Securities Mosaic® Blogwatch
October 16, 2017
Bridging the Week: October 9 - 13 and October 16, 2017 (Spoofing; Supervision; De Minimis Threshold; Automated Trading System Gone Bad)
by Gary DeWaal

The Commodity Futures Trading Commission brought and settled an enforcement action against a Dubai-based brokerage company and trading firm for the purported spoofing-type trading by one of its employees. The Commodity Exchange, Inc. also brought an action against the same entity for spoofing, and additionally charged the firm with failure to supervise. Separately, J. Christopher Giancarlo, CFTC Chairman, told a Congressional committee that he would be recommending a one year delay in the implementation date of any new swap dealer de minimis threshold amount in order to determine who should be registered as a swap dealer; this amount currently is scheduled to decrease from US $8 billion to US $3 billion at the end of 2018.  He said he would request the delay, among other reasons, out of deference to two new CFTC commissioners, in order to assess relevant data and "get the right result;" however, the two new commissioners did not seem to be in favor of a further delay. As a result, the following matters are covered in this week’s edition of Bridging the Week:

  • Proprietary Trading Firm Charged by CFTC With Spoofing Based Solely on the Alleged Wrongful Trading of One Employee (includes Legal Weeds and Compliance Weeds);
  • CFTC Chairman Proposes to Again Postpone Final Action on Swap De Minimis Threshold; Suggests CFTC and SEC Already Working to Address Some Overlapping Rules (includes My View);
  • ICE Futures U.S. Sanctions Proprietary Trading Firm for Failure to Supervise for Malfunctioning Automated Trading System (includes Compliance Weeds); and more.


  • Proprietary Trading Firm Charged by CFTC With Spoofing Based Solely on the Alleged Wrongful Trading of One Employee: The Commodity Futures Trading Commission and the Commodity Exchange, Inc. brought and resolved charges against Arab Global Commodities DMCC for alleged spoofing-type trading by one of the firm’s unnamed traders in 2016.

According to the CFTC, from at least March through August 2016, a trader for AGC – a Dubai-based broker and trading firm – on multiple occasions placed orders involving COMEX-traded copper futures that involved the same pattern: placement of a small lot order on one side of the market typically one or two levels away from best bid or offer; placement of a series of larger orders on the other side of the market with an alleged intent to cancel; and cancellation of the larger orders following execution of the smaller order in whole or part. On occasion, said the CFTC, the trader used another AGC trader’s account to disguise his activity.

The CFTC claimed that AGC did not have an anti-spoofing policy; did not train its traders or managers regarding US prohibitions against spoofing; did not monitor for spoofing; and did not detect its trader’s purported spoofing. Moreover, charged the CFTC, even after AGC’s futures commission merchant alerted one branch of the firm to its suspicions regarding the trader’s conduct, there was no internal elevation of the issue to more senior managers within AGC. Only after CME Group indicated it was investigating the trader did AGC review the individual’s conduct and “promptly” terminate him, said the Commission.

To resolve this matter, AGC agreed to pay to the CFTC a fine of US $300,000. The CFTC acknowledged the firm’s assistance; early stage resolution; and remedial measures to deter similar conduct in the future in accepting AGC’s offer of settlement.

In addition to charging AGC with a violation of its prohibition against disruptive practices, COMEX also charged the firm with a violation of its duty to supervise. COMEX said that AGC’s failure to provide its traders with “sufficient training regarding Exchange rules,” as well as to monitor its employees’ trading for potential violations, was the basis for this charge. AGC agreed to pay an additional US $70,000 to resolve the COMEX disciplinary action.

The relevant individual was not charged by either the CFTC or COMEX. AGC is formally organized as a free zone company registered with the Dubai Multi Commodities Center and regulated by the Emirates Securities and Commodities Authority.

Legal Weeds: The obligation of persons to supervise their employees under CFTC rules only applies to registrants (click here to access CFTC Rule 166.3). The obligation to supervise employees and agents under COMEX rules applies to any person who trades on the exchange – whether they are members or not. AGC was a not a COMEX member. (click here to access New York Mercantile Exchange Rule 432.W).

Compliance Weeds: Although these two actions against AGC break no new ground regarding the CFTC’s or CME Group’s view regarding spoofing, they do provide clear articulation by the regulators of at least some elements of what they expect as the components of effective compliance program regarding disruptive trading: (1) a written policy prohibiting spoofing; (2) training; (3) monitoring tools and monitoring; and (4) follow-up on red-flags emanating from such monitoring or otherwise. Moreover, potential violations are expected to be elevated within a company and appropriate action taken.

Last year, CME Group exchanges brought and settled disciplinary actions against Geneva Trading USA, LLC and two of its employees – Krzysztof Marzec and Robert Kimmons – for engaging in alleged spoofing-type activities on the New York Mercantile Exchange, Inc. and the Commodity Exchange, Inc. from March 2013 through July 2013. To resolve the matter, Geneva Trading agreed to disgorge aggregated COMEX and NYMEX trading profits of US $91,241. For the actions of its two traders, Geneva Trading was charged by the CME Group exchanges with violating just and equitable principles of trades and related violations, but solely on a strict liability basis. The firm was not charged with failure to supervise, and it was not assessed a fine.  The CME Group exchanges implied that no fine was assessed because the firm had and enforced robust policies and procedures regarding the purported wrongful conduct of its employees. (Click here for background in the article “CME Group Settles With Trading Firm for Spoofing-Type Offenses, Holding It Strictly Liable for Acts of Agents; Orders Disgorgement of Profits” in the October 9, 2016 edition of Bridging the Week.)

  • CFTC Chairman Proposes to Again Postpone Final Action on Swap De Minimis Threshold; Suggests CFTC and SEC Already Working to Address Some Overlapping Rules: Chairman of the Commodity Futures Trading Commission, J. Christopher Giancarlo, said he would soon call for another one year delay in the automatic reduction of the current interim swap dealer de minimis threshold amount scheduled to occur at the end of 2018.

Mr. Giancarlo called for this extension during an appearance before the House of Representatives’ Committee on Agriculture on October 11, saying it was appropriate because of the recent turnover of commissioners and staff at the CFTC, and the Commission’s current vacancy of two commissioners. Mr. Giancarlo said he wanted all commissioners to have the benefit of any new data in order to assess what the correct amount of the threshold should be. The objective, Mr. Giancarlo said, “is to get the right result, not a rushed result.”

Under CFTC regulation, a person is not to be considered a swap dealer unless its swap dealing activities for the prior 12-month period exceeds a gross notional threshold amount of US $3 billion after a phase-in requirement of US $8 billion (click here to access CFTC Rule 1.3(ggg)(4)). The phase-in period was originally scheduled to expire on December 31, 2017, but was extended by the CFTC to the end of 2018, following issuance of an August 2016 final report by the Commission’s Division of Swap Dealer and Intermediary Oversight. (Click here for background in the article “Just in Time for Football Season, CFTC Chairman Decides to Punt Swap De Minimis Threshold for One Year” in the September 18, 2016 edition of Bridging the Week.)

Virtually contemporaneously with Mr. Giancarlo’s testimony, the two new CFTC commissioners issued press releases suggesting that no delay in finalizing the de minimis threshold amount should occur. According to one of the new commissioners, Brian Quintenz, “[w]hile we should always consider new data in the ongoing evaluation of public policy, it is well past time to address this issue head-on, finalize a rational and effective threshold, and provide the market with clarity.” Rostin Behnam, the other new commissioner, said “[a]dditional delays of the swap dealer de minimis threshold will only serve to prolong uncertainty for market participants and create market risk.”

Separately, in his testimony, Mr. Giancarlo reiterated his strong commitment to ensuring that “America’s derivatives markets operate free from fraud, manipulation, and other trading abuses,” and discussed the Division of Enforcement’s new self-reporting program to help the Commission “identify the individuals… most culpable for any wrongdoing.” (Click here for background on this reporting program in the article “New Math: Come Forward + Come Clean + Remediate = Substantial Settlement Benefits Says CFTC Enforcement Chief” in the October 1, 2017 edition of Bridging the Week.)

Additionally, Mr. Giancarlo provided an overview of the Commission’s LabCFTC and Project KISS initiatives, as well as his promotion of efforts to support cybersecurity at the CFTC and at derivatives markets. He also pointed to the need to amend current swaps trading rules, to enhance swaps data reporting, and to work with international regulators to promote cooperation and coordination. He cautioned European regulators not to unilaterally amend agreements regarding the oversight of systematically important cross-border clearinghouses in anticipation of Brexit as potentially contemplated. “If the EU must reconsider its approach to cross‑border supervision of systemically important CCPs, then we cannot have piecemeal and contradictory rule making,” said Mr. Giancarlo.

Mr. Giancarlo also indicated that he and Jay Clayton, Chairman of the Securities and Exchange Commission,  had been regularly speaking since they both became chairman of their respective agencies, in order to help harmonize and simplify overlapping rules. According to Mr. Giancarlo, “[w]e hope to soon announce some interagency understandings that will result in real regulatory efficiencies,” perhaps as early as year-end.

My View: It is not clear that further delay in assessing an appropriate de minimis threshold amount will likely change the outcome of any CFTC vote. Although, in his testimony before the House Agriculture Committee, Mr. Giancarlo promised that he would make a recommendation in early 2018 on this matter, it seems a foregone conclusion – and the CFTC should save precious resources by formally proposing now to maintain the de minimis exception at US $8 billion, consistent with findings in DSIO’s 2016 final report.

  • ICE Futures U.S. Sanctions Proprietary Trading Firm for Failure to Supervise for Malfunctioning Automated Trading System:  IMC Chicago, LLC agreed to pay a fine of US $30,000 to resolve a disciplinary action brought by ICE Futures U.S.  The exchange claimed that on “numerous occasions” between January 2016 and March 2017, the firm’s automated trading system successively entered orders in Cotton No. 2, Russell Complex and MSCI Complex futures, and then in response to such orders, immediately deleted them and entered new orders because of a “feedback loop.” IFUS said that, under the duty of supervision (click here to access IFUS Rule 4.01), IMC had an obligation to monitor such transactions, which IFUS implied the firm did not. In agreeing to the sanction, IMC neither admitted nor denied the rule violation.

Separately, Marex Financial, Limited, was charged with market disruption and failure to supervise in connection with the trading of an employee, Jake Wiltshire. Mr. Wiltshire was separately charged with market disruption.

According to IFUS, from May through October 2016, Mr. Wiltshire, trading for Marex and himself pursuant to a profit‑sharing arrangement, manually entered large orders on one side of the cocoa futures market to induce executions of smaller quantity orders on the other side. After the smaller orders were executed, Mr. Wiltshire cancelled the larger orders. Marex settled the IFUS disciplinary action by agreeing to pay a fine of US $25,000 and disgorging profits of more than US $9,000. Mr. Wiltshire settled his disciplinary action by agreeing to a 360‑day IFUS trading suspension.

