Securities Mosaic® Blogwatch
August 1, 2015
Fed's Proposed Amendments to Capital Plan & Stress Test Rules
by Dan Ryan
Editor's Note: Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, Mike Alix, Adam Gilbert, and Armen Meyer.

On July 17th, the Federal Reserve Board ("Fed") issued a proposed rule that provides some relief from capital stress testing requirements.[1] Most notably, it eliminates advanced approaches risk-weighted assets and tier 1 common capital ("T1C") calculations from stress testing, and provides a one year delay in the application of the supplementary leverage ratio ("SLR") to stress testing. The proposal also does not incorporate the G-SIB surcharge into stress testing at this stage-see PwC's First take: Key points from the Fed's final G-SIB surcharge rule (July 22, 2015)-and makes clear that no additional changes will be applied to next year's stress testing cycle.

  • Advanced Approaches RWA calculations remain excluded from stress testing. Advanced Approaches RWA ("AA RWA") is very unlikely to ever be included in stress testing projections, as the Fed has delayed their introduction "until further notice." This is great news for those large Bank Holding Companies ("BHCs") that have exited, or are in the process of exiting, parallel run. Including AA RWA calculations into stress testing projections would have been a significant burden for BHCs [2] and a likely problem for the Fed which would have had to develop AA RWA models (on top of its many other stress testing models) with potentially limited supervisory benefit. The continued exclusion of AA RWA from stress testing is the latest step in the Fed's and the Basel Committee's efforts to limit the importance of BHC models to capital adequacy assessments.[3]
  • Bye-bye Basel I—T1C is eliminated from stress testing. BHCs will no longer report T1C or be subject to the T1C 5% minimum threshold as part of stress testing.[4] This change is a reporting and systems benefit to all firms, as they now have the option to turn off their Basel I capital deduction machinery.[5] The rationale for this change is that common equity tier 1 ("CET1") is already more binding (despite its lower 4.5% minimum threshold) or will become more binding as the phase-in of Basel III in the US is completed.[6]
  • The SLR will not be incorporated into stress testing until 2017. Rather than force advanced approaches BHCs to build their stress testing SLR capabilities over the next 6 to 8 months in advance of the new April 5th submission deadline, the Fed has decided to follow the implementation schedule as it existed before last October’s change from January to April submissions (i.e., SLR inclusion still will not start until the 2017 cycle).[7] This was a source of uncertainty, but BHCs can now focus their near-term energies on enhancements and remediating any outstanding issues in preparation for 2016. Advanced approaches BHCs should, however, continue to consider both their internal processes for projecting the SLR and developing capital plan policies that will keep the SLR above the 3% minimum threshold under the Fed’s severely adverse scenario (and must of course continue to meet the tier 1 leverage ratio minimum of 4%).
  • Calendar delays for savings and loan holding companies. The Fed clarified that savings and loan holding companies ("SLHCs") with more than $10 billion in assets will not be subject to firm-run stress testing until the 2017 cycle. This resolves the concern of some SLHCs that Fed stress testing would have begun for them in 2016.
  • The proposal improves the coherence of stress testing rules, in the following ways:

    1. Permits BHCs and SLHCs with $10 to $50 billion in assets, which are only subject to firm-run stress tests under Dodd-Frank, to no longer follow the fixed-dividend assumption embedded in DFAST rules.[8] This will let them create more realistic capital distribution assumptions—e.g., around the "upstreaming" of dividends from their depository institutions under stress—which could boost their minimum post-stress capital ratios.
    2. Allows a BHC to include in its DFAST submission any planned capital issuances associated with planned acquisitions. The current DFAST rules cause an inconsistency between the right- and left-hand sides of the balance sheet because BHCs must assume the assets from an acquisition without assuming the associated capital issuance, while CCAR allows BHCs to assume both. This was a source of frustration for several BHCs in the 2015 cycle because the existing rule forces an artificial wedge between their CCAR and DFAST capital results and prevents their DFAST balance sheet from balancing.
    3. Seeks to make DFAST rules around dividend assumptions more coherent by allowing large BHCs to assume that they pay dividends on common stock issuance related to expensed employee compensation (following a change in October 2014 that allowed BHCs to assume such issuances in the first place). Currently, DFAST requires that dividends be constant over the planning horizon regardless of these new common stock issuances, which reduces a BHC’s dividends per share as the amount of stock increases.
    4. Applies the Volcker Rule’s definition of capital, which deducts aggregated investments in covered funds from tier 1 capital, to stress testing. [9] This does not come as a surprise, as it seemed self-evident and also promotes consistency across regulatory reporting.
  • Endnotes:

    [1] In this First take, “stress testing” refers to both Comprehensive Capital Analysis and Review (“CCAR”) and Dodd-Frank Act Stress Testing ("DFAST").
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    [2] These banks must of course still calculate both standardized RWA and AA RWA to complete their quarterly FR Y-9C filings and to determine their capital adequacy outside of stress testing.
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    [3] This global momentum away from models-based approaches accelerated when Fed Governor Daniel Tarullo indicated in May 2014 that Fed stress tests provide a better risk-sensitive basis for setting minimum capital requirements than do internal ratings-based approaches under the Basel II framework (as well as under Basel III’s AA RWA). See PwC’s Regulatory brief, Operational risk capital: Nowhere to hide (November 2014) (discussed on the Forum here), as an example of the application of this concept.
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    [4] T1C became prominent as the Fed’s preferred capital measure during the Supervisory Capital Assessment Program in 2009 and, by design, was a more binding constraint than Basel I tier 1 capital (which was the standard at the time).
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    [5] Although T1C was not itself a Basel I measure, it required calculating capital deductions on a Basel I basis. BHCs have already stopped reporting those Basel I deductions on their quarterly FR Y-9C filings.
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    [6] See PwC’s Regulatory brief, Basel III capital rules finalized by Federal Reserve (July 2013).
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    [7] Banks were concerned as the one-quarter delay to the stress testing calendar (that takes effect in 2016) pushes the 9-quarter planning horizon for 2016 into the first quarter of 2018—i.e., beyond the January 1, 2018, effective date for applying the SLR. See PwC’s First take, Ten key points from the 2015 CCAR guidance and final revised capital plan rule (October 2014).
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    [8] See PwC’s First take: Ten key points from the Fed’s 2015 DFAST (March 2015) (discussed on the Forum here) which explains that DFAST, unlike CCAR, relies on banks’ most recent dividends to project distributions through the 9-quarter planning horizon.
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    [9] See PwC’s First take: Ten key points from the Fed’s covered funds extension (December 2014).
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    August 2, 2015
    DC Circuit Vacates SEC's Application of Dodd-Frank Provision
    by Darrell Cafasso, Jennifer Sutton and Stephen Meyer
    Editor's Note: Darrell S. Cafasso is a partner in the Litigation Group at Sullivan & Cromwell LLP. This post is based on a Sullivan & Cromwell publication by Mr. Cafasso, Stephen H. Meyer, and Jennifer L. Sutton. The complete publication, including footnotes, is available here.

    On July 14, 2015, the U.S. Court of Appeals for the District of Columbia Circuit (the "DC Circuit") held that the Securities and Exchange Commission (the "SEC" or "Commission") could not employ certain remedial provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank" or the "Act") to retroactively punish an investment adviser for conduct that occurred prior to enactment of the Act. The court's decision not only casts doubt on numerous similar punishments previously levied by the SEC based on pre-enactment misconduct, but could provide a basis for institutions to object to certain sanctions sought by the Consumer Financial Protection Bureau (the "CFPB").

    Background Dodd-Frank Expanded SEC Authority

    The Securities and Exchange Act of 1934 (the "“Exchange Act") makes it unlawful for "any person," in connection with the purchase or sale of securities, "[t]o use or employ...any manipulative or deceptive device or contrivance in contravention of [SEC] rules." The Investment Advisers Act of 1940 (the "Advisers Act") prohibits investment advisers from engaging in similar conduct. Prior to enactment of Dodd-Frank Act, the SEC could bar individuals who violated either the Exchange Act or the Advisers Act from associating with various securities industry participants, including stock brokers, dealers and investment advisers. The Act expanded that power to include municipal advisers and nationally recognized statistical rating organizations ("credit rating agencies").

    Dodd-Frank Conferred And Expanded CFPB Authority

    Title X of Dodd-Frank empowers the CFPB to pursue remedial measures, including cease and desist orders, penalty assessments and injunctive relief, against any covered person or service provider who violates Federal consumer financial law or engages in any unfair, deceptive, or abusive act or practice ("UDAAP"), as well as against any person who knowingly or recklessly provides substantial assistance to a covered person or service provider in violation of the prohibition on UDAAP.

    Dodd-Frank defines Federal consumer financial law broadly to encompass more than a dozen enumerated consumer protection statutes that were extant prior to enactment of the Act, including the Equal Credit Opportunity Act, the Truth in Lending Act ("TILA"), the Fair Debt Collection Practices Act, the Home Mortgage Disclosure Act of 1975, and the Real Estate Settlement Procedures Act ("RESPA").

    Effective July 20, 2011, Dodd-Frank conferred on the CFPB the "powers and duties" vested in the Federal banking agencies (and certain other agencies) related to consumer protection functions, including the authority to issue orders pursuant to Federal consumer financial law. Under various "savings provisions," the Act preserves legal rights relating to any transferred consumer financial protection function that existed on July 20, 2011. Accordingly, the other agencies' authorities to take enforcement actions under the enumerated consumer protection statutes transferred to the CFPB as of that date. The same cannot be said of the prohibition on UDAAP or new enforcement powers conferred on the CFPB by Dodd-Frank, including under RESPA and TILA.

    UDAAP did not exist prior to enactment of Dodd-Frank, and the Act specifically excludes from the definition of Federal consumer financial law the Federal Trade Commission Act's separate but similar prohibition on unfair or deceptive acts and practices. The CFPB's UDAAP authority, unlike its authority under the enumerated consumer protection statutes, did not have a pre-existing statutory basis. Similarly, certain amendments to TILA did not become effective until on or after the enactment of Dodd-Frank. Likewise, the agency charged with enforcing RESPA prior to enactment of Dodd-Frank, the U.S. Department of Housing and Urban Development, had no authority to obtain civil money penalties for violations of RESPA and, therefore, there was no power to assess penalties that transferred to the CFPB. The power to assess penalties for RESPA violations came into effect on the Act's effective date.

