Tag: Dodd-Frank Wall Street Reform and Consumer Protection Act

Supreme Court Limits SEC Internal Tribunals

“When the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial.”

SEC v. Jarkesy

The case presented three issues:

(1) Whether statutory provisions that empower the Securities and Exchange Commission to initiate and adjudicate administrative enforcement proceedings seeking civil penalties violate the Seventh Amendment.
(2) Whether statutory provisions that authorize the SEC to choose to enforce the securities laws through an agency adjudication instead of filing a district court action violate the nondelegation doctrine.
(3) Whether Congress violated Article II by granting for-cause removal protection to administrative law judges in agencies whose heads enjoy for-cause removal protection.

The Supreme Court ruled on the first item and didn’t address the other two. Fights for another day.

Dodd-Frank granted the Securities and Exchange Commission broader rights to use its internal administrative law tribunals for non-registered parties. [Section 929P(a)]. Of course with the addition of private fund managers by Dodd-Frank, the world of non-registered parties got smaller.

Mr. Jarkesy and his Patriot28 fund were investigated by the SEC for inflating the fund values and lying about its service providers prior to Dodd-Frank. It decided to charge them using the in-house tribunal by using its new authority under Dodd-Frank. Mr. Jarksey lost the decision in 2014 and has been fighting ever since.

The Supreme Court decision looks at the Public Rights Exception to Article III jurisdiction. This exception allows some matters to go through administrative law proceedings and don’t require Article III proceedings. The Supreme Court essentially determines that civil penalties are designed to punish and deter and not compensate. Therefore, a case seeking civil penalties can’t go through the in-house tribunal.

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Private Funds Rule is Vacated

We consider a challenge to the Final Rule by petitioners National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association collectively “Private Fund Managers”). For the following reasons, we VACATE the Final Rule.

The central focus is thus on whether the Dodd-Frank Act expanded the Commission’s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act, see Part III.B.1., and whether section 206(4) authorizes the Commission to adopt the Final Rule, see Part III.B.2. We hold neither section grants the Commission such authority

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The Court found that the language in Section 211(h) applies to retail customers and therefore the SEC exceeded its authority. It looks at Section 913 of Dodd-Frank and points out that it applies to the defined term “retail customers.” Section 211(h) was enacted under Section 913. Therefore, rules under 211(h) should only be for the protection of retail investors. Private fund investors are not “retail customers.”

As for enacting the Private Fund Rules under the anti-fraud provisions of Section 206, the Fifth Circuit found the SEC conflated “lack of disclosure” with fraud or deception.

The Fifth Circuit found the remedy to be vacating the entire Private Funds Rule.

I assume the SEC will appeal the decision to the Supreme Court. The reasoning of the Fifth Circuit is strong enough that it risks invalidated other SEC rules if left standing. I’m hoping that the SEC will formally announce the delay of the compliance deadlines under the Private Fund Rules. It looks like it is pencils down on these new requirements.

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A New Regulatory Action to Help Potential Whistleblowers

In response to a Congressional mandate in Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Back in 2016 the Securities and Exchange Commission filed a series of cases against companies that restricted departing employees from contacting government authorities. Some of the language the SEC found illegal was broad non-disparagement clauses that forbid former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Companies responded by adding carve-outs that explicitly stated that employees could contact government regulators to reporting possible wrongdoing.

Monolith Resources included that language in its separation agreements:

“nothing in this agreement is intended to limit in any way your right or ability to file a charge or claim with any federal, state, or local agency,”

But Monolith took away the financial aspect of a whistleblower by adding:

“You retain the right to participate in any such action, but not the right to recover money damages or other individual legal or equitable relief awarded by any such governmental agency.”

Monolith’s former employees could file a whistleblower complaint, but not get any cash. An interesting approach, but one that is clearly designed to impede whistleblower actions.

Monolith got hit with a $225,000 fine. There was no indication that any employee was impeded from communicating with the SEC and Monolith never enforced that provision.

Maybe there has been some prior action by the SEC on this type of pretaliation and I just missed it. Let me know.

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Private Funds and the Economic Growth, Regulatory Relief, and Consumer Protection Act

Last week, the Economic Growth, Regulatory Relief, and Consumer Protection Act became law,  providing some revisions to Dodd-Frank and some new regulatory wrinkles. Some of those revisions apply to private funds.

Section 203 exempts Banks and Bank Holding Companies with (1) $10 billion or less in total consolidated assets and (2) total trading assets and trading liabilities of 5% or less of total consolidated assets from the Volcker Rule.

Section 204 allows hedge funds and private equity funds to share the name with a banking entity acting as its investment adviser provided that the investment adviser is not an insured depositary institution and the name does not contain the word “bank.” Interestingly, that new exemption would seem to apply to real estate funds or venture capital funds.