In accepting Marex’s settlement, IFUS noted that after it alerted Marex regarding the employee’s conduct, the firm immediately terminated the employee and disciplined his supervisor. IFUS noted, however, that a monitoring tool used by Marex was not activated for cocoa markets during the relevant time.

Additionally, Peace River Citrus Products and R. William Becker agreed to pay a fine of US $7,500 to resolve charges by IFUS that they executed wash sales purportedly to move positions between firm accounts. Similarly, Chenwei Zhu, was ordered by a business conduct committee of the Chicago Mercantile Exchange to pay a fine of US $25,000, disgorge profits of over US $19,000, and serve a 35-business day suspension on all CME Group exchanges, related to trading to transfer equity between accounts. The BCC held that such trading was pre-arranged in violation of a CME rule prohibiting such conduct (click here to access CME Group Rule 432.G).

Compliance Weeds: Under the relevant IFUS rule (Rule 4.01), the duty of a person to “diligently supervise” its employees and agents applies to “every person” whether a member or not. Moreover, “agent” expressly includes “any Exchange-related activities associated with automated trading systems that generate, submit and/or cancel messages without human intervention.”

The parallel CME Group rule is not as explicit on its face. However, in a Market Regulation Advisory Notice entitled Supervisory Obligations for Employees, CME Group notes that, under its parallel rule, agents include not only natural persons, but “any automated trading systems … operated by any party.” (click here to access MRAN RA1517-5; click here to access CME Group Rule 432.W),

More briefly:

  • European Commission and CFTC Reach Accord on Comparability of Margin Rules for Uncleared Swaps and a Common Approach to Trading Venues: The Commodity Futures Trading Commission and the European Commission agreed that each other’s rules relating to margin requirement for uncleared swaps are comparable. As a result, US-registered swap dealers and major swap participants that have no prudential regulator – so called “covered swap entities” – and that are subject to both CFTC and European Union margin rules regarding uncleared swaps may rely on substituted compliance for all aspects of their US margin requirements. Additionally, the EC and CFTC agreed on a common approach to permit authorized trading venues in each jurisdiction to serve as qualified venues for transactions subject to a mandatory trading obligation in the other jurisdiction. The regulators committed to take steps to promptly implement the common approach.
  • SEC Inspector General Says Ensuring Effective Cybersecurity Program Remains a Management Challenge for Agency: The Inspector General of the Securities and Exchange Commission issued a report on October 5 saying that ensuring an effective cybersecurity program remained one of the Commission’s management and performance challenges for the just-started 2018 fiscal year. The report noted that the Office of Inspector General is still reviewing actions taken by the SEC to close out 18 information security recommendations made by OIG as part of a 2016 audit, and that the SEC had submitted to the General Accounting Office evidence of corrective actions taken in response to recent information security recommendations by GAO.
  • Model State Virtual Currency Law Finalized Finally: The model law approved in July for the regulation of virtual currency businesses was finalized and formally issued last week by the National Conference of Commissioners on Uniform State Laws for potential adoption by each of state of the United States. The model law – known as the Uniform Regulation of Virtual Currency Business Act – proposes the regulation of all persons engaged in a “virtual currency business activity” absent an exemption. Among other things, such activity includes exchanging, transferring, or storing virtual currency with or on behalf of residents. Potential licensees must complete an application containing a host of specific information required about the licensee itself and each control person, as well as evidence of a minimum net worth, reserves that a state may require, and other documents. Proposed licensees and registrants must prepare and, once granted their status, maintain policies and procedures addressing information and operational security; business continuity; disaster recovery; anti-fraud; anti-money laundering; preventing funding of terrorist activity; and adherence to the VCBA and other relevant state and federal laws. The final rule publication includes a prefatory note that provides background and color on the model law. (Click here for further details in the article “Model State Law Regarding Virtual Currency Businesses Virtually Finalized” in the August 20, 2017 edition of Bridging the Week.)
  • CME Group Summarizes Summary Fines Process for Reporting Errors: CME Group issued a revised Market Regulation Advisory Notice that sets forth infractions subject to summary fines (i.e., fines that are not less than US $1,000 or exceed US $5,000 for individuals, or US $10,000 for firms or facilities for each offense). These infractions include large trader, open interest and long positions eligible for delivery reporting; block trade and exchange of futures for related position reporting; user IDs and automated/manual indicators on CME Globex trades (Tag 50s, Tag 1028s); and customer type indicator codes and registrar reports. Market Regulation noted that it still may issue warning letters for a first offense although no person may receive more than one warning letter for the same offense during a rolling 12-month period.
  • SEC Discloses Proposed Simplified Disclosure Obligations for Public Companies, Investment Companies and Investment Advisers: The Securities and Exchange Commission proposed amendments to existing rules to modernize and simplify disclosure obligations for public companies, investment advisers and investment companies as required under the Fixing America’s Surface Transportation Act. The SEC’s recommended amendments would, among other things, authorize registrants to forgo including discussion of the oldest information in their Management Discussion and Analysis to the extent the material has previously been reported and is no longer relevant. Also, the proposed changes would authorize registrants to exclude certain confidential information from material contract exhibits if not material and would cause competitive harm if publicized. The SEC will accept public feedback through 90 days after publication of the proposed amendments in the Federal Register.
  • CFTC Agrees to Transfer Enforcement Action Against Retail Metals Dealer to Venue Closer to Defendants: The Commodity Futures Trading Commission consented to the transfer of venue to a federal court closer to defendants of its lawsuit against Monex Deposit Company and two affiliated companies (collectively, “Monex”) and Louis Cabrini and Michael Cabrini, the firms’ principals. The CFTC sued the defendants last month in a federal court in Illinois claiming they engaged in fraud and illegal precious metal transactions with retail clients. Earlier this month, the defendants made a motion to transfer the litigation to a federal court in California, closer to Monex’s location. (Click here for background in the article “Retail Metals Dealer Sued by CFTC for Not Fulfilling Delivery Obligations to Financed Customers Says Actual Delivery Was Made” in October 8, 2017 edition of Bridging the Week.)
October 16, 2017
How State Competition for Corporate Charters Has Changed the Delaware Effect
by Anne Anderson, Jill Brown and Parveen Gupta

An important feature of U.S. corporate law is regulatory competition among various states. Unlike firms in other industrialized countries, American corporations can choose to incorporate in any state, even if they do not do business there. A large body of academic literature has studied the merits and weaknesses of this approach to regulating corporations, focusing primarily on the value of state corporate laws. This debate has focused on two competing hypotheses. In the first, interstate competition in corporate laws promotes a "race to the top" by motivating states to enact laws that are optimal for shareholders and that minimize managerial moral hazard and agency costs. In the second hypothesis, interstate competition in corporate law results in a "race to the bottom" because states, motivated by the desire to maximize corporate tax revenue and other benefits, enact laws that tend to favor managerial discretion and entrenchment (more than do the laws that protect the investors), because managers ultimately decide where to incorporate.

Delaware is in the crossfire of this debate because it has virtually won the competition, with a large number of U.S. publicly traded companies continuing to choose Delaware as their state of incorporation or reincorporation. Delaware’s unique Court of Chancery, a 110-year-old specialty court that only hears cases involving business entities, has a reputation for striking a fair balance in resolving complex disputes between shareholders and boards – particularly with its "business judgment rule," which presumes that directors of a corporation act with adequate information and in good faith and in the best interests of the company. However, there are more than two sides to the debate. A third view advocates federal intervention, attributing Delaware’s dominance to weak competition (or even lack of competition) from other states. This view argues that Delaware holds a monopoly that the federal government should break for the benefit of the shareholders.

We explore these arguments in the context of U.S. state chartering competition to examine whether Delaware incorporation continues to provide additional value for shareholders as popularly believed, and as earlier (pre-Sarbanes Oxley) studies have contended.. Though its registration fees and taxes are relatively high, Delaware has many advantages over other states. A big one is its Court of Chancery, which is known for expertise in issues involving mergers and acquisitions, management and its duties to shareholders, and other areas of corporate law. Backed by comprehensive statutes, the court is considered adept at protecting the rights of boards of directors and shareholders. Additionally, incorporating in Delaware brings a degree of prestige, given that over 60 percent of Fortune 500 firms are incorporated in Delaware, as are more than half of all companies whose securities trade on the NYSE, NASDAQ, and other exchanges.

However, over the last few years, several states have begun to compete. For example, Nevada and Wyoming have sought to attract more companies with management-friendly corporate laws and low fees and taxes. Their state websites make comparisons with other states based on factors like: 1 ) whether stockholders must reveal their identities to the state, 2 ) whether companies must issue an annual report before the anniversary of their incorporation date, 3) whether they must disclose the identity of their officers or members, 4) whether unlimited stock is allowed, of any par value, 5) whether nominee shareholders are allowed, and 6) whether a statute requires that the company indemnify officers, directors, employees, and agents. These hot-button governance issues are often marketed as indicators of whether a state favors stockholders or management, complementing academic debates about legal variations between Delaware and other states that affect the extent of agency problems.

Prior studies have explored some of these arguments, but we contend that it is time to re-visit the Delaware Effect for several reasons. First, since the abundance of Delaware studies in the early and late 1990’s, there have been many changes in the corporate laws of various states including Delaware as well as at the federal level. For example, in 2006, Section 141(d) of the Delaware General Corporation Law ("DGCL") was rewritten to allow directors to confer greater or lesser voting powers on one or more directors (whether or not such directors are separately elected by the holders of any class or series of stock) so long as a corporation’s certificate of incorporation allowed the directors to do so. In 2015, a new DGCL Section 102(f) and an amended section 109(b) prohibited fee-shifting provisions, in a corporation’s certificate of incorporation or its bylaws, that would make shareholders liable for all attorneys’ fees and expenses in connection with an internal corporate claim. In 2016, DGCL Section 251(h) was broadened to allow the consummation of certain acquisitions (employing a two-step structure), under specific conditions, without shareholder approval. At the federal level, in 2002, the Sarbanes-Oxley Act created some of the most significant corporate governance reforms since the 1930s. They included requirements for greater board independence, increased audit committee responsibilities, codes of ethics covering company e financial officers, CEO certification of financial statements, an independent audit of a company’s system of internal control over financial reporting, and more instances in which in-house counsel would have to report material violations to the SEC.

Second, in the wake of the global financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted. Its requirements included shareholder say-on-pay votes on executive compensation, more independence for compensation committee directors, increased oversight of executive compensation consultants, enhanced executive compensation disclosure (i.e., pay ratio rule), claw backs of incentive compensation in certain circumstances, access to company proxy ballots for certain shareholders under certain conditions, and disclosure of the justifications for having one person serves as both board chair and the CEO..