    Koch v. SEC

    Factual Background

    Donald L. Koch was the sole investment adviser, owner and principal of Koch Asset Management ("KAM"). His investment strategy was to buy stock from small community banks as long-term investments. KAM used a registered broker-dealer, Huntleigh Securities Corporation ("Huntleigh"), to execute trades and maintain client accounts. According to the SEC, Koch traded stock in three small banks at the end of the trading day so as to artificially inflate the respective stocks’ value—a practice called "marking the close." This conduct occurred on two trading days in 2009.

    In April 2011, the SEC instituted enforcement proceedings, charging both Koch and KAM with market manipulation in violation of the Exchange Act, the Advisers Act and their respective implementing regulations. The SEC sought to bar Koch from associating with various securities industry participants, including the municipal advisors and credit rating agencies that the SEC was empowered to bar him from associating with only by virtue of Dodd-Frank.

    The enforcement proceedings were heard before an administrative law judge ("ALJ"), who found that Koch violated the Exchange Act, the Advisers Act and their implementing regulations, and ordered a bar, but declined to extend that bar to those participants added by the Dodd-Frank Act. Koch and KAM appealed to the Commission. In a decision issued in May 2014, the Commission, like the ALJ, found that Koch and KAM violated the Exchange Act, but relying on its December 2012 decision in In the Matter of John W. Lawton, concluded that although Dodd-Frank was enacted after Koch’s misconduct, "such collateral bars are not impermissibly retroactive because the decision to impose such a bar is based on a present assessment of 'whether such a remedy is necessary or appropriate to protect investors and markets from the risk of future misconduct.'" The Commission concluded that such a remedy was in the public interest and imposed a bar that included associating with municipal advisers and credit rating agencies. Koch and KAM appealed the Commission's decision to the DC Circuit.

    DC Circuit Decision

    On May 14, 2015, a three-judge panel of the DC Circuit affirmed, except with respect to the Commission's expansive bar. The court's analysis focused in relevant part on whether the Commission's decision barring Koch from associating with municipal advisors and rating organizations represented an impermissible retroactive application of Dodd-Frank. According to the DC Circuit, there is a presumption against retroactive legislation that is "deeply rooted in our jurisprudence and embodies a legal doctrine centuries older than our Republic." Although such legislation is not per se unlawful, to lessen its inherent unfairness courts will not enforce a statute retroactively unless Congress has made clear its intention that the legislation apply retroactively.

    The court then turned to the relevant provision of Dodd-Frank. That provision, according to the court, contains no mention of retroactive application; the closest the Act comes to such a mention is its "generic statement that '[e]xcept as otherwise specifically provided in this Act,' the Act's provisions 'shall take effect 1 day after the date of enactment'" - language that says nothing about retroactivity. Since the Act does not expressly authorize retroactive application, the court then considered whether applying the provision to Koch "would impair rights [he] possessed when he acted, increase [his] liability for past conduct, or impose new duties with respect to transactions already completed." According to the court, at the time of Koch's misconduct, the SEC could not bar an individual from associating with municipal advisors or credit rating agencies and the Commission's decision to nevertheless apply such a penalty to Koch attached a new disability to conduct completed well before enactment of the Act, enhanced penalties for a violation of the securities laws, and attached new legal consequences to Koch's conduct. As such, the Commission's application to Koch of Dodd-Frank’s bar on associating with municipal advisors and rating organizations was impermissibly retroactive. Accordingly, the court vacated that portion of the Commission's order.


    Since enactment of Dodd-Frank, the SEC has relied on Lawton in dozens of proceedings barring individuals from associating with municipal advisers and credit rating agencies based on conduct that occurred, at least in part, prior to enactment of Dodd-Frank. The DC Circuit's decision casts doubt on, and raises a number of questions about, those punishments, including whether they are enforceable. It remains to be seen whether the SEC will seek a rehearing or Supreme Court review.

    Much like the SEC bar at issue in Koch, a number of the CFPB's enforcement actions address UDAAP violations premised on conduct that, at least in part, predates Dodd-Frank. The same can be said of CFPB penalty assessments for RESPA violations. In limited instances, the CFPB seems to have acknowledged possible constraints on its authority to sanction conduct that predates Dodd-Frank's enactment. Indeed, in the context of civil money penalties for RESPA violations, the CFPB apparently recognizes that it cannot assess penalties for conduct predating Dodd-Frank because the authority to assess such penalties was first conferred in Dodd-Frank. Such recognition by the CFPB, however, is not universal, and the DC Circuit's decision in Koch could provide a basis for institutions to object to certain sanctions sought by the CFPB.

