm.

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