Third, technology and globalization of the financial markets have made it unnecessary for a corporation to list its securities on a domestic exchange. Many corporations list on foreign exchanges for reasons that include being able to differentiate themselves in the capital markets by "renting the corporate laws" of the foreign jurisdiction. In essence, these changes are facilitating a market for corporate charters.

Finally, there has been a recent increase in the popularity of corporate inversions, whereby U.S. publicly traded companies incorporate outside of the United States to save taxes. Foreign-chartered corporations pay U.S. tax only on their domestic profits while U.S.-chartered corporations also pay taxes on their overseas profits (with credit for taxes paid overseas). This practice has implications for corporate governance, where strong U.S. state corporate laws and governance are bundled with taxation policies. In sum, the contested nature of state chartering competition suggests that there is much work to be done in understanding how and why U.S. firms select where to incorporate, and the value that decision provides shareholders.

With data that extends over a 16-year period and a sample of all firms that file Form 10-K with the SEC, including foreign firms, we find that Delaware incorporated firms appear to have less debt and a higher value, as measure by Tobin’s Q, than firms incorporated elsewhere, suggesting that they are managed to create high shareholder returns and thus support race-to-the-top arguments. However, when taking into account fixed effects, and expanding the sample to include companies that are publicly traded in the U.S. but incorporated overseas, the effect of Delaware incorporation is negative on shareholder wealth. Foreign incorporated firms provide significantly more value for shareholders over longer periods than do Delaware corporations. We suggest that this may be attributable to increasing shareholder lawsuits and associated legal costs in Delaware, as well as higher taxes and reporting requirements that lower firm value. Our results also suggest that the popularity of Delaware incorporation can be attributed in part to the state’s management-friendly laws and courts.

Incorporating in Delaware may afford directors the autonomy and discretion needed to balance demands from multiple stakeholders, supported by the state’s unique Chancery Court system. Our findings also suggest that it is time to move beyond "race to the bottom" and "race to the top arguments" that may be negligible in the wake of new regulation and opportunities for businesses to differentiate themselves through corporate charters.

This post comes to us from Professor Anne Anderson at Lehigh University, Professor Jill Brown at Bentley University, and Professor Parveen Gupta at Lehigh University. It is based on their recent article, "Jurisdictional Competition for Corporate Charters and Firm Value: A Reexamination of the Delaware Effect," available here.

October 16, 2017
K&L Gates Discusses Tax-Free Cryptocurrency Transactions and Reporting Obligations
by Elizabeth Crouse, Mary Burke Baker, Rob Crea, Claire White and Rachel Trickett

As cryptocurrencies such as Bitcoin and Ethereum become more prevalent in investment circles
and acceptable for commercial transactions, the United States Internal Revenue Service ("IRS")
has said little other than to label "virtual currencies" as property and state that transactions
involving virtual currencies may be subject to taxation under generally applicable law. 1
However, on September 7, the United States Congressional Blockchain Caucus 2 (the "Caucus")
introduced the Cryptocurrency Tax Fairness Act (the "Act"), which would exempt certain
cryptocurrency transactions and create a cryptocurrency-specific information reporting

The Cryptocurrency Tax Fairness Act

Under the Act, gross income would not include "gain from the sale or exchange of virtual
currency for other than cash or cash equivalents." However, the amount excluded "with respect
to a sale or exchange shall not exceed $600." In other words, transactions that result in gain of
less than $600 that use virtual currency to acquire anything other than cash or a cash equivalent
would not be subject to income tax. This deceptively simple language presents several questions.

First, it is not clear what is meant by "cash equivalent" in this context. Importantly, would other
virtual currencies be considered cash equivalents? In Notice 2014-21 (the "Notice"), the IRS
declared that it will treat "virtual currency" as property. The Act would not change that
classification and refers to "virtual currency" (as opposed to any of the other terms used to
describe digital or cryptocurrencies), which may indicate that the Caucus agrees with the IRS
definition. However, the Notice could be interpreted to indicate that the IRS views virtual
currency as a cash equivalent, at least in some contexts. In part, the Notice states that "in some
environments, [virtual currency] operates like ‘real’ currency — i.e., the coin and paper money of
the United States or of any other country that is designated as legal tender, circulates, and is
customarily used and accepted as a medium of exchange in the country of issuance." However,
the term "cash equivalent" is rarely used in the Code or Treasury Regulations, leaving an open
question as to what exactly the Caucus means by the term.

In addition, the Act appears to provide a per transaction exclusion. This is helpful in the case of
routine transactions that taxpayers typically do not think of as taxable: for example, using
Bitcoin to pay for a Microsoft Windows subscription. This tactic has been used in a few very
limited contexts, typically through IRS guidance. However, a broadly applicable exception such
as that in the Act is unusual. Also, exclusions from gross income typically apply to an annual
aggregate amount. Accordingly, should this exception be read as an indication that the Caucus
wants to encourage the use of cryptocurrencies in routine transactions?

Finally, in what may be a response to the IRS’s ongoing litigation to obtain records of
cryptocurrency exchanges executed using the Coinbase platform 3 or simply a strategic effort to
increase voluntary compliance by taxpayers using cryptocurrencies, the Act also requires that the
U.S. Department of the Treasury issue guidelines for reporting virtual currency transactions that
give rise to gain or loss. Although the Notice stated that cryptocurrency transactions are
generally subject to reporting under existing provisions of the Code, existing reporting
mechanisms would not account for many types of cryptocurrency transactions. Given that the
Act specifically directs Treasury to devise information reporting, the inclusion of this directive
indicates that the Caucus intends that reporting be broadened. Nonetheless, the Act provides little
direction regarding the details of the information reporting requirements.

For example, by not specifying that reporting applies to only cryptocurrency transactions that do
not give rise to excluded gain, the Act indicates that all cryptocurrency transactions will be
reportable. Reporting all transactions would be consistent with the general goal of increasing
voluntary compliance (which generally increases with information reporting). However, must the
report be made per transaction? Or annually? The latter would increase information reporting
compliance and be consistent with most existing provisions in the Code, but the Act is silent.
Another concern is that the information reporting requirement in the Act is not part of the
provision that would be added to the Code. Therefore, it may be necessary to create a new statute
under which the IRS would issue reporting guidelines if they are to vary from existing statutory
authority. Also, which agency of Treasury will issue the information reporting regulations and
collect the reports? While the IRS is an obvious choice, responsibility could be delegated by the
Secretary of the Treasury to a different branch of the Treasury, for example, the Financial
Crimes Enforcement Network, which already collects information about cryptocurrency
transactions as well as information about U.S. persons’ foreign financial accounts (which could
be viewed as bearing some resemblance to cryptocurrency "wallets").

Considering the growing international importance of cryptocurrency transactions and the volume
of reporting that may be required, it is important that Congress consider taxpayer burdens while
the Act is considered — particularly if an additional provision under the Code is necessary —
and that the officials at Treasury begin considering how reporting could be made efficiently
enough to increase taxpayer compliance while providing the government with adequate

What Now?

The Act shines a spotlight on many unanswered and controversial questions concerning the
taxation and reporting of virtual currency transactions. If enacted, implementing the new law
would require the IRS (or perhaps another Treasury agency) to develop an efficient and robust
reporting and compliance regime that provides the tools Treasury needs to ensure tax compliance
while also encouraging voluntary compliance by taxpayers. Given the White House’s instruction
to overhaul regulatory guidelines, Treasury and IRS resource constraints, and the complexity of
the issues surrounding virtual currencies, issuing workable guidelines in a timely manner would
be a challenge. In the meantime, the Notice leaves open several areas that the Caucus or the IRS
could consider for future action, for example:

  • whether or when the IRS will view virtual currencies as a specific type of property, e.g.,
    securities or commodities, which may particularly impact U.S. federal income taxation of
    many partnerships and non-U.S. persons; 4
  • when the IRS will treat a person as engaged in a trade or business in respect of virtual
    currencies, e.g., through mining or trading activities;
  • whether a mining pool, that is, a group of people collectively mining for virtual
    currencies, constitutes a publicly traded partnership; and
  • whether U.S. law should conform to that of a growing number of countries that treat
    cryptocurrencies as currency for purposes of at least some types of taxation.

This post comes to us from K&L Gates LLP. It is based on the firm’s alert, "Tax-Free Cryptocurrency Transactions Could Come with Reporting Obligations," dated September 15, 2017, and available here.

1 For example, under current guidance, if a consumer uses Bitcoin to pay for a Microsoft Windows subscription, the
consumer would generally recognize taxable gain on that transaction if the value of the Bitcoin used increased since
the consumer purchased or mined that Bitcoin.
2 Formed in February of this year by Congressmen Jared Polis (D-CO 2nd District) and David Schweikert (R-AZ 6th
District), the Caucus is a bipartisan effort focusing on the use of blockchain technology to improve government and
healthcare services and manage identity protection. In addition, in June of 2017, Congressmen Polis and Schweikert
wrote to the Secretary of the Treasury to request further guidance in regard to the taxation of cryptocurrency
3 N. Dist. Ca., Docket 3:16cv06658.
4 The views of other regulators may influence the IRS’ view on this point. For example, the CFTC and SEC have
provided some indication of how they view certain types of cryptocurrencies. A CFTC order regarding Bitcoin is In
re Coinflip, Inc., d/b/a/ Derivabit, et al., CFTC Docket No. 15-29 (Sept. 17, 2015),
pdf. The SEC recently released an investigative report ruling concerning treatment of DAO tokens, which may be
found at Our alert concerning the SEC report may be
found at

October 16, 2017
New Special Study of the Securities Markets: Institutional Intermediaries
by Allen Ferrell, John Morley
Editor's Note: Allen Ferrell is Harvey Greenfield Professor of Securities Law at Harvard Law School and John D. Morley is Professor of Law at Yale Law School. This post is based on their recent paper.

This paper, written for the Conference on the New Special Study of Securities Markets at Columbia Law School, identifies and reviews the key regulatory challenges posed by institutional intermediaries in America’s capital markets. We cover investment funds, credit-rating agencies and broker-dealers. We review existing research, identify new areas of research and suggest possibilities for legal reform.

We begin with investment funds, focusing primarily on publicly registered investment companies, such as open-end mutual funds. The first task of the regulation of these funds is to define what exactly an investment fund is. And on this score the existing regulation is doing poorly. The industry’s principal regulatory statute, the Investment Company Act of 1940, defines an “investment company” (the statute’s name for what is commonly known as an “investment fund”) as a company that holds a lot of securities, rather than a company that holds operating assets like land and intellectual property. This definition is impractical and often has the unintended effect of treating operating companies—including Microsoft and Yahoo!—as though they were the legal equivalent of mutual funds. We suggest that rather than focusing on securities ownership, the definition of an investment company should focus on organizational structure. The truly distinctive feature of an investment fund, we argue, is a fund’s unusual tendency to maintain a separate existence and a separate set of owners from the management company that operates it.