    August 3, 2015
    Occupational Licensing
    by Gordon Smith

    The White House recently released an excellent report on occupational licensing. The purported goal of occupational licensing is to improve the quality of services, but the costs of licenses on workers and consumers can be substantial. As noted in the Executive Summary, "There is evidence that licensing requirements raise the price of goods and services, restrict employment opportunities, and make it more difficult for workers to take their skills across State lines." The report recommends alternative forms of occupational regulation, notably certification, to strike a better balance of costs and benefits. Amen!

    The new report follows License to Work, a report by the Institute for Justice on the effects of occupational licensing. Most of these licenses (including law) look like protectionism to me, and I am not sure this new report will significantly change the landscape. The report offers a list of "best practices," but in a world of regulatory capture, it would be nice to see governors and legislatures pressing the issue more forcefully.

    August 3, 2015
    Dirks, Newman, Tippees And The Government's Cert Petition
    by Tom Gorman

    The Government filed its long awaited Petition for a Writ of Certiorari with the Supreme Court in the Newman insider trading case. The Petition presents three key issues which were generally presaged in the request for rehearing en banc: 1) The Second Circuit's decision is contrary to Dirks, adding an impermissible gloss to the personal benefit test; 2) Newman conflicts with decisions in other circuits; and 3) policy reasons counsel that the Court reverse the decision and remand it to the lower courts for reconsideration. Petition for a Wirt of Certiorari filed in US. v. Newman (S.Ct. Filed August 31, 2015).

    The Petition

    The sole question presented for resolution by the High Court "is whether the court of appeals erroneously departed from this Court's decision in Dirks by holding that liability under a gifting theory requires "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," according to the Petition.

    Following a lengthy recitation of the facts, which centered on trading in the shares of Dell and NVIDIA by down the chain tippees, the Petition argues that Newman added an impermissible "gloss" to Dirks. Trading on the basis of inside information by a corporate insider "qualifies as a deceptive device, within the meaning of Section 10(b), because it violates the relationship of trust and confidence that exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position..." the Petition states (citations and internal quotations omitted). A corporate insider must either publically disclose the information or abstain from trading.

    Dirks focused on the scope of "tipper-tippee" insider trading liability. While the securities laws do not require a parity of information, they do bar some tipping. The key is whether the insider will personally benefit from the disclosure, the Government told the Court while quoting Dirks: "The Court identified two different sets of cases in which a factfinder may infer from 'objective facts and circumstances' the existence of such a benefit... . First, 'there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient.'" That could be a pecuniary gain or reputational benefit that will translate into future earnings. "Second, '[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend,' as [t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient... .'" the Petition notes, quoting Dirks.

    Newman is "irreconcilable" with the test enunciated by Dirks. The Second Circuit altered the Dirks test by holding that while a personal benefit may be inferred from the "a personal relationship between the tipper and tippee, where the tippee's trades 'resemble trading by the insider himself followed by a gift of the profits to the recipient...we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at lest a potential gain of a pecuniary or similarly valuable nature,'" the Petition argues while quoting Newman. It is this new formulation of the Dirks test which presents the difficulty. Dirks, the Petition argues, allowed a inference of a personal benefit when either the insider expects something in return or there is a gift. While Newman acknowledged both, the Government argues that it eliminated the second by tying the "gift" theory to receiving something – essentially a quid pro quo. Newman also limited this category by requiring that the relationship be "meaningfully close," another restriction which is contrary to Dirks.

    The Second Circuit's decision also conflicts with that of other circuits. The primary case cited is U.S. v Salman, 2015 WL 4068903 (9th Cir. July 6, 2015). There, in an opinion by Judge Rakoff sitting by designation (here), the court rejected the notion that "unless the government proves that the insider receives something consequential for disclosing confidential information..." the proof is not sufficient. While Defendant Salman relied on Newman in arguing that evidence of friendship or familial relation alone is not sufficient, and that there must be a tangible benefit between the tipper and tippee, the Ninth Circuit rejected the proposition, creating a conflict.

    Similarly, the Seventh Circuit in SEC v. Maio, 51 F. 3d 623 (7th Cir 1995) rejected that notion. There the court found that an insider's disclosure of inside information was an improper gift. In reaching its conclusion the court rejected a defense contention that the disclosure was not improper because the insider did not receive any direct or indirect personal benefit as a result of the tip.

    Finally, the Petition argued that the "erroneous redefinition of personal benefit" will harm the securities markets. By eliminating the use of inside information for personal advantage Dirks sought to ensure the fair and honest workings of the securities markets. Newman undercuts this goal. The decision will also negatively affect the activities of analysts. This is because if "certain analysts sidestep [the hard job of analyzing a company] by siphoning secret information from insiders...then other analysts will be discouraged... ." Accordingly, Newman should be reversed and remanded the government told the High Court.


    The views of the Government, presented in the Petition, contrast sharply with those of the Newman court on the record as well as the actual holding and meaning of Dirks. The Petition contains a lengthy recitation of the record which contrasts sharply on key points with Newman. For example, in discussing the questions of what Messrs. Newman and Chiasson knew about the source of the information for Dell the Petition states: "Respondents had ample reason to conclude that the Dell information came from insiders who disclosed it for personal reasons rather than to advance the interest of Dell or its shareholders." The Petition contains a similar statement regarding their knowledge of NVIDIA and, at one point in note 6, claims that transcript cites by the Second Circuit on the question of the defendants’ knowledge do not support the court's statements.