Section 504 Revises the exemption in 3(c)(1) of the Investment Company Act. it adds a new exemption for “qualifying venture capital funds” to have up to 250 investors instead of the 100 investors limit for other types of funds. A “qualifying venture capital funds” is a venture capital fund that has not more than $10 million in aggregate capital contributions and uncalled committed capital.

I suppose this allows venture capital fund managers to create a pool with a larger number of less wealthy investors that are making smaller commitments. Otherwise, to exceed 100 investors, a fund manager would have to use the 3(c)(7) exemption that requires investors to be Qualified Purchasers. This was a Senate amendment sponsored by Senator Heitkamp as the “Supporting America’s Innovators Act.”

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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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Dodd-Frankly, My Dear, I Don’t Give..

Perhaps one day there’ll be another famous movie line: “Dodd-Frankly, my dear, I don’t give…” But probably not. Its not clear if Dodd-Frank has been a success or a failure.

GoneWiththeWind1

It certainly has been a change.

From the regulated side, I think the failure or success depends on which part of Dodd-Frank affects you. New regulations make winners and losers. Most research shows that it makes it harder for new firms to enter the regulated space.

From 2009 to 2013 only 7 new banks were formed, fewer than 2 per year. From 1990 to 2008, over 2,000 new banks were formed, more than 100 per year. Its easy to blame that on Dodd-Frank, but the economy has been weak and interest rates low.

Certainly, big banks are not any smaller and few believe that too big to fail is gone. It brief glance at bank credit ratings, you can see a boost in the ratings for an implied government bail-out.

It also depends on how you rate size: amount of deposits, amount of assets, amount of lending activity.

We have seen the reach of the non-bank too big to fail labeled and then removed. The firms may be important, but not systemically important.

One of the clear winners is the compliance profession. Dodd-Frank clearly requires more compliance efforts and people to take on those efforts.

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Yet Another Rule to Discourage Companies From Going Public

sec-seal

There has always been a tension between regulating the capital markets to protect the public and making capital formation more efficient. While I was focusing on Tuesday’s meeting SEC Advisory Committee on Small and Emerging Companies discussing changes to private placements, the SEC passed another rule that smacks public companies. Now public companies need to start worrying about the ratio of the CEO’s compensation to the median compensation of all employees.

I think it’s a silly rule that will do nothing except fire up shareholder activists and further discourage companies from going public.

At least this rule is not the fault of the Securities and Exchange Commission. Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act mandated this rule. Blame Congress, not the SEC.

(b) ADDITIONAL DISCLOSURE REQUIREMENTS.—

(1) IN GENERAL.—The Commission shall amend section 229.402 of title 17, Code of Federal Regulations, to require each issuer to disclose in any filing of the issuer described in section 229.10(a) of title 17, Code of Federal Regulations (or any successor thereto)—

(A) the median of the annual total compensation of all employees of the issuer, except the chief executive officer (or any equivalent position) of the issuer;

(B) the annual total compensation of the chief executive officer (or any equivalent position) of the issuer; and

(C) the ratio of the amount described in subparagraph (A) to the amount described in subparagraph (B).

There is an exception for Emerging Growth Companies from the rule. Yet another benefit to grabbing this status under the JOBS Act.

The SEC did not mandate any particular methodology for the calculation. This rule will be a big challenge for bigger companies and multi-national companies.

I also wonder if there will be a math problem with companies using “average” instead of “median.” Surely, at least one company will put someone in charge of the calculation that does not know the difference.

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Action in Congress

act of congress

Robert Kaiser was granted rare access to the action behind the scenes of the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Act of Congress is an enjoyable study of the enactment of that law, used as tool to explore how Congress works, and largely how it it doesn’t work.

Kaiser was already an associate editor and senior correspondent with the Washington Post and had just finished a book on lobbying and money in Washington. He proposed to Congressman Frank that Kaiser become the historian of the congressional response to the Great Crash of 2008. Frank was planning a big legislative changes to the financial services industry and the new president shared this goal. Senator Chris Dodd and Representative Barney Frank let Kaiser talk on the record with staff.

Act of Congress lives by the famous remark “Laws are like sausages, it is better not to see them being made.” The book’s goal is to be both entertaining and educational as it sneaks behind the curtain to watch the sausage production.

“Of the 535 members of the House and Senate, those who have a sophisticated understanding of the financial markets and their regulation could probably fit on the twenty-five man roster of a Major League Baseball team.”

Kaiser lets the stupidity of some Congress make it to the pages. He lets their public statements stand for themselves, although he tosses the phrase “intellectual lightweight” at a few. I sense he had a lot of personal perspective some of the congressmen that did not make it to the pages.

I found the book to be well-written and interesting. I suspect the interesting part may be governed more by my interest in the Dodd-Frank Act. It’s an enormous piece of legislation with profound impact on the financial services industry. In places it is poorly written and in others it’s full of exemptive holes. This books will enlighten you to some of the compromises that were made to get the law enacted.