We also survey the regulation of mutual fund fees and find several potential areas for improvement. Existing fee disclosure formats have never been scientifically tested and too little is known about the characteristics of the highest-fee funds in the industry. Additionally, the system of fiduciary liability for excessive fees created by Section 36(b) of the ICA is hobbled by mechanical problems, with the consequence that excessive fee litigation tends mainly to attack the largest advisers, rather than the most expensive advisers.

The regulation of capital structure in registered investment companies is similarly badly designed. Though we could imagine many reasons for wanting to regulate the capital structure of mutual funds, the rules on capital structure that appear in the ICA are not actually consistent with any of these reasons. If, for example, the reason we limit borrowing by mutual funds is to reduce risk to the financial system, then why do we permit unlimited borrowing by hedge funds? The ICA exempts hedge funds from the ICA on the theory that hedge fund investors are large and sophisticated enough to protect themselves, but this theory makes no sense if the goal is to protect the financial system, rather than to protect fund investors.

Shareholder voting and governance also require reform. The ICA’s voting scheme—which makes shareholder voting mandatory on certain matters—was constructed at a time when the investment fund industry was still dominated by closed-end funds. The ICA scheme thus ignores the distinct needs of open-end funds, which have long since eclipsed closed-end funds in size and significance. Voting is much less useful in open-end funds than in closed-end funds, because the legal feature that defines an open-end fund—redemption rights—completely eliminate a shareholder’s incentive to vote. Voting requirements should thus be eliminated for open-end funds, even if they are retained for closed-end funds.

We also suggest a need to revisit the distinction between private and public investment funds. The ICA distinguishes public funds (such as mutual funds), from private funds (such as private equity and hedge funds), on the basis of the number, size and sophistication of their investors. In drawing the distinction this way, the ICA followed a pattern previously established by the Securities Act of 1933 and Securities Exchange Act of 1934, which regulate ordinary operating companies. This pattern may not be appropriate to investment funds, however, because the governance of investment funds is radically different from ordinary companies, with the effect that investor size and number are much less important in investment funds than ordinary companies.

The second part of our paper surveys credit rating agencies and broker-dealers. To understand the regulation of credit rating agencies, we survey the economics literature for answers to a number of questions, including how much the market actually relies on credit ratings; how flawed the ratings are; and whether regulation can prevent inaccurate ratings. We argue that social scientific evidence suggests that credit ratings are reasonably reliable for most corporate and municipal debt securities, so that most of the problems in credit ratings concern complex structured finance products. Indeed, much of this research has been focused on the performance of ratings for complex structured finance products during the financial crisis of 2007-2008. It is thus these products that should attract the greatest concern. Special concern should also attach to ratings given to securities issued during good economic times, to securities that are highly rated, and to securities issued by larger issuers. We explore a number of specific possibilities for reform.

We conclude by examining the regulation of broker-dealers. We examine the controversy over whether broker dealers should be fiduciaries and call for research to identify more precisely the differences between a fiduciary standard and the older suitability standard. We also examine the controversy over commission-based compensation for brokers and suggest that the evidence is complex and conflicting. We conclude by examining several areas of possible reform, including enhanced disclosures, improved enforcements, and greater uniformity between broker-dealers and investment advisers.

The complete paper is available here.

October 16, 2017
Proxy Season Legal Update
by Laura Richman, Michael Hermsen, Mayer Brown
Editor's Note: Laura D. Richman is counsel and Michael L. Hermsen is a partner at Mayer Brown LLP. This post is based on a Mayer Brown publication.

Advance planning is a key component of a successful proxy and annual reporting season. While work on proxy statements, annual reports and annual meetings typically kicks into high gear in the winter, autumn is the ideal time to begin preparations. This is especially important for the 2018 proxy season because this will be the first time that pay ratio disclosure will generally be required in proxy statements. This post provides an overview of key issues that companies should consider as they get ready for the upcoming 2018 proxy and annual reporting season.

Pay Ratio Disclosure

Most public companies will be required, for the first time, to include pay ratio disclosure in their 2018 proxy statements.

Briefly, pay ratio disclosure will require public companies to disclose:

  • The median of the annual total compensation of all employees other than the chief executive officer;
  • The annual total compensation of the chief executive officer; and
  • The ratio of these amounts.

The pay ratio rule of the US Securities and Exchange Commission (SEC) contains many details regarding how this calculation should be made and disclosed. For more information about this rule and its practical implications, see our Legal Update “Understanding the SEC’s Pay Ratio Disclosure Rule and its Implications,” dated August 20, 2015, our Legal Update “SEC Provides Pay Ratio Disclosure Guidance,” dated October 25, 2016, our Legal Update “Get Ready for Pay Ratio,” dated September 6, 2017, and our Legal Update “Pay Ratio Rule: SEC Provides Additional Interpretive Guidance,” dated September 28, 2017.

During the first half of 2017, many people were discussing whether the SEC’s pay ratio disclosure rule would be repealed or have its implementation delayed. In early February 2017, then-acting SEC Chairman Michael S. Piwowar issued a statement seeking public input on any unexpected challenges companies were facing as they were preparing to comply with the rule and whether relief was needed. In addition, he directed the SEC staff to reconsider the pay ratio rule based on comments submitted and to determine whether additional guidance or relief may be appropriate.

In the spring of 2017, the House of Representatives approved the “Financial CHOICE Act,” complex legislation that, among other things, would repeal the Dodd-Frank pay ratio requirement. Although it has been submitted to the Senate for its consideration, at this point it is not certain when the House-approved bill will be debated by the full Senate. Given legislative priorities, it does not seem likely that action by the Senate on the Financial CHOICE Act, including its pay ratio repeal provision, will be considered before the 2018 proxy season. And, if the Financial CHOICE Act is considered by the Senate, there is no assurance that all of its current provisions, including the pay ratio repeal provision, will remain in what ultimately is adopted.

On September 21, 2017, the SEC and the staff of its Division of Corporation Finance (Staff) issued guidance on the pay ratio rule, which in addition to providing interpretations, effectively signaled that the SEC would not be delaying the implementation of this new disclosure requirement. The SEC issued an interpretive release providing guidance on using reasonable estimates, assumptions, methodologies, statistical samplings and internal records, as well as tests for determining independent contractor status, to assist companies in their efforts to comply with the new pay ratio disclosure requirements. At the same time, the Staff provided additional guidance, including examples, to assist companies in determining how to use statistical sampling and other reasonable methods to identify the median employee’s compensation. Finally, the Staff revised one previously issued compliance and disclosure interpretation (CDI), added a new CDI and withdrew one previously issued CDI relating to guidance on the methodology for applying compensation measures and determining the employee population to identify the median employee.

Pay ratio preparations can be time consuming. In addition to working through the complexities of the actual calculation and the required disclosure, companies should allow time to potentially modify the overall compensation discussion and analysis to put the ratio in context as well as consider what, if any, implications this additional disclosure will have on the annual say-on-pay advisory vote and other compensation matters the issuer may be presenting to shareholders for consideration (e.g., revised equity plans or awards). For all the reasons discussed above, companies should now be actively preparing for pay ratio disclosure.

Say-on-Pay and Other Compensation Matters

Say-on-Pay. After being on proxy ballots for seven years, the advisory vote on the compensation of the named executive officers has become a regular feature of annual shareholder meetings, often involving year-round planning. This agenda item has shaped a new look for proxy statements as companies increasingly incorporate graphic design elements to explain their executive compensation programs. Say-on-pay has also driven shareholder engagement on executive compensation. Many companies have made changes to their compensation programs in response to their say-on-pay vote and related conversations with their key investors.

Although say-on-pay is an advisory vote, there are real consequences to a failed say-on-pay vote. Generally, if investors vote against executive compensation in large numbers, they will expect the company to make changes to its compensation program. If the company does not, its investors may cast a binding vote against compensation committee members or other directors in addition to voting against named executive officer compensation when the next say-on-pay vote is conducted. As a result, companies are very focused on receiving not only majority approval of their executive compensation, but achieving high levels of support.

For the most part, companies were successful with their say-on-pay votes in 2017. Executive compensation consultant Semler Brossy reports that through September 11, 2017, only 1.4 percent of Russell 2000 companies had failing say-on-pay votes during the 2017 proxy season. The average support for say-on-pay during this period was 91.7 percent, representing the highest average since the commencement of mandatory say-on-pay voting. The percentage of companies receiving support above 90 percent of the votes cast was 78 percent in 2017, which was slightly higher than in any other year.

Proxy advisory firms such as Institutional Shareholder Services (ISS) have become very influential in the say-on-pay process. As a result, if a company receives a negative proxy voting recommendation from a proxy advisory firm, it often (but not always) prepares additional material in support of its executive compensation program, which it must file with the SEC as definitive additional soliciting materials not later than the date first distributed or used to solicit shareholders. According to Semler Brossy, when ISS recommends an “Against” vote for a say-on-pay proposal, shareholder support for the proposal is 26 percent lower than at companies that receive a “For” recommendation. Although an “Against” recommendation does not always result in a failed say-on-pay vote, the drop in shareholder support may influence the ongoing level and tone of shareholder engagement on compensation matters and director nominees in the coming year.

Say-When-on-Pay. Many companies were required to conduct an advisory vote in 2017 to see if their shareholders preferred that the say-on-pay vote be conducted every year, every two years or every three years. An annual say-on-pay vote was supported as the desired frequency in the vast majority of these say-when-on-pay votes.

Equity Plan Voting. Semler Brossy reports that the failure rate for equity plan proposals during 2017 was 0.7 percent. While only a small number of companies had equity plans that failed to achieve the support of the majority of the votes cast, this percentage represents the highest failure rate for equity plans since mandatory say-on-pay was instituted in 2011. Although nearly all equity plan proposals passed in 2017, the failure rate serves as a reminder that investors may use the tool of a binding vote on an equity plan or equity plan amendment if they are not happy with how a company makes equity awards or on other matters.

Compensation Litigation. Because executive compensation sometimes has been the subject of litigation, compensation decisions should be made, and compensation disclosures should be prepared, with care, especially for companies that anticipate resistance to their compensation program. Compensation committee members should be able to demonstrate that they exercised due care in applying their business judgment to determine executive compensation by reviewing adequate information, asking questions and understanding the pros and cons of various alternatives, any or all of which can involve the assistance of company personnel or outside experts, as appropriate.