    The facts recited by the Second Circuit diverge sharply on key points from those presented in the Petition. For example, after concluding that the instructions were erroneous, the Court examined the evidence in detail, adopting the view most favorable to the government. Yet the Court found that "[t]he circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips." The Court amplified this conclusion: "Even assuming that the scant evidence described above was sufficient to permit the inferences of a personal benefit, which we conclude it was not, the Government presented absolutely no testimony or any other evidence that Newman and Chiasson knew that they were trading on information obtained from insiders, or that those insiders received any benefit in exchange for such disclosures... ."

    Petition's discussion of Dirks and its characterization of Newman's holding also differs markedly from that of the Second Circuit. The Petition repeatedly contends that the Circuit Court put an "impermissible" gloss on the Dirks personal benefit test by requiring evidence of actual benefit and a meaningful relationship. That view is perhaps highlighted in the discussion of Maio where the Petition notes that: "And the inference that Maio drew – that a personal benefit for the insider can often be inferred from the absence of a 'legitimate reason' for a disclosure...would be unavailable under the Second Circuit's analysis, which imposes additional artificial barriers to proving a personal benefit."

    The Newman Court, in contrast, presented its holding as fitting squarely within Dirks: "While we have not yet been presented with the question of whether the tippee's knowledge of a tipper's breach requires knowledge of the tipper's personal benefit, the answer follows naturally from Dirks. Dirks counsels us that the exchange of confidential information for personal benefit is not separate from an insider's fiduciary breach...the insider's disclosure of confidential information, standing alone, is not a breach. Thus, without establishing that the tippee knows of the personal benefit...the Government cannot meet its burden... ." The court then went on to note that the concept of a personal benefit is "broadly defined" and includes a pecuniary gain, a reputational benefit that could translate into future earnings and the "benefit one would obtain from simply making a gift of confidential information to a trading relative or friend."

    While the Petition's views of the record and Dirks contrasts sharply with that of the Newman court, it overlooks one key point Dirks and Newman share: Dirks sought to create a limiting principle on the theory of tippee liability for the protection of analysts. Newman sought to create a limiting principle on tippee liability: "We note that the Government has not cited, nor have we found, a single case in which tippees as remote as Newman and Chiasson have been held criminally liable for insider trading."

    August 3, 2015
    Akin Gump discusses Rebutting the Fraud-on-the-Market Presumption in Securities Class Actions: Halliburton Class Certified Over Price Impact Objections
    by Scott Barnard

    On July 25, 2015, Judge Barbara Lynn of the Northern District of Texas issued a formative opinion in the class actions securities arena. The case, The Erica P. John Fund, Inc., et al. v. Halliburton Co., et al., No. 3:02-CV-1152-M, is viewed as a bellwether among securities class actions due to its treatment of novel issues regarding, among other things, a defendant's ability to disprove reliance-i.e., a causal link between alleged misrepresentations and an eventual drop in stock prices upon correction-for purposes of class certification.

    Rather than requiring plaintiffs to prove reliance for each individual shareholder, securities class action cases have long permitted a more efficient approach to establish the necessary causal link. This approach, set forth in Basic v. Levinson, 485 U.S. 224 (1988), invokes a rebuttable presumption in favor of reliance if certain elements are met. Recently, in connection with the Halliburton case, the Supreme Court held this presumption can be rebutted if a defendant shows an alleged misrepresentation did not affect the market price of a security. If the presumption is rebutted, the class cannot be certified.

    In the July 25 opinion, the Halliburton court addressed one of the key questions left open after the Supreme Court's ruling: What level of proof is necessary to rebut this reliance presumption? After considering plaintiffs' motion for class certification for claims arising from six corrective disclosures of Halliburton, the court granted class certification with respect to one of the alleged disclosures, and denied certification with respect to the remaining five.

    In arriving at this decision, the court first concluded that Halliburton, as defendant, bore the burden of both production and persuasion. This meant Halliburton was required to "persuade the Court that its expert's event studies are more probative of price impact than [plaintiffs’] expert's event studies." The court also declined to consider Halliburton's argument that the alleged disclosures were not "corrective," because such an argument went to the underlying merits of the claim and was more properly considered at a later stage of the litigation.

    Regarding evidence of price impact (i.e., impact of alleged disclosures on the market price of Halliburton shares), the court conducted a careful analysis of the evidence and expert testimony presented by both sides. One noteworthy aspect of the court's analysis is its endorsement of a "multiple comparison adjustment" advocated by defendants' expert, despite acknowledging that such adjustments are rarely utilized in event studies for securities litigation. The court indicated its decision to apply these adjustments, which help mitigate the risk of relying on "statistical flukes," was due to the substantial number of comparisons being tested for statistical significance in plaintiffs' expert's analysis. The court's decision was also at least partially influenced by allegations from Halliburton that plaintiffs reverse engineered their claims by initially running a statistical comparison to uncover thirty-five dates found to have a statistically significant price movement and, from these dates, selecting events to allege misstatement based on their coinciding with news releases.

