Securities Mosaic® Blogwatch
August 18, 2017
PwC Explains Why Fraud Governance Means More Than Just Compliance
by Julien Courbe, Sean Joyce, Jeff Lavine, Genevieve Gimbert, Brian Castelli and Roberto Rodriguez

Fraud incidents have increased by over 130 percent in the past year, resulting in significant monetary and reputational losses for financial institutions. Many of these incidents — including high-profile crimes such as the Society for Worldwide Interbank Financial Telecommunication ("SWIFT") attacks from last year — involved the exploitation of governance deficiencies and ineffective operating models.1

Maintaining proper governance for risk management has been a major point of focus for industry groups and regulators, including the Office of the Comptroller of the Currency, the Basel Committee on Banking Supervision, the Committee of Sponsoring Organizations of the Treadway Commission, and the FFIEC.2 Accordingly, regulators expect that financial institutions develop an operating model assigning clear roles and responsibilities for risk management – including fraud risk management– across the "three lines of defense."3

However, the need to develop strong fraud governance practices goes beyond regulatory compliance – such practices are necessary to properly identify and defend against emerging threats that are growing in complexity, including risks related to the Cloud4 and digital transformation (e.g., mobile applications), theft of personally identifiable information through business e-mail compromise, and account takeover through mobile self-servicing.5 In addition, such practices help organizations operate more efficiently and reduce costs as they result in clear accountabilities, enhanced cross-collaboration, and fraud loss reduction.

To realize these benefits, financial institutions should take steps to establish a strong foundation for fraud risk management, including formalizing governance structures and documenting roles and responsibilities for functional groups. Taking such steps will pave the way for financial institutions
to implement a robust three lines of defense operating model for fraud risk management.

This Financial crimes observer discusses key fraud governance challenges, and explains what financial institutions should be doing now.

Key challenges

The most significant challenge we see in achieving a sound fraud management operating model stems from functional silos for fraud prevention and detection. Financial institutions often struggle with clearly defining roles and responsibilities for fraud prevention and detection functions, and ensuring that all three lines of defense are working together effectively and not duplicating roles. As a result, we often see inefficiencies in organizations as activities
are unnecessarily duplicated across multiple layers (and lines of defense).

Finally, financial institutions are challenged with navigating the vast and constantly evolving universe of fraud risks. This is especially challenging for larger organizations that have multiple business units, products, and services. As an example, larger organizations that have not dedicated enough resources to fully assess their fraud risks tend to focus their efforts on highly publicized external fraud risks such as business email compromise and account takeover,
and often miss key threats facing their organization.

What should financial institutions be doing?

To ensure effective collaboration and coordination across the organization, financial institutions should establish a fraud management operating model using the three lines of defense framework. This framework minimizes the duplications or conflicts that exist between the pursuit of business objectives (first line of defense) and the need for objective risk oversight (second line of defense), while independently assuring that fraud management activities are being carried out
in accordance with written policies and procedures (third line of defense).

In establishing this operating model, organizations should develop formal and open communication mechanisms among and within lines of defense teams to enhance information sharing, escalation processes, and prevention capabilities.

Preliminary steps

Prior to implementing a three lines of defense framework, financial institutions should take steps to establish a foundation to support this operating model. These steps include:

  • Formalizing governance structures and fraud-focused committees, aligned with broader
    financial crime risk management (e.g., cybersecurity, anti-money laundering, and anti-bribery and corruption) and operational risk management, to oversee and make decisions about fraud.
  • Evaluating the target operating model design based on organizational culture and determining whether a centralized, hub-and-spoke, or combination model best suits the organization.6
  • Developing a RACI (Responsible, Accountable, Consulted, and Informed) model to define
    expected roles and responsibilities as well as levels of participation for functional groups.7
  • Documenting roles and responsibilities for each functional group to ensure that duties are properly segregated and critical fraud management activities (e.g., deterrence, prevention and detection, investigation and response, and analytics and reporting) are appropriately addressed.
  • Defining reporting lines and requisite skillsets for key fraud risk management roles.
Establishing a "three lines of defense" operating model

Fraud risk management practices should be incorporated throughout each line of defense –
business units, independent risk management, and internal audit. Developing this operating model requires clearly defining roles and responsibilities for each line of defense and the functions within them.