Director compensation can potentially raise additional litigation concerns because of self-dealing issues, requiring the application of an evaluation against a heightened “entire fairness” standard rather than the business judgment rule. To minimize this risk, companies and boards should carefully review existing director compensation arrangements (perhaps on a separate cycle from executive compensation) and consider adding shareholder approved annual limits or annual formula-based awards to current (or new) plans. Alternatively, companies and boards may choose to develop a factual record of these arrangements with a view to withstanding an “entire fairness” scrutiny, including by reviewing director compensation paid at a carefully selected group of comparable companies, possibly with the assistance of an outside expert.

Shareholder Proposals

General. There have been some efforts to change the shareholder proposal process. For example, the Financial CHOICE Act, as approved by the House of Representatives, would increase the share ownership and resubmission thresholds and would prohibit shareholders from authorizing other persons to submit a proposal on their behalf. It is not yet known when, if at all, the House-approved bill will be considered by the full Senate. In addition, if the Senate does act, there is no assurance that they will not make changes to the Financial CHOICE Act as adopted by the House of Representatives. Therefore, at the present time, the current requirements of Rule 14a-8 continue to govern the shareholder proposal process.

Companies must be ready to react promptly when they receive any shareholder proposal and to evaluate their most appropriate course of action in response to the particular proposal. Under Rule 14a-8, if there are specified procedural deficiencies with a proposal (such as failing to provide the requisite proof of ownership) or if the proposal falls within one or more of the 13 substantive grounds that are set forth in the rule, the company can seek a no-action letter from the Staff concurring with the exclusion of the shareholder proposal from its proxy statement. Whether a company is seeking exclusion based on procedural or substantive grounds, it will need to comply with deadlines set forth in the rule. Alternatively, or in addition to submitting a no-action request, companies often attempt to negotiate with the proponent to see if an agreement can be reached, resulting in the withdrawal of the proposal.

Shareholder proposals do not only represent investor relations issues. They may give rise to publicity if they become the subject of a no-action request or if they are included in a company’s proxy statement. Accordingly, when shareholder proposals are received, companies should assemble teams comprised of members of management, investor relations and public and media relations, as well as the law department. The Board of Directors or appropriate committees also should be apprised of the proposals promptly.

Proxy Access. An increasing number of companies in the United States have adopted proxy access bylaws over the past three years, largely as a result of shareholder proposals requesting companies to conduct shareholder votes on proxy access, an initiative that gained traction when the New York City Comptroller and the New York City Pension Funds launched the Board Accountability Project in 2014 to push for proxy access. Many companies that received proxy access shareholder proposals for the 2017 proxy season adopted proxy access bylaw provisions before their 2017 annual meetings, with the proposals being withdrawn or otherwise omitted from the proxy statements. When shareholder proposals requesting the adoption of proxy access were voted upon in 2017, they often received majority support of the votes cast. Currently, more than 60 percent of the companies in Standards & Poor’s 500 Index have adopted proxy access bylaw or charter provisions and that percentage may increase by the end of 2017.

As the number of companies with proxy access has grown, a consensus has developed for what constitutes “market” practice for proxy access. Most of the US proxy access provisions have a 3 percent-for-3-year-ownership threshold, allow aggregation by groups of up to 20 holders to reach the designated threshold, limit the number of proxy access nominees to 20 percent of the board, but often with a minimum of two nominees, and specify a minimum level of support for re-nominations in future years. There are quite a few other details on which proxy access provisions vary, although there have been a sufficient number of US proxy access provisions adopted that there is general agreement as to which variations are viewed as customary.

Some shareholders submitted proposals for the 2017 proxy season to companies that had already adopted proxy access, seeking to amend a number of specific proxy access features to broaden the right, such as by raising the maximum number of directors eligible for election through proxy access from 20 percent to 25 percent, removing a limit on the number of shareholders whose holdings could be aggregated to meet the proxy access ownership threshold or eliminating refinements such as ownership definitions or nominee qualifications. In response to no-action requests to exclude such “fix it” proposals, the Staff generally permitted the proposals to be excluded as substantially implemented if a company had already adopted a proxy access bylaw that conformed to market practice of a 3 percent for 3-year ownership threshold, a 20 holder limit on aggregation and a 20 percent cap on proxy access directors. However, in July 2017, the Staff refused to permit the exclusion of a proxy access amendment proposal as substantially implemented where the proposal addressed only a single feature: the elimination of a cap on the number of shareholders that can aggregate their shareholdings for the purpose of satisfying the ownership requirement necessary to make a proxy access nomination. Nevertheless, during the 2017 proxy season, proposals to amend proxy access provisions containing what is now considered the standard features so far have failed to receive majority support.

Companies that do not have proxy access provisions in place should be familiarizing themselves with the latest developments in this area. It would be useful for them to examine market provisions so that they are ready to react quickly if they receive a proxy access shareholder proposal for the 2018 proxy season. Companies in this position may want to develop a draft proxy access provision for internal discussion purposes to better understand the mechanics for such a nomination procedure and how it would interact with existing advance notice bylaws and other governing documents and law.

Although many US companies have adopted proxy access in the last few years, to date proxy access has not been successfully used to actually nominate directors. An asset management company and affiliated companies filed a Schedule 14N in November 2016 to disclose a proxy access nomination. However, the company determined that the nomination did not satisfy the “passive investment” requirement of its bylaws, the nominee withdrew and the investor group reported in an amended Schedule 13D that they were not pursuing proxy access.

Other Shareholder Proposals. While proxy access proposals have garnered attention over the past few years, there are also other areas that have been a focus of shareholder proposals, especially in the environmental, social and governance areas. According to the database maintained by Proxy Monitor, 50 environmental shareholder proposals were voted on at Fortune 250 companies in 2017 through September 15, 2017. More than half of these proposals received support in excess of one quarter of the votes cast and three proposals requesting reports on the impact of policies to limit global warming received majority support. The number of shareholder proposals relating to board diversity increased in 2017, although many were withdrawn after companies agreed to address board diversity through recruitment. Lobbying and political spending continued to be popular topics for shareholder proposals in 2017, often receiving in excess of one quarter of the votes cast. Requests that the chairman of the board be an independent director remained a relatively common topic for shareholder proposals in 2017, but none received majority shareholder support. Executive compensation shareholder proposals, on the other hand, have been declining.

The shareholder proposal topics described above are likely to be common subjects for shareholder proposals that companies receive for the 2018 proxy season, although there may be variations in approach or frequency of some of the submissions this year. Certain proposal categories may be refined in light of Staff no-action positions. Other proposal types may become more prevalent as a result of successful voting results in 2017. There also may be changes in the shareholder proposal landscape to reflect the fact that many of the 2017 shareholder proposals were sent to companies before the change in the US administration and related developments. For example, as a result of the US decision to withdraw from the Paris climate accord and changing environmental regulation, there may be an increase in climate change shareholder proposals as investors turn to “private ordering” to address global warming concerns on a company-by-company basis. And, as always, there may be some shareholder proposals submitted on subjects of concern to a limited number of companies or a small group of shareholders.

Institutional Shareholder Initiatives

Submitting shareholder proposals for inclusion in a company’s proxy statement is one way shareholders attempt to force companies to take certain actions or to publicize particular issues. Institutional shareholders, by virtue of their larger holdings, have additional ways to influence companies, such as through their proxy voting policies and engagement practices. Companies should therefore not only track who their large shareholders are but should also pay attention to positions these investors have taken with respect to various topics.

While mandatory say-on-pay has made executive compensation a frequent subject of shareholder engagement, compensation is not the only issue of concern to institutional investors. For example, State Street Global Advisors has identified board diversity, and in particular gender diversity, as a key issue for its 2017 proxy voting. State Street Global Advisors carried through on this policy during the 2017 proxy season, voting against the reelection of directors having the responsibility to nominate new board members at 400 companies that failed to make any significant effort to address the lack of a single woman on their board of directors. And, the ISS 2017-2018 Global Policy

Survey, published September 25, 2017, (ISS Survey) found that out of 129 investors who responded prior to the survey deadline, 69 percent consider it problematic for there to be no female directors on a public company board, and the largest number of these investors identified engaging with the board and/or management as the most appropriate response for shareholders to take on this issue.

In its August 31, 2017, open letter to directors of public companies worldwide, Vanguard identified the functioning and composition of the board, governance structures, appropriate compensation and risk oversight as the four pillars that it considers in evaluating corporate governance. In this letter, Vanguard articulated its increased focus on climate risk and related disclosure and gender diversity, making clear that these are ongoing priorities. The New York City Comptroller and the New York City Pension Funds issued a press release on September 8, 2017, announcing the launch of their Boardroom Accountability Project 2.0 to “ratchet up the pressure on some of the biggest companies in the world to make their boards more diverse, independent, and climate-competent.” This campaign is asking the boards of 151 US companies, 92 percent of which have adopted proxy access, to disclose race and gender of their directors, together with board members’ skills, in a standardized matrix format and to enter into a dialogue on their board “refreshment process.”

Companies should remain aware of the topics that their large shareholders have identified as important to them. Even when such areas are not the subject of proposals being voted on at the annual meeting, companies may choose to add or expand disclosures in their proxy statements and annual reports as a form of shareholder engagement to highlight their efforts and progress.

Virtual Meetings

With technological advances, a growing number of companies have begun to hold virtual annual meetings, although such meetings have remained a minority practice. Online shareholder meetings can take a variety of forms. Some are hybrids, with in-person meetings supplemented by audio and/or video options. Other companies conduct fully virtual meetings.

The number of companies conducting virtual annual meetings has been increasing steadily over the past few years. According to the New York City Comptroller, the number of companies holding virtual-only meetings increased 700 percent since 2010, from just 19 in 2010 to 155 in 2016. Broadridge reports that, during 2016, 187 companies held virtual meetings, of which 155, or 83 percent, were virtual-only.

Broadridge identifies approximately 200 companies that have held or scheduled virtual meetings in the first three quarters of 2017.

Some investors have criticized virtual-only meetings. A number of companies received shareholder proposals for the 2017 proxy season requesting in-person meetings, but on December 28, 2016, the Staff issued a no-action letter permitting a proposal requesting a corporate governance policy to initiate or restore in-person meetings to be excluded from a proxy statement as dealing with ordinary business operations in reliance on Rule 14a-8 (i)(7).

In early spring 2017, the New York City Comptroller called upon more than a dozen major corporations to host in-person annual meetings rather than continuing to hold virtual-only meetings. In addition, the New York City Pension Funds adopted a policy in its proxy voting guidelines in April 2017 to vote against incumbent directors serving on a nominating committee who are up for re-election at a virtual-only meeting.