    Other determinations by the court included utilizing an additional "Analyst Index" advocated by plaintiffs to measure the statistical significance of stock price movement. The court also determined it would consider the effects of events on the market price of stock with reference to a one-day, rather than a two-day, window following the announcement or event in question.

    Utilizing these methods, the court determined only one of the six alleged disclosures had an impact on the market price of Halliburton stock. The disclosure in question was Halliburton's announcement on December 7, 2001, that it had lost a substantial verdict as the defendant in an asbestos litigation case. Plaintiffs argued this disclosure "corrected" Halliburton's previous disclosures that it was not exposed to significant liability in asbestos cases and was efficiently handling such litigation. Despite Halliburton's argument that this drop was caused by events other than the disclosure plaintiffs alleged, the court found that Halliburton failed to meet "its burden of showing lack of a price impact" with respect to the December 7 announcement. This finding led the court to grant plaintiffs' motion to certify with respect to only the December 7 disclosure.

    The most recent Halliburton class certification decision is not altogether unsurprising: it likely reflects the decision of a judge whose class certification decisions were twice reversed by the U.S. Supreme Court. The decision is a win for plaintiffs, who finally obtained class certification after a seven-year battle. Defendants, however, are well positioned going forward since they successfully defeated five of the six corrective disclosures and are now left with a single corrective disclosure to attack on summary judgment. Judge Lynn's analysis will likely be a roadmap for both securities class action plaintiffs and defendants in evaluating class certification in the future.

    The full and original memorandum was published by Akin Gump on July 28, 2015 and is available here.

    August 3, 2015
    In re Merrill Lynch, Pierce, Fenner & Smith: Failure to Supervise Allegations Result in $2.5M Fine
    by Mark Proust

    In In re Merrill Lynch, Pierce, Fenner, & Smith, Mass. Sec. Div., Docket No. E-2014-0002 (March 23, 2015), the Massachusetts Securities Division ("Division") entered into a Consent Order ("Order") with Merrill Lynch arising out of an investigation into its compliance policies and procedures required under the Investment Advisers Act of 1940 ("the Act"). On March 22, 2015, Merrill Lynch submitted an Offer of Settlement ("Offer") to the Division for the purpose of disposing the allegations set forth in the Offer.

    According to the consent order (in which the facts are neither admitted nor denied), Merrill Lynch in 2010 created an Optimal Practice Model Team ("OPM Team") that focused on developing a framework to assist financial advisors in delivering more consistent customer service. This team would, among other things, create internal presentations to train financial advisors. Merrill Lynch's policies and procedures required its compliance department to provide prior approval of internal-use materials. As a result, the presentations were to be reviewed by a separate compliance team and then approved by a registered principle.

    The OPM Team developed an OPM Tools Presentation ("OPM Presentation") focusing on suitability obligations and fiduciary standards for financial advisors. In late 2012, the OPM Team presented the OPM Presentation two times in Boston without any Merrill Lynch compliance approval.

    According to Merrill Lynch's records, the OPM Team did not submit any version of the OPM Presentation for review until February 4, 2013. The Internal-Use Compliance team at Merrill Lynch did not approve any version of the presentation until shortly thereafter, nearly a month after the first Boston OPM Presentation. Upon review, it was determined that a required disclosure slide was not included in the Boston OPM Presentation.

    The Order indicated that the version of the OPM Presentation submitted to the Compliance team for review included different content than that what had been used during the Boston OPM Presentation. First, the version submitted for review contained the title "Optimal Practice Model: Tools," which was much broader than the version used in Boston (which was titled "OPM Tools Overview, Optimal Book Management Tool and Business Calculator."). Second, the version submitted for review did not include all of the slides presented during the Boston OPM Presentation, slides that were not part of the Boston presentation, and slides with content different from the Boston Forum.

    The Division alleged that Merrill Lynch, by failing to comply with its internal-use policies and procedures, failed to observe equitable principles of trade in the conduct of its business, resulting in a violation of Section 204(a)(2)(B) of the Act.

    The Division also alleged that based on the reasons described, Merrill Lynch failed to reasonably supervise its OPM Team in connection with the Boston Forum, constituting a violation of Mass. Gen. Laws ch. 110A §204(a)(2)(J).

    As a result, Merrill Lynch agreed to the following undertakings as part of the Order. First, Merrill Lynch agreed to permanently cease and desist from conduct in violation of the Act and Regulations in the Commonwealth of Massachusetts. Second, Merrill Lynch agreed to pay a $2,500,000 administrative fine.

    Also, Merrill Lynch's Chief Compliance Officer was required to provide a report to the Division within 120 days of the Order. This report must (1) certify a review of policies and procedures has been conducted, and (2) identify any changes or enhancements to Merrill Lynch Wealth Management practices, policies, and procedures that have been, or will be made. 