First Line of Defense

The first line of defense – the client-facing business – "owns" and manages fraud risk, and drives the building out and bolstering up of fraud risk defenses. Key first line activities include developing and implementing the authentication and fraud strategy, as well as owning the fraud detection, surveillance and analytics, fraud call center, claims management, fraud investigation, recovery, Suspicious Activity Report filing, and business transformation functions.

We recommend that financial institutions formally assign a senior executive from the first line of defense to focus, coordinate, and prioritize fraud prevention and detection efforts on an enterprise-wide basis. This position should be given the autonomy to execute policy and set the tone at the top. Importantly, this fraud management leader is responsible for collaborating closely with the various businesses and product lines (including second line of defense counterparts) to lead the organization to the desired fraud management state.

For example, designing a risk-based authentication strategy involves balancing security concerns with the customer experience. Achieving this balance requires close collaboration between the first line fraud operations, client-facing functions, and information security. Additionally, collaboration between the first line and technology functions is essential to building out the infrastructure needed to detect emerging threats and develop surveillance scenarios. The front line is also responsible for collaborating across the broader financial crimes unit – e.g., with cybersecurity and anti-money laundering functions – to share data and conduct investigations.

Finally, the first line of defense should operate within the guidelines set forth by the second line of defense and follow the frameworks put at their disposal by the second line (as explained below).

Second Line of Defense

The primary role of the second line of defense is to provide objective review and credible challenge to fraud risk management efforts carried out by the first line of defense. Accordingly, the second line of defense creates guidelines through which the first line of defense must manage the fraud risks arising from business pursuits — a key component of which is the development of a fraud risk policy (i.e., the written set of standards for fraud risk management) and its companion fraud risk management framework (i.e., the actions that should be taken to meet those standards). The fraud risk management framework includes determining the organization’s fraud risk appetite and developing the fraud risk assessment methodology, fraud model risk management, fraud policy compliance testing requirements, and fraud risk reporting requirements.

One of the biggest challenges faced by the second line of defense is the responsibility to understand the fraud threat landscape and develop a fraud taxonomy – i.e., a classification system designed to assist with the evaluation, organization, and grouping of fraud threats. Taxonomies serve as an essential organizing tool for the analysis and reporting of fraud risk, breaking down threats into their elements, such as actors, method, channel (e.g., online, phone), exposure, and motives. By developing this common language used for reporting and identifying threats throughout the organization, the second line can identify key risk areas and prioritize
areas that require additional investment.

Additionally, second line of defense teams provide credible challenge to the first line’s self-assessments to determine risk levels more objectively.

Finally, the second line of defense is responsible for monitoring and testing compliance with fraud policies. In doing so, the compliance department plays an operational role within the second line of defense. The compliance department is tasked with determining whether the organization is complying with applicable fraud regulations and internal policy as well as determining the activities to be undertaken in order to achieve and maintain compliance with applicable requirements as they evolve.

Third Line of Defense

The third line of defense, internal audit, is responsible for providing assurance by independently assessing the design and effectiveness of fraud risk and control policies, frameworks, processes and systems. Accordingly, the main role of the third line of defense in a fraud management operating model is to evaluate the efforts of both the first and second lines of defense.

We have seen a number of financial institutions actively integrate the third line of defense into their fraud management operating model and increase the number of fraud-focused audits, ultimately augmenting the levels of resources dedicated to areas most prone to fraud risk such as client authentication and payment processing.

Additionally, increased regulatory focus on governance and operating models calls for the third line of defense to put more focus on testing fraud prevention and detection capabilities. As a result, financial institutions should determine whether additional investment into their audit departments is necessary to provide an appropriate level of assurance.

What’s next?

Financial institutions have made progress in implementing a fraud management three lines of defense operating model, but many still have work to do. Particularly, we have seen the OCC issue "matters requiring attention" (MRAs) regarding first line monitoring of risk activities consistent with risk appetite, the ability of the second line to influence and credibly challenge first line decisions, and the ability of both the first and second lines to proactively mitigate problems.

We expect that regulatory scrutiny of operating models will continue to increase. Because of this regulatory pressure – in addition to the rapidly evolving threat landscape – financial institutions should begin implementing or enhancing their three lines of defense operating model now.


1. For additional information on the SWIFT attacks, see PwC’s Financial crimes observer, SWIFT action: Preventing the next $100 million bank robbery (June 2016).

2. The Federal Financial Institutions Examination Council (FFIEC) is a regulatory council composed of the Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Consumer Financial Protection Bureau, and the National Credit Union Administration.