I suspect those who have that interest may be limited. If you have made it this far, perhaps you share that interest. In which case you should add Act of Congress to your reading list.

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Dodd-Frank a year on: Where is the compliance industry now?

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so excuse the typos.

David Smolen, Chief Compliance Officer, Silver Lake
Brynn Peltz, Partner, Goodwin Procter LLP
Roman A. Bejger, Counsel and Chief Compliance Officer, Providence Equity Partners, LLC
Michael Barnes, Senior Manager, Financial Services, Ernst & Young LLP

Fund managers fell into four categories: 1. those who accepted, 2. those who are still kicking and screaming, and 3. Those who are fighting and trying to find ways to escape, and 4. Those who registered and restructured to escape registration.

The panel felt that it’s inevitable that carried interest will be taxed differently. Of curse it’s felt inevitable for a few years and nothing has been implemented. In perspective, the change in tax of carried interest is estimated to be between $1.3 billion and $1.6 billion per year.

As a result of the Volcker Rule, we are seeing more business development companies coming on line to address bank’s trading activity. Whenever the rule comes out it may have broad impact on funding and capital commitments for private funds.

There is an uncertainty about marketing rules with the changes mandated by the JOBS Act.

There is increased focus on fees as part of examinations. The SEC is trying to re-label fees, other than advisory fees, as compensation that could require broker-dealer registration. Brynn has seen this in several deficiency letters over the last few months. The SEC is asking examinees to explain why they do not have to register as a broker-dealer. Acquisition fees, disposition fees and other transaction based fees could trigger the question of broker-dealer registration. A marketing department is suspect if the employee compensation is tied to successful placement of interests in a fund.

The SEC does not seem to be using the term “presence exam” when initiating an exam. The panelists seem to think that the SEC is still robustly conducting regular exams and presence exams are not being conducted as widely as expected.

What additional responsibilities have you taken on post-registration?

  • Lobbyist registration
  • International blue sky law analysis
  • Review of secondary transfers
  • Form PF
  • Internal marketing of compliance
  • Tracking regulatory changes
  • EU’s AIFMD
  • FCPA

Is there personal liability for CCOs?

We are looking for more guidance in this area. Keep the CCO from having supervisory liability. If the CCO hands out discipline, then the CCO could be considered a supervisor and be held liable for the bad act. However, the cases imposing supervisory liability on CCO generally are at the extreme, involving fraud or other egregious acts.

Presence exams generally last a few days. Union examiners leave right at 5. Non-union may stay longer. Generally it’s 2 to 3 people, with a junior person, a mid-level manager, and a senior person who usually does not stay all day. Sometimes there will be a group of trainees. Sometimes enforcement will also come, but it may be just a learning experience and not an indication of wrongdoing. Ask for an exit interview. If it’s refused then the exam may not be over.

 

First the SEC, Now the CFTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act is getting ready to land its second regulatory punch to private equity funds. The first was the registration requirement with the Securities and Exchange Commission. The second is the upcoming registration requirement with the Commodities Futures Trading Commission.

Two recent developments pull fund managers into the CFTC’s world. The first is the inclusion of interest rate and foreign exchange swap transactions into the regulatory oversight of the CFTC. That’s part of the Dodd-Frank regulation of derivatives. The second is the repeal of a popular exemption from registration. That exemption was available for funds that were limited to investors that were accredited investors and qualified eligible persons. That exemption will cease to be available after December 31, 2012.

Title VII (the “Derivatives Act”) of Dodd-Frank creates a new framework for regulating derivatives. Securities derivatives get SEC oversight, but non-securities derivatives get CFTC oversight.

Under the Commodity Exchange Act, as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether an entity is a “commodity pool” and whether the operator or adviser to the entity is a Commodity Pool Operator or Commodity Trading Advisor.

  • A “Commodity Pool” is “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product, or swap. . .””
  • A “Commodity Pool Operator” (a “CPO”) is any person “engaged in a business that is of the nature of a commodity pool…and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property. . .for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product or swap. . .”
  • A “Commodity Trading Advisor” (a “CTA”) is any person “who, for compensation or profit, engages in the business of advising others. . . as to the value of or advisability of trading in… any contract of sale of a commodity for future delivery, security futures product, or swap . . .””

I don’t think most private equity funds would consider themselves to be “trading” in commodity interests. However, the CFTC release indicates that entering into a single commodity interest transaction would be sufficient to cause a fund to be a Commodity Pool. So, a fund that enters into a single interest rate hedge could be treated as a Commodity Pool and the adviser of the fund would have to register as a CPO or CTA, or establish an available exemption.

I would guess that the CFTC will have a few thousand new registrants by the end of the year. Fortunately, there is another exemption that should allow many funds to avoid the full regulatory oversight of the CFTC. More on that later.

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