    The primary materials for this Consent Order can be found at the DU Corporate Governance Website

    August 3, 2015
    Chief Compliance Officers: SEC Enforcement Debate
    by Randi Morrison

    SEC Chair White sought to quash increasing concerns – and temper a recent debate between Commissioners – about compliance officer liability in these recent remarks, wherein she indicated that the SEC did not intend to use its enforcement program to target compliance professionals, but rather only took enforcement action against them when "their actions or inactions cross a clear line that deserve sanction." Her remarks presumably were responsive to last month's debate between Commissioners Gallagher and Aguilar about whether the SEC is appropriately supporting (or inappropriately targeting) compliance officers on the heels of two recent enforcement actions against investment advisor compliance chiefs.

    By way of background, in April, the SEC charged BlackRock's then-CCO with violations of the 1940 Investment Company and Investment Advisers Acts for failing to report a conflict of interest-related compliance violation to the funds' boards of directors and failing to adopt and implement certain compliance policies and procedures. In June, the SEC charged the CCO of SFX Financial Advisory Management Enterprises with violating the Advisers Act for causing the firm's compliance failures by negligently failing to conduct certain reviews required by the firm's compliance policies and perform an annual compliance review, and making a misstatement in SFX's Form ADV. Commissioner Gallagher dissented in both cases.

    In his recent remarks, Gallagher expressed concern that the enforcement actions put the onus on the CCOs to implement their firms' compliance policies and procedures, and held them strictly accountable for failure to adhere to what is more appropriately a firm (rather than CCO) obligation. That being the case, these actions could disincentive CCOs (or prospective CCOs), thus ultimately harming the compliance function, which Gallagher described as "not only the first line of defense" but – for the vast majority of advisers – "the only line of defense." Commissioner Aguilar disagreed, citing the SEC’s "relatively few" CCO-targeted enforcement actions over the past five years, which he claims have been limited to a handful of cases wherein the CCOs demonstrated specific types of egregious misconduct.

    Although I'm not taking sides, I believe the potential for missignaling the compliance officer's role and potential liability both within and outside of the financial services arena is real. As noted in one of my earlier blogs, based on a recent survey of more than 600 CCOs and other financial services compliance practitioners, most CCOs are worried about the threat of increasing personal liability for corporate misconduct. And a compliance lawyer reportedly advised that compliance officers outside that sector "should be paying close attention" (and I believe they are) "to what is happening in these cases, as other agencies could follow suit in their rulings and enforcement activities."

    While I think Chair White's remarks were necessary in view of the public nature of this debate, I tend to doubt that they will reverse the trend toward increasing concerns among compliance professionals about potential personal liability for non-rogue behavior. Although when she talks, I believe that people generally listen (very carefully), I think all bets are off when it comes to concerns about personal liability – where actions tend to speak much louder than words.

    See also these InvestmentNews and MarketWatch articles, this SEC Actions blog, and our oodles of compliance resources in our "Compliance Programs" Practice Area.

    Survey: Compliance Program Effectiveness Favors Dual GC/CCO Role

    LRN's recently released 2015 Ethics & Compliance Effectiveness Report, based on a survey and analysis of over 280 companies, reveals some particularly important findings about compliance program effectiveness. Most notably, among programs reporting directly to the CEO, those led by dual GC/Chief Compliance Officers are more effective than those led by standalone CCOs.

    The study explains this surprising finding this way: "What we see suggests that the greater effectiveness of the GC/CECOs’ programs reflects the nature of the GCs' interactions and other roles within their organizations...[G]enerally speaking, the dedicated CECO today has neither the corporate stature nor the internal relationships associated with the GC. In this light, building stature and cultivating key relationships may be seen as one of the dedicated CECO's most important tasks, and the key to higher impact programs."

    Additional noteworthy findings include:

    – Programs where the CCO reports to the CEO or the board are noticeably more effective than are those reporting to the GC.
    – It is increasingly common for the CCO to report directly to the CEO and – to a lesser, but noteworthy, extent (14%) – to the board or a board committee (typically the audit committee). And while a direct reporting line to the GC remains the most common structure (41%), it is no longer true of a majority of programs.
    – Top-performing programs conduct assessments more frequently and use more metrics than those ranked in the bottom fifth.
    – Companies whose codes of conduct emphasize corporate values, and whose employees are likely to look to the code when faced with a decision or dilemma, tend to be associated with higher program effectiveness.
    – Program effectiveness ranks highly in those companies where members of the C-Suite often address ethics and compliance issues in staff meetings, operational reviews and similar settings.

    See also this WSJ article, Jeff Kaplan's blog, and heaps of additional surveys and other helpful resources in our "Compliance Programs" Practice Area.

    In a related and interesting development on compliance program effectiveness, Reuters reports that the DOJ is hiring a compliance expert to assist in evaluating whether companies' compliance programs are "robust...or mere window dressing" for charging decision-making purposes.

    More on "The Mentor Blog"

    We continue to post new items daily on our blog – "The Mentor Blog" – for members. Members can sign up to get that blog pushed out to them via email whenever there is a new entry by simply inputting their email address on the left side of that blog. Here are some of the latest entries:

    – Many Companies Still Using Old COSO Internal Controls Framework
    – An Alarming Liability Award Against Non-Profit Organization’s D&Os
    – A Bad Mix: Small Cap Exchanges & Larger Tick Sizes
    – Germany Sets Gender Quota in Boardrooms
    – ISS Study: Board Practices & Refreshment Studies

    Our August Eminders is Posted!