3. Under this framework, the first line of defense, as the business unit, is responsible for owning and managing fraud risks; the second line, consisting of independent risk management functions, is responsible for overseeing and monitoring fraud risks; and the third line, internal audit, provides independent assurance for fraud management activities. For additional information, see PwC’s A closer look, Sales practices: OCC exams and beyond (October 2016).

4. For additional information on the Cloud, see PwC’s financial services digital publication, Get your head in the cloud (August 2016).

5. For additional information on business e-mail compromise and account takeover, see PwC’s Financial crimes observer, Fraud: Email compromise on the rise (February 2016).

6. For additional information, see PwC’s Financial crimes observer, Bank fraud: Old defenses won’t stop new threats (April 2016).

7. The RACI model is a tool for determining roles and responsibilities. It identifies which staff own specific responsibilities, to whom such staff are accountable, which staff can provide support, and which staff must be notified of results.

This post comes to us from PwC. It is based on the firm’s "Financial crimes observer –Fraud governance: It’s more than just compliance," dated July 2017 and available here.

August 18, 2017
Losing Stockholder Standing to Assert and Enforce Corporate Inspection Rights
by Jacqueline Rubin, Matthew Stachel, Paul Weiss
Editor's Note: Jacqueline P. Rubin is a partner and Matthew D. Stachel is an associate in the litigation department at Paul, Weiss, Rifkind, Wharton & Garrison LLP. This post is based on a Paul Weiss publication by Ms. Rubin and Mr. Stachel and is reprinted with permission from Delaware Business Court Insider. This post is part of the Delaware law series; links to other posts in the series are available here.

The rights of stockholders to demand to inspect a corporation’s books and records under state corporation laws are a powerful method of ensuring the stockholders’ rights and interests are safeguarded. Such inspection rights are not, however, unfettered. Exercising them involves balancing the inspection rights with the rights of corporations “to be free of frivolous or vexatious demands to examine records, and to avoid production of records to individuals pursuing interests other than those relating to stock ownership.” To strike an appropriate balance, stockholders must first comply with certain requirements. Among these are requirements governing the making of an inspection demand on the corporation and the requirement of articulating a proper purpose for the demanded inspection.

A more fundamental requirement—that can be taken for granted—is that the stockholders must have standing as stockholders, both when the inspection demand is made and when they file a lawsuit seeking to enforce their inspection rights. But stockholder standing can be lost in more ways than the voluntary disposition of the stockholders’ shares. Courts have recently considered the impact of some of these situations, including corporate life-cycle events like mergers and other federal and state statutes. Practitioners who represent stockholders and those who represent corporations should be mindful of these situations when counseling their clients.

Merger Held to Divest Stockholder of Standing

In Weingarten v. Monster Worldwide, C.A. No. 12931-VCG, (Del. Ch. Feb. 27). the Delaware Court of Chancery considered (as a matter of first impression) the effect of a merger that deprived a stockholder of his stock on the stockholder’s subsequent lawsuit seeking to compel the corporation’s compliance with Delaware’s books and records statute. In August 2016, Monster Worldwide, Inc. (Monster) entered into a merger agreement that contemplated that all of its outstanding stock would be acquired through a cash tender offer pursuant to 8 Del. C. Section 251(h). The tender offer began on Sept. 6, 2016, and expired at midnight on Oct. 28, 2016. On Nov. 1, following the successful consummation of the tender offer, all of Monster’s outstanding stock, excluding shares held by the acquirer, Monster, and stockholders who validly exercised their appraisal rights, was cancelled and converted into the right to receive the merger consideration.

Monster stockholder Joe Weingarten submitted an inspection demand on Oct. 19, 2016, several weeks after the launch of the tender offer. Weingarten sought to inspect certain books and records to determine whether to pursue litigation against some of Monster’s directors for alleged wrongdoing in connection with the contemplated transaction. Monster rejected the demand, but expressed a willingness to discuss a narrow production. Weingarten attempted to discuss that production with Monster, but reached no agreement and filed no complaint before the transaction closed. Weingarten’s stock was among the shares cancelled following the tender offer. On Nov. 22, 2016, Weingarten filed an action in the Court of Chancery to compel the corporation to grant his demanded inspection.

In its post-trial opinion, the Court of Chancery held that Weingarten lacked stockholder standing because he was not a stockholder when he filed his complaint. The court reasoned that by requiring a plaintiff to demonstrate “both that it ‘has’—past tense—complied with the demand requirement, and that it ‘is’—present tense—a stockholder, the legislature has made clear that only those who are stockholders at the time of filing have standing to invoke this court’s assistance.”

The court also distinguished two previous Court of Chancery opinions: Cutlip v. CBA International, C.A. No. 14168 NC, (Del. Ch. Oct. 27, 1995), and Deephaven Risk Arb Trading v. UnitedGlobalCom, C.A. No. 379-N, Del. Ch. July 13, 2005). Both of those cases involved stockholders who lost their stock due to mergers while their books and records actions were pending. In both of those cases, the court held that the subsequent loss of stock did not deprive the stockholders of standing because they had standing at the time they filed suit.

Following Weingarten, practitioners should consider the effect of corporate life-cycle events like mergers on pending books and records demands. For example, practitioners representing stockholders should be prepared to file a books and records lawsuit before the merger or tender offer closes to maintain standing to enforce their inspection rights.

Federal Statute Held to Divest Stockholder of Standing

In Pagliara v. Federal Home Loan Mortgage, the U.S. District Court for the Eastern District of Virginia examined whether a federal statutory transfer of power to a conservator deprived a junior preferred stockholder of his standing to demand inspection of the Federal Home Loan Mortgage Corporation (Freddie Mac). Freddie Mac is a federally chartered corporation, but its organizational documents obligated it to follow the corporate governance practices and procedures of the commonwealth of Virginia, including Virginia’s books and records statute. The court held that the stockholder lacked standing.

During the Great Recession, Congress passed the Housing and Economic Recovery Act of 2008 (HERA), which created the Federal Housing Finance Authority (FHFA) to regulate Freddie Mac. HERA authorized FHFA to place Freddie Mac in conservatorship and also provided that if FHFA becomes Freddie Mac’s conservator, then FHFA shall “immediately succeed” to “all rights, titles, powers and privileges” of any Freddie Mac stockholder with respect to Freddie Mac and its assets.

In September 2008, exercising this authority under HERA, FHFA became Freddie Mac’s conservator. The next day, FHFA caused Freddie Mac to enter into a senior preferred stock purchase agreement with the United States Department of the Treasury. In 2013, an amendment to that agreement gave the Treasury Department the right to a receive a quarterly dividend from Freddie Mac in the amount of Freddie Mac’s net worth, except for a small capital reserve. After the amendment, Freddie Mac paid to the Treasury Department approximately $74 billion in dividends but paid no dividends to its junior preferred stockholders.

In January 2016, Timothy Pagliara, a junior preferred stockholder of Freddie Mac, submitted a books and records demand to Freddie Mac. Pagliara sought to inspect certain documents to determine whether to institute a lawsuit against Freddie Mac’s directors and others in relation to the 2013 amendment and the declaring of dividends pursuant to that amendment. Freddie Mac did not respond to the demand, but FHFA did, explaining that Freddie Mac’s directors served on FHFA’s behalf and thus owed no fiduciary duties to its other stockholders. Pagliara filed a lawsuit six weeks later, seeking to compel Freddie Mac to grant his inspection demand.

In its memorandum opinion, the Eastern District of Virginia held that Pagliara lacked standing to assert inspection rights. The court reasoned that Virginia’s books and records statute requires stockholders to have stockholder standing when they submit an inspection demand to the corporation. The court explained that Pagliara lacked stockholder standing because HERA’s statutory transfer to FHFA of “all rights, titles, powers, and privileges” of any Freddie Mac stockholder unambiguously included inspection rights.

Pagliara thus reminds practitioners to consider whether there are any federal or state statutes that might affect stockholder standing to assert and enforce inspection rights.

Stock Transfer Restrictions Did Not Divest Stockholder of Standing

In Henry v. Phixios Holdings, C.A. No. 12504-VCMR, (Del. Ch. July 10), the Delaware Court of Chancery explored whether written stock transfer restrictions contained in a stockholder agreement were validly applied to revoke a stockholder’s stock and thus deprive him of standing to enforce compliance with his books and records demand. When Phixios Holdings, Inc. (Phixios) was formed in July 2013, its board of directors approved and executed a stockholder agreement that contained certain written stock transfer restrictions. Those restrictions provided that stock was subject to revocation by a majority vote of all voting stockholders if a stockholder were “found to be engaging in acts … that are damaging to Phixios,” including working for competitors, willfully disclosing proprietary information, or “other willful acts” harmful to Phixios “as determined by a majority vote of the board of directors and all voting stockholders.”

In March 2015, Jon Henry became a Phixios consultant. As part of his compensation, Henry received 50,000 certificated shares of Phixios stock. The stock certificate Henry received did not contain or otherwise note the existence of any stock transfer restrictions. There was no written documentation that Henry was informed of the restrictions, nor did he receive a copy of the stockholder agreement before becoming a stockholder. While a Phixios representative contended that the company’s delay in issuing the shares to him.

In May 2016, Henry’s consulting relationship with Phixios was terminated. In early June 2016, Phixios sent Henry a cease and desist letter, asserting that he had worked for a competitor while he was a Phixios consultant.

On June 23, 2016, Henry submitted a books and records demand to Phixios, seeking to investigate, among other things, alleged corporate mismanagement. Phixios did not respond to the demand. On July 12, 2016, Phixios held a special meeting of the stockholders at which all of Henry’s stock was purportedly revoked pursuant to the stock transfer restrictions contained in the stockholder agreement for allegedly engaging in work for a Phixios competitor. On July 22, 2016, Henry filed a books-and-records lawsuit.

In a post-trial opinion, the Court of Chancery held that the written stock transfer restrictions did not apply to Henry, Phixios’s attempt to revoke his stock was invalid, and Henry maintained his status as a stockholder at all relevant times. The court explained that under Section 202 of the Delaware General Corporation Law, a written stock transfer restriction in a stockholder agreement is binding on those who acquire stock if the restriction is noted conspicuously on the stock certificate, the stockholder has actual knowledge of the restriction at the time he acquires the stock, or the stockholder subsequently consents to be bound by the restriction through a stockholder vote or agreement with the stockholders or the corporation. The parties did not dispute that the stockholder in March 2015, concluding that Henry’s testimony that the only discussions he had related to Phixios’s delay in issuing him shares was more credible than the testimony of Phixios’ representative that she discussed every provision of the stockholder agreement in telephone calls with him. The court also found that Henry did not subsequently assent to the restrictions.

Although the stock transfer restrictions in Henry were held unenforceable, the opinion demonstrates that such restrictions could be found valid in a different factual scenario. Like Pagliara, Henry is a reminder of the effects that different statutory schemes can have on standing to assert and enforce inspection rights.


Weingarten, Pagliara, and Henry illustrate some of the various ways that stockholders who have not directly transferred their stock could nonetheless lose standing to assert and enforce their inspection rights. Practitioners counseling stockholders and corporations should ensure that they look beyond nominal stock ownership to see if there are other corporate life-cycle events, statutes, or even agreements that might operate to divest stockholders of their inspection rights.

August 18, 2017
Regulating Motivation: A New Perspective on the Volcker Rule
by Marcel Kahan, Ryan Bubb
Editor's Note: Marcel Kahan is the George T. Lowy Professor of Law and Ryan Bubb is Professor of Law at New York University School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here); The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 by Lucian Bebchuk, Alma Cohen, and Holger Spamann (discussed on the Forum here); and How to Fix Bankers’ Pay by Lucian Bebchuk (discussed on the Forum here).

The myriad problems with the Dodd-Frank Act’s ban on proprietary trading by banks have led to a rare bipartisan consensus: the Volcker Rule must be pared back or even repealed. At the root of the Rule’s problems is a fundamental definitional challenge. Whether a particular trade is banned turns on its motivation—is the trade intended to profit from short-term price movements or is it incidental to core financial intermediation functions such as market marking and underwriting—which is difficult for regulators to determine.

The definitional challenges inherent in the current “define and ban” approach have resulted in a highly complex rule that entails high compliance costs and real risks of both under- and over-deterrence. Existing proposals for reform short of repeal entail tinkering with the same basic approach. We propose a new paradigm for achieving the Volcker Rule’s objectives: rather than define and ban proprietary trading, regulators should simply ban banks from paying traders on the basis of trading profits.

Our proposal takes advantage of the competition between firms in two key markets that are essential to proprietary trading: the securities market and the labor market for traders.

Firms that engage in the type of speculative trading targeted by the Volcker Rule compete in the securities market to identify and exploit trading opportunities. Importantly, however, making bets on short-term price movements of securities is inherently a zero-sum game. This is most obvious in the form of bilateral securities, like a credit default swap. If two parties make opposing bets using a credit default swap, then if the reference security defaults, the buyer will make money on the contract and the seller will lose money—and vice-versa if the reference security does not default. Speculating on short-term price movements of securities is fundamentally similar. The securities market as a whole will generate