The ISS Survey found that 87 percent of its investor respondents generally consider holding hybrid shareholder meetings to be an acceptable practice. In addition, a majority of the investor respondents indicated that virtual-only meetings would be acceptable, at least in certain circumstances, with 19 percent of the investor respondents reporting that they generally consider virtual-only meetings to be acceptable and 32 percent indicating that they would be comfortable with virtual-only shareholder meetings if they provided the same shareholder rights as a physical meeting. On the other hand, the ISS Survey found that 44 percent of the investor respondents objected to virtual-only meetings.

Notwithstanding the concerns raised by some investors, many companies hosting virtual meetings often emphasize shareholder engagement as well as cost savings and observe that web participation may exceed physical attendance, allowing shareholders the ability to attend the annual meeting from any location around the world. Thus, using technology provides a platform that encourages meaningful shareholder engagement at the annual meeting.

Companies considering or planning a virtual meeting should begin preparations early. They should confirm that their governing law permits virtual meetings and that their charter and bylaws contemplate the practice. They should decide whether they will retain an in-person component of the meeting and whether the virtual component will be audio only or will include video. A very important aspect of a virtual meeting is how shareholder questions will be handled. Another issue is whether anyone will be permitted to observe the virtual meeting or whether only shareholders will be allowed access. Therefore, it is critical for companies conducting virtual meetings to be sure the technology is in place and adequately tested before the meeting.

Annual Report Risk Factors

Updating risk factors is an important part of a company’s process for preparing its annual report on Form 10-K or Form 20-F. This section of the annual report must explain in plain English the specific risks that impact the company and its securities. The risk factors must be tailored for the specific issues affecting the company under current circumstances. While the prior year’s risk factor presentation can be the starting place for analysis, companies must be sure the risk factors are current.

When drafting the risk factors that will appear in the current year’s annual report, companies must consider whether it is appropriate to disclose new risks, to provide additional details on existing risks or to delete any risks. The answer will vary by company—there is no one-size-fits-all approach. Some key risk factor topics to consider at this time, either as stand-alone risk factors or in conjunction with other risk factor discussions, include the following:

Cybersecurity. Cybersecurity is now recognized as an issue that impacts companies of all types, with cybersecurity risks from both an economic and security perspective increasing. Therefore, companies should assess whether they need to expand or revise their cybersecurity disclosures to avoid potentially incomplete or misleading disclosures, especially in light of any events that may have occurred over the past year, whether or not such events affected them directly. Updated cybersecurity disclosure can also be helpful from a shareholder engagement perspective to demonstrate that the company is aware of the significant impact of cybersecurity risk and is taking steps to address it.

Political Changes. Changes and potential changes in law, regulation and policy resulting from the Trump presidency and the dynamics of the majority-Republican Congress may impact the risk profile of certain companies, thereby requiring modifications to risk factor disclosure that consider the potential uncertainty in the regulatory environment. For example, travel and immigration policies may present risks to companies that rely on foreign employees or consultants. Some companies may be facing increased risks with respect to potential withdrawal or modification of international trade agreements. Other companies may be concerned about changes in tax policy, such as the elimination of renewable energy tax credits or significant changes to the current tax system. Companies in the health care or insurance industries may face risks relating to efforts to repeal and replace the Affordable Care Act. Some companies have already disclosed risks from such recent political changes in their SEC filings. It is a worthwhile disclosure control exercise for companies to consider whether they face particular risks as a result of the current political climate, even if they ultimately determine that they do not need to address this topic as a risk factor.

Brexit. Following the United Kingdom referendum in favor of leaving the European Union, some companies began including Brexit risk factors in their periodic reports to address political, social and economic uncertainty, as well as stock market volatility and currency exchange rate fluctuations. For example, Brexit has been mentioned in the context of risk factors on topics such as currency exchange rates, global economic conditions and international operations, as well as having been discussed as a separate risk factor. Brexit is an ongoing process that will still take some time to fully negotiate and implement. As Brexit negotiations progress, impacted companies should continually evaluate whether Brexit poses a risk to their business, what level of Brexit-related disclosure is appropriate under the circumstances and whether any prior Brexit risk factor needs to be updated.

Climate Change and Sustainability. Sustainability and climate change have garnered increasing attention, including in the context of risk factor disclosure. Climate change risk factor disclosure may discuss the impact of existing or pending legislation, regulation or international accords, as well as the physical impact of climate change or the impact of public awareness of sustainability issues on a company’s business. To the extent deemed relevant, a risk factor could also discuss uncertainties with respect to a company’s business from potential changes in climate change regulation and treaties, especially in light of the US withdrawal from the Paris climate accord. Because climate change is an evolving area, the necessity for and scope of a climate change and sustainability risk factor is something that a company should carefully consider.

Shareholder Activism. Some companies are now including shareholder activism as a risk factor, either as part of a litany of matters that can impact the share price or as a separate risk factor describing how the company’s business could be impacted as a result of actions by activist shareholders or others. For example, risk factors have stated that actions taken by activist shareholders could cause the company to incur substantial costs, including litigation, and could divert management attention and resources. Some have indicated that actions by activists could create uncertainty, making it more difficult to attract and retain employees, business partners and customers, and could result in the loss of business opportunities. Risk factors have mentioned that shareholder activism may hinder investment or other strategies and impact stock price.

Terrorism and Armed Conflict. Companies should consider whether they should add or expand risk factors addressing the potential impact of terrorism, armed conflict, possible use of nuclear weapons or other geopolitical issues in light of developments during the past year.

Non-GAAP Financial Measures

The Staff has continued to review compliance with the requirements for use of non-GAAP financial measures since issuing new and updated CDIs on the subject in May 2016. Many of the Staff’s comments on SEC filings containing non-GAAP financial measures have been directed at the requirements for presenting the most directly comparable GAAP measure with equal or greater prominence and the company’s justification for use of the non-GAAP measure outside of the context of pay-related proxy statement discussions as noted below. Companies should actively consider the most recent CDIs and Staff comments when preparing their annual reports and related earnings releases if they contain non-GAAP financial measures.

Regulation S-K and Staff interpretations provide limited special relief regarding non-GAAP financial measures used in pay-related proxy statement discussions with respect to target levels for performance. These interpretations afford additional relief as to the location of required GAAP reconciliation and other information when non-GAAP financial measures are disclosed in pay-related circumstances. However, companies sometimes include non-GAAP financial measures in their proxy statements in circumstances which do not relate directly to compensation, such as in a summary or a letter included in the proxy statement. Therefore, it is prudent for companies to carefully consider the limits of Staff’s guidance on non-GAAP financial measures when preparing their proxy statements.

Audit Committee Disclosure

The technical requirements for the audit committee report for the proxy statement are quite modest. Item 407(d) of Regulation S-K only requires the audit committee report to state whether:

  • The audit committee reviewed and discussed the audited financial statements with management;
  • The audit committee discussed with the independent auditors the matters required to be discussed by Public Company Accounting Oversight Board (PCAOB) auditing standards;
  • The audit committee has received the written disclosures and the letter from the independent accountant required by the PCAOB regarding the independent accountant’s communications with the audit committee concerning independence and discussed the independent accountant’s independence with the independent accountant; and
  • Based on such review and discussions, the audit committee recommended to the board of directors that the audited financial statements be included in the company’s annual report on Form 10-K. In 2015, the SEC issued a concept release requesting comments on possible revisions to audit committee disclosures. The concept release focused on three main areas of disclosure:
  • The audit committee’s oversight of the auditor;
  • The audit committee’s process for appointing or retaining the auditor; and
  • The audit committee’s consideration of the qualifications of the audit firm and certain members of the engagement team.

The comment period for the audit committee disclosure concept release has expired, but the SEC has not issued any specific proposals in response to the issues raised by the concept release. However, in the interest of transparency, some companies have already expanded their audit committee disclosures beyond the mandatory requirements.

In a recent analysis of 75 companies in the Fortune 100 list that filed proxy statements in each year from 2012 to 2017 (for annual meetings through August 15, 2017), Ernst & Young LLP (EY) found a continued increase in voluntary audit committee disclosures.

According to this EY study, in 2017, 87 percent of such Fortune 100 companies explicitly stated that the audit committee is responsible for the appointment, compensation and oversight of the external auditor, 84 percent stated that the audit committee considers non-audit fees/services when assessing auditor independence, 77 percent named the audit firm in the audit committee report, 75 percent stated that the audit committee was involved in the lead partner selection and 73 percent stated that the choice of external auditor is in the best interest of the company and its shareholders.

Expanding audit committee reports may be well received by institutional investors, some of which advocated for additional audit committee disclosures even before the SEC issued its concept release. As the 2018 proxy season approaches, those responsible for preparing the proxy statement may want to discuss with their audit committees and auditors whether they consider it appropriate to voluntarily expand any audit committee disclosures at this time.

New Auditors’ Report Requirements

The PCAOB has adopted a new standard for unqualified auditors’ reports of financial statements. As of the date of this Legal Update, the SEC has not yet approved the PCAOB’s changes to auditors’ reports. Some commentators have expressed objections to certain of the new PCAOB provisions.

The PCAOB’s changes would, among other things, require:

  • Disclosure of critical audit matters, as well as communication to the audit committee, relating to accounts or disclosures that are material to the financial statements which involved especially challenging, subjective or complex auditor judgment;
  • Disclosure of the year in which the auditor began serving consecutively as the company’s auditor; and
  • Improvements to the auditor’s report to clarify the auditor’s role and responsibilities, and make the auditor’s report easier to read.

Subject to SEC approval, the provisions for the new audit report, other than those related to critical audit matters, are proposed to become effective for audits of fiscal years ending on or after December 15, 2017. Provisions related to critical audit matters are proposed to become effective for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirements apply. Once the SEC approves the final standard, auditors may elect to comply with the new requirements early. Companies and audit committees should discuss the new audit committee report requirements with their auditors.

New Revenue Recognition Standard

The new revenue recognition standard, ASU No. 2014-09, goes into effect starting with fiscal years beginning after December 15, 2017. Calendar year companies will need to apply this new standard in their first quarterly report for 2018 rather than in their annual reports for 2017. However, companies that are required to apply the new standard should include robust transition disclosures in their annual reports to enable investors to understand the anticipated effects of the new standard. Companies affected by the new revenue standard should be discussing the anticipated effects of the new standard with their accountants and audit committees and preparing appropriate disclosure for their financial statement footnotes, management’s discussion and analysis and/or other sections of their annual reports.

Companies transitioning to the new revenue recognition standard have a choice of two methods: the full retrospective method and the modified retrospective method. For a discussion of how the choice of method may affect registration statements of Form S-3, see our Legal Update “Implications of New Revenue Recognition Standard on Certain Form S-3 Registration Statements,” dated September 20, 2017.

Exhibit Hyperlinks

The SEC now generally requires the exhibits listed in the exhibit index of specified filings, including annual reports on Form 10-K or Form 20-F, to be hyperlinked. The hyperlink requirement covers both exhibits that are filed as part of a report and exhibits that are incorporated by reference to prior filings. The technical instructions for providing the required hyperlinks are contained in Chapter 5 of Volume II of the EDGAR Filer Manual. Note that Item 601(a)(2) of Regulation S-K and Item 102(d) of Regulation S-T require the exhibit index to appear before the required signatures in the registration statement or report.

Because an annual report on Form 10-K or Form 20-F generally has a substantially longer list of exhibits than other SEC registration statements and reports, it would be very useful for companies to identify the URLs for the exhibits that will be incorporated by reference into their annual reports well before the filing is due. Companies can start this process by gathering the exhibit indexes from last year’s annual report and subsequent periodic and quarterly reports filed with the SEC and annotating them with the URLs. Appropriate company personnel should review the relevant EDGAR instructions and coordinate with their financial printers, EDGAR filing agents or software providers to understand what has to be done to ensure that their annual report exhibit indexes are appropriately prepared so that technical glitches do not interfere with the annual report filing when made.

For more information on the exhibit hyperlink requirement, see our Legal Update “SEC Requires Hyperlinks for Exhibits in Company Filings,” dated March 9, 2017, and our Legal Update “Get Ready to Hyperlink SEC Exhibit Filings Beginning September 1,” dated July 20, 2017.

Form 10-K Developments

Summary. The SEC issued an interim final rule in 2016 amending Form 10-K to expressly allow, but not require, companies to include a summary of information required by that form.

Item 16 of Form 10-K authorizes optional summary information that is presented fairly and accurately if there is a hyperlink to the material contained in the Form 10-K, including exhibits, disclosed in the summary. Many companies chose not to include such a summary in annual reports on Form 10-K for the year ended December 31, 2016, often referencing Item 16 in their Form 10-Ks, indicating “none” or similar words. If used, the summary may only refer to information that is included in the Form 10-K at the time it is filed. Companies do not need to update the summary for information required by Part III of Form 10-K that is incorporated by reference to a proxy or information statement filed after the Form 10-K, but in that case the summary must state that it does not include Part III information because that information will be incorporated from a later-filed proxy or information statement involving the election of the board of directors.

Cover Page. There have been some technical changes to the cover page of Form 10-K. In addition to the boxes indicating whether the registrant is a large accelerated file, an accelerated filer, a smaller reporting company or a non-accelerated filer, there must also be a box for an emerging growth company to check. In addition, the cover page must include a check box designed to indicate whether a registrant that is an emerging growth company has elected not to use the extended transition period for complying with any new or revised financial accounting.

Status of Other Dodd-Frank Compensation-Related Rulemaking

In addition to pay ratio disclosure, Dodd-Frank directed the SEC to adopt rules in the following areas involving compensation-related matters. Unlike pay ratio, these rules have stalled at the proposal stage, without the adoption of final rules.

Clawbacks. In 2015, the SEC proposed a new rule directing national securities exchanges and associations to establish listing standards that prohibit the listing of any security of a company that does not adopt and implement a written policy requiring the recovery, or “clawback,” of certain incentive-based executive compensation payments. The recovery would equal the amount of incentive compensation payments that are later shown to have been paid in error, based on an accounting restatement that is necessary to correct a material error of a financial reporting requirement.

Pay Versus Performance Disclosure. In 2015, the SEC proposed a “pay versus performance” rule to require companies to disclose in a clear manner the relationship between executive compensation actually paid and the financial performance of the company, with performance measured both by company total shareholder return (TSR) and peer group TSR. This proposal would require companies to add a new pay versus performance table to their proxy statements to separately provide annual compensation information for the chief executive officer for each of the past five fiscal years. In addition, the table would have to provide average annual compensation for the named executive officers (other than the chief executive officer) identified in the summary compensation table for those years. A clear description of the relationship between pay and performance would have been required to accompany the proposed new table.

Hedging Disclosure. The SEC also proposed a new disclosure requirement in 2015 addressing hedging by employees, officers and directors. This proposal would require companies to disclose in their proxy statements whether their employees (including officers) or directors are permitted to engage in transactions to hedge or offset any decrease in the market value of their companies’ equity securities granted to them as compensation or held directly or indirectly by them.

Current Status. The Financial CHOICE Act, as approved by the House of Representatives, would, among other things, limit the Dodd-Frank clawback requirement and repeal the Dodd-Frank hedging disclosure requirement. At this point it is not certain when, if at all, the House-approved bill will be considered by the full Senate, let alone what legislative changes, if any, will be made to these or other compensation-related initiatives.

During the summer of 2017, the SEC moved its Dodd-Frank clawback, pay versus performance disclosure and hedging disclosure proposals from the proposed action section of the unified agenda of regulatory actions to long-term actions, which is the section of the agenda for items under development for which the SEC does not expect to have a regulatory action within 12 months.

Based on the above, it does not seem likely that any of these Dodd-Frank compensation-related proposals will directly impact the 2018 proxy season. However, it is possible that some investors, proxy advisory firms or organizations that rate corporate governance may be influenced by voluntary disclosures in this area.

The complete publication, including footnotes, is available here.

October 16, 2017
What If the Reg Flex Agenda Became "Real"?
by Liz Dunshee

One of the things that I’ve blogged about more than I would like is how the Reg Flex Agenda is merely aspirational – and people should pay little mind to it (here’s one of my more recent entries). History certainly has borne out the truth – I imagine the SEC has missed it’s predicted timetables for rulemakings listed in the Reg Flex Agenda many more times than not. And not that there’s anything wrong with that, it’s always been viewed as a meaningless regulatory exercise for those "in the know."

But now – probably due to all the Congressional & media attention being paid to it – SEC Chair Clayton recently told the Senate Banking Committee that he intends to make the Reg Flex Agenda more realistic, including streamlining it (see this Cooley blog).

Kudos if the SEC can pull it off. But I worry that by promising to make deadlines, the SEC is placing a bullseye upon itself. In recent years, the Staff has smartly avoided mentioning any "hard" time frames for conducting rulemaking. That’s because it’s nearly impossible to predict when a rulemaking will come out, even when you’re the one actually writing the rules! It’s difficult to even predict which season of the year it will happen.

There’s a myriad of review layers within the SEC, including:

1. Your superiors within your Division (and there might be quite a few of those)
2. The folks within the SEC’s Office of General Counsel
3. That ever-growing newish Division of Economic & Risk Analysis (DERA)
4. Each Commissioner (and their counsels)
5. Possibly other Divisions or Offices within the SEC, depending on the nature of the rulemaking
6. Possibly members of Congress (or their staff) if it’s a politically-sensitive topic

You think its tough getting your proxy through an internal review? That’s nothing. A proposing/adopting release can easily go through 20 drafts. Anyway, I draw your attention to the transcript of one of my favorite webcasts if you want to learn more: "How the SEC Really Works"…

Poll: I Love the Reg Flex Agenda for…

Please participate in this anonymous poll:

find bike trails

Broc Romanek

October 15, 2017
Cross-Border Reincorporations in the European Union: The Case for Comprehensive Harmonisation
by Carsten Gerner-Beuerle, Edmund-Philipp Schuster, Federico Mucciarelli, Mathias Siems
Editor's Note: Federico M. Mucciarelli is Reader in Financial Law at the University of London and Associate Professor at the University of Modena & Reggio Emilia. This post is based on a recent paper by Professor Mucciarelli; Carsten Gerner-Beuerle, Associate Professor of Law at the London School of Economics; Edmund‐Philipp Schuster, Associate Professor of Law at the London School of Economics; and Mathias Siems, Professor of Commercial Law at Durham University.

Can companies, incorporated under the law of an EU Member State, subject themselves to another Member State’s law without going through the process of liquidation in their original jurisdiction? Such operations are usually labelled “cross-border reincorporations”, or just “reincorporations”. Cross-border reincorporations and regulatory competition in EU company law has long been a focus of scholarly work in EU company law. The present work adds to previous studies a comparative analysis of all Member States of the European Union regarding rules on transfer of a company’s registered office and cross-border reincorporations. In particular, the question arises whether the freedom of establishment under the Treaty on the Functioning of the EU also covers the right to reincorporate in other Member States and, consequently, whether Member States should grant domestically incorporated companies the possibility of reincorporating under the law of a different jurisdiction and foreign companies the possibility of converting into domestic entities without liquidation. The answer is still unclear, despite recent decisions of the Court of Justice of the European Union.

In its Cartesio decision, the European Court of Justice (CJEU) explained that companies have the right to reincorporate abroad under the Treaty, and that Member states thus must not restrict these reorganisations. Strictly speaking, however, this statement was just obiter dictum, which probably explains why many Member States have not felt it necessary to explicitly endorse these rights. Regarding restrictions on inbound reincorporations, the VALE decision of 2012 maintained that any restriction placed by the country of arrival should be proportionate and reasonable. The issue of whether and to what extent the freedom of establishment also covers cross-border reincorporations, therefore, is still partially uncertain and, as a matter of fact, several Member States still effectively restrict such transactions or even prohibit them outright. Our analysis shows that, while some Member States have thoroughly regulated cross-border reincorporations, most Member States either have not regulated this issue at all, or only provide for partial and incomplete rules.

In those Member States without any explicit rules on reincorporations, or with partial and incomplete rules, the “law on the books” needs to be supplemented by scholarly interpretations, judicial decisions or opinions of notary authorities. For instance, both Austrian and German lawyers argue that EU law, after the Cartesio and VALE decisions, mandates Member States to allow cross-border reincorporations and that, as a consequence, domestic law should be interpreted and applied accordingly, even though no explicit provision exists for implementing midstream changes of company law. By contrast, in other Member States that likewise have no explicit rules on reincorporations, scholars and practitioners either argue that a domestic legislation is necessary to make reincorporations possible, or simply ignore this issue. As a consequence, from the standpoint of several Member States, outbound and inbound reincorporations are, as a matter of fact, not feasible, despite the Cartesio and VALE rulings. This situation will probably not change even if the Court of Justice explicitly decided that voluntary outbound reincorporations were covered by the freedom of establishment. This confused situation could give rise to opportunistic reincorporations at the expenses of creditors or other stakeholders.

Based on this comparative analysis, we argue in favor of EU harmonization of rules and proceedings on reincorporations. At the same time, we argue that any future directive on this matter should not harmonize private international law and should leave Member States free to require domestically incorporated companies to keep some kind of “physical” connection to their territory. Thus, a new directive should concern the procedural requirements that domestic companies should meet when they decide to reincorporate under a different jurisdiction or when foreign companies aim at converting into a domestic entity. Additionally, since outbound reincorporations might jeopardize creditors, minority shareholders and other stakeholders (such as workers when the country of origin follows some form of codetermination), a new directive should provide for a minimum harmonization of mechanisms aimed at protecting these stakeholders. In this respect, although it is reasonable that harmonization efforts would only set minimum requirements, we also argue that Member States should not be entirely free to decide on the content of these protection mechanisms.

The full paper is available for download here.

This paper is part of wider project: see also the report Study on the Law Applicable to Companies drafted by the authors for the European Commission, an ECGI Working Paper on “Why Do Businesses Incorporate in Other EU Member States? An Empirical Analysis of the Role of Conflict of Laws Rules”, and a forthcoming book on The Private International Law of Companies in Europe.

October 14, 2017
Recent Cases on Lending Safeguards in Bankruptcy
by Daniel Denny, Matthew Kelsey, Samuel Newman, Gibson Dunn
Editor's Note: Samuel A. Newman and Matthew K. Kelsey are partners at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn publication by Mr. Newman, Mr. Kelsey, Daniel B. Denny, and Brittany N. Schmeltz.

As discussed in our August 8, 2016 client alert, [1] lenders and borrowers continue to experiment with creative structures to prevent a bankruptcy filing. As discussed below, recent decisions clarify previous case law, develop the prevailing rules and highlight outstanding open issues.

I. Case Law Developments

In two recent cases, In re Lexington Hospitality Group, LLC [2] and Squire Court Partners LP v. Centerline Credit Enhanced Partners LP (In re Squire Court Partners LP)[3] bankruptcy courts continue to look past parties’ structures and have invalidated restrictions where the intent is to allow a lender to prevent or control its borrower’s ability to seek bankruptcy protection. These decisions, from Kentucky and Arkansas respectively, provide further guidance to lenders seeking to protect against the risks of bankruptcy.

A. In re Lexington Hospitality Group, LLC

In Lexington Hospitality, decided September 15, 2017, the court denied a secured lender’s motion to dismiss a borrower’s bankruptcy petition, holding that certain bankruptcy-filing restrictions in the borrower’s operating agreement, which was amended in connection with a loan and subsequent forbearance agreement, were void as contrary to public policy. [4]

Under Lexington Hospitality’s original operating agreement, the company manager was authorized to manage the borrower’s business and affairs, with no express provisions authorizing the borrower’s manager to commence a bankruptcy on behalf of the borrower. [5]

In connection with an acquisition loan secured by hotel assets, Lexington Hospitality agreed to: (1) amend its operating agreement to require the authorization of an independent manager and a 75% vote of the members before a bankruptcy filing could be authorized by the borrower, (2) grant the secured lender veto power over the borrower’s bankruptcy authorization regardless of obtaining the consent of the independent manager and 75% of the members, and (3) transfer 30% of its membership interests to an entity controlled by the lender. [6] When Lexington Hospitality initially defaulted on the loan and entered into a forbearance agreement with the secured lender, Lexington Hospitality agreed to amended its operating agreement to transfer an additional 20% of its membership interests to entities controlled by the secured lender. [7]

Despite these significant limitations on its ability to commence a bankruptcy proceeding, Lexington Hospitality filed for bankruptcy without the secured lender’s consent. On that basis, the secured lender sought to dismiss the bankruptcy case, arguing that Lexington Hospitality did not obtain the appropriate corporate consents. Upon review, the court found that the borrower’s ability to ever file for bankruptcy protection was frustrated by the reduction in the company manager’s membership interests—making it impossible for the members to achieve a 75% majority without the lender’s affirmative vote—and by the lender’s veto power. [8] As a result, the court held that the bankruptcy restrictions benefitting Lexington Hospitality’s secured lender were void as contrary to public policy and denied the secured lender’s motion to dismiss. [9]

B. In re Squire Court Partners LP

Earlier this year, in Squire Court, the court affirmed the bankruptcy court’s dismissal of a general partner’s bankruptcy petition, holding that the limited partners were permitted to retain for themselves the decision whether to file a bankruptcy petition, even if that decision required the unanimous consent of all of the partners in the partnership. [10]

Here, the Squire Court partnership consisted of two limited partners and one general partner. [11] The amended partnership agreement gave the general partner the exclusive authority to manage and control the partnership, but required unanimous consent of both the general partner and the two limited partners before the partnership could file for bankruptcy protection. [12]

The general partner filed a voluntary petition to commence a bankruptcy for the partnership without receiving unanimous consent. The general partner defended the bankruptcy filing, arguing that the provision in the partnership agreement requiring the unanimous consent of the general and limited partners to commence a bankruptcy case was void as contrary to public policy because only a fiduciary may decide whether an entity could receive relief by filing bankruptcy. [13]

Upon review, the court found no cases had been presented to indicate that a bona fide equity owner must hold a fiduciary position before it can make a decision on whether to file for bankruptcy. Instead, as the court noted, relevant case law focuses on whether the persons or entities managing a partnership had been delegated the authority to file for bankruptcy by the other partners. Here, the limited partners did not delegate authority to file for bankruptcy to the general partner; rather, the limited partners retained the authority to make the decision for themselves. [14] Accordingly, the court affirmed the bankruptcy court’s dismissal of the general partner’s bankruptcy petition. [15]

II. Clarification Regarding Public Policy Limiting Bankruptcy Restrictions

In our previous client alert, we discussed the Delaware bankruptcy court’s holding in In re Intervention Energy Holdings, LLC[16] In that case, the court held that it is void as against public policy for a creditor to require a borrower to issue a creditor “golden share” and amend its operating agreement to require unanimous consent to file for bankruptcy, with the purpose that the creditor could control—and withhold consent from—potential filings. [17] We observed that, despite the holding in Intervention Energy, it remained uncertain whether a lender’s required consent to file bankruptcy may be valid if the transaction was structured so that a lender was also an equity investor in borrower with “more than immaterial actual equity investment.” [18]

The outcome in Lexington Hospitality—finding invalid an arrangement where an entity controlled by the creditor was transferred 30%, and then an additional 20% of the borrower’s membership interests—partially addresses this question. In Lexington Hospitality, a party that was a lender at the outset of the relationship, remained a lender for these purposes notwithstanding having been transferred a substantial equity stake in the borrower. It did not appear to matter that the lender had a meaningful actual equity investment, rather than simply one golden share.

III. Further Issues in Structuring Bankruptcy-Remote Entities

The ruling in Squire Court adds weight to the line of cases that hold that members or equity holders of a business entity may agree among themselves the appropriate threshold for authorizing a bankruptcy filing. The caveat to this rule, as articulated in Lexington Hospitality and Intervention Energy, is that a lender cannot insert itself into this decision-making process by creating a veto right to authorize a bankruptcy filing, even if the lender holds a meaningful equity stake in the borrower. These rulings are consistent with the ruling by the Tenth Circuit BAP in DB Capital Holdings v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC)[19] where the court affirmed the dismissal of a bankruptcy petition filed by the manager of an LLC where the operating agreement indicated the manager did not have authority to file the bankruptcy without consent of both of the members. [20] The logic of the DB Capital opinion appears to have increased its reach in the recent opinions discussed above.

IV. Remaining Open Issues

We note several issues have not been resolved that may provide opportunities for lenders seeking to protect against the risks of a borrower bankruptcy. First, while Lexington Hospitality indicates that granting more than an immaterial amount of equity interest to a lender does not in and of itself allow the required-consent right to survive, the lender in that case also had an absolute veto right regardless of member consent. If the lender had a meaningful equity stake that did not result in a veto, the result could be different.

Second, the reverse situation—where an equity holder freely entering an agreement not to file bankruptcy subsequently becomes a creditor—has not been addressed specifically in case law. As is often the case, equity holders seek to support a failing company and may become both equity holders and lenders as a situation deteriorates. It is not clear whether such a change in status will invalidate an otherwise valid authority-to-file restriction.

Third, and finally, it is unclear under the current line of cases what level of independence an independent manager must have from a secured lender for a court to rule that the independent manager is really an alter ego of the lender and, therefore, requiring the vote of an independent manager to commence a bankruptcy is, in essence, giving the lender a veto right over the filing. Lenders and investors should continue monitoring new cases in this area as they consider how to mitigate risks associated with borrower bankruptcies.


1Bouslog, Matthew G., Little, Robert B. & Rosenthal, Michael A., Delaware Court Invalidates Lender’s Attempt to Prevent Bankruptcy Through Issuance of “Golden Share,” Gibson Dunn Client Alert (August 8, 2016).(go back)

2No. 17-51568, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017).(go back)

3No. 4:16CV00935JLH, 2017 WL 2901334 (E.D. Ark. July 7, 2017). The District Court’s order was appealed to the Eighth Circuit Court of Appeals on August 3, 2017, but as of the date of this publication the appellants have filed a notice of settlement which may result in dismissal of the appeal. See docket for Appellate Case 17-2700 (8th Cir.).(go back)

4In re Lexington Hospitality Group, at *6.(go back)

5Id. at *2.(go back)

6Id. at *2-3.(go back)

7Id. at *4.(go back)

8Id. at *6-8.(go back)

9Id. at *8.(go back)

10In re Squire Court Partners LP, at 4-5.(go back)

11Id. at *1.(go back)

12Id.(go back)

13Id. at 2.(go back)

14Id. at *4.(go back)

15Id. at *5.(go back)

16553 B.R. 258 (Bankr D. Del. 2016).(go back)

17Id. at 265-66.(go back)

18Bouslog, Little & Rosenthal, supra note 1.(go back)

19463 B.R. 142 (B.A.P. 10th Cir. 2010) (unpublished).(go back)

20Id. at 3. Still, it should be noted that because the debtor in DB Capital failed to bring forth any evidence on whether the amendment to the operating agreement was coerced by a creditor, the court was not able to rule on the impact of creditor coercion in such an agreement among the members. Id.(go back)

View today's posts

10/16/2017 posts

Bridging the Week: Bridging the Week: October 9 - 13 and October 16, 2017 (Spoofing; Supervision; De Minimis Threshold; Automated Trading System Gone Bad)
CLS Blue Sky Blog: How State Competition for Corporate Charters Has Changed the Delaware Effect
CLS Blue Sky Blog: K&L Gates Discusses Tax-Free Cryptocurrency Transactions and Reporting Obligations
The Harvard Law School Forum on Corporate Governance and Financial Regulation: New Special Study of the Securities Markets: Institutional Intermediaries
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Proxy Season Legal Update Blog: What If the Reg Flex Agenda Became "Real"?
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Cross-Border Reincorporations in the European Union: The Case for Comprehensive Harmonisation
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Recent Cases on Lending Safeguards in Bankruptcy

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