    We have posted the August issue of our complimentary monthly email newsletter. Sign up today to receive it by simply inputting your email address!

    – by Randi Val Morrison

    August 3, 2015
    The Delaware Delusion
    by Robert Anderson IV

    Delaware dominates the incorporation market, with approximately 60% of publicly traded companies in the United States incorporated there, including 63% of the Fortune 500 companies. Over 90% of companies that incorporate outside of their principal state of operations make Delaware their state of incorporation. The unresolved question is why corporate lawyers and their clients are drawn to Delaware when most companies have little more than a P.O. Box based in the state.

    In The Delaware Delusion, we set out to empirically assess whether there is an economic basis for Delaware's appeal in the market for company incorporations. We set out to test empirically the two leading schools of thought which hold that Delaware's appeal lies either in its superior legal regime that enhances shareholder value better than other states or in Delaware's protectionist appeal in adding "managerial value" by entrenching corporate managers at shareholders’ expense. We apply an innovative technique to show empirically that both the "race to the top" and "race to the bottom" schools of thought are based on false assumptions because Delaware law neither adds nor subtracts value compared to other states-the applicable law simply does not seem to matter to capital markets.

    We test these hypotheses using a novel "merger reincorporation" approach, which leverages the fact that each inter-state merger is effectively a reincorporation of the target company business into the state of incorporation of the acquiring company. This fact creates the opportunity to gauge the market’s assessment of the value of Delaware law relative to that of other states by comparing the pre- and post-acquisition value of acquirers and targets in a cross-section of intra- and inter-state mergers.

    We analyzed an eleven-year data set of mergers (from 2001 to 2011) and found that financial markets place no economically consequential value on Delaware law relative to that of other states, which contradicts both of the leading schools of thought. This result suggests that lawyers are engaging in default decision-making based on Delaware's past preeminence, rather than actively weighing the value-added Delaware and other states offer to their clients. Lawyers appear to turn to Delaware because it is the law they are most familiar with; they assume markets value Delaware law; and they regard Delaware as a safe default that does not trigger pushback from corporate managers. These reasons make it understandable why risk-averse lawyers steer their clients to Delaware. But the problem is that decisions to incorporate in Delaware appear based on faith and path dependency, rather than on any empirical basis. This constitutes a disservice to corporate clients as well as to the market as a whole.

    To break up herding effects among lawyers and spur lawyers to assess this opportunity to add value to transactions, we argue for the consideration of "shareholder say" on the state of incorporation. Empowering shareholders to have a say on the state of incorporation could be accomplished easily through private ordering, a statutory change, a Securities and Exchange Commission regulatory mandate for public companies, or through stock-exchange listing rules. Empowering shareholders to vote on retaining or changing the state of incorporation would subject this decision to greater scrutiny and give shareholders the opportunity to address this principal-agent failure. This strategy would incentivize proxy advisory firms to analyze the merits of states of incorporation and to recommend to shareholders to retain or change the state of incorporation. This approach would also turn on the market test of institutional investors' weighing the benefits and costs of investing their energies in changing the state of incorporation.

    The need to justify incorporation decisions to shareholders would force lawyers to actively assess the value-added by Delaware law and the law of other states. Creating incentives for lawyers to acquire legal fluency in multiple corporate governance jurisdictions, rather than to rely solely on their knowledge of the law of Delaware, would make it more likely that corporate lawyers will spearhead change in a proactive way to extract value for companies. This heightened scrutiny will create market pressures for Delaware and other states to compete to assess and enhance the quality of their corporate governance law. While Delaware's hegemony would not change overnight, over time this approach would dampen Delaware-centric herding and foster constructive state competition.

    The preceding post comes to us from Robert Anderson IV, Associate Professor of Law at Pepperdine University School of Law, and Jeffrey Manns, Associate Professor of Law at George Washington University Law School. It is based on their article, which is entitled "The Delaware Delusion" and available here.

    View today's posts

    8/3/2015 posts

    HLS Forum on Corporate Governance and Financial Regulation: Fed's Proposed Amendments to Capital Plan & Stress Test Rules
    HLS Forum on Corporate Governance and Financial Regulation: DC Circuit Vacates SEC's Application of Dodd-Frank Provision
    Conglomerate: Occupational Licensing
    SEC Actions Blog: Dirks, Newman, Tippees And The Government's Cert Petition
    CLS Blue Sky Blog: Akin Gump discusses Rebutting the Fraud-on-the-Market Presumption in Securities Class Actions: Halliburton Class Certified Over Price Impact Objections
    Race to the Bottom: In re Merrill Lynch, Pierce, Fenner & Smith: Failure to Supervise Allegations Result in $2.5M Fine Blog: Chief Compliance Officers: SEC Enforcement Debate
    CLS Blue Sky Blog: The Delaware Delusion

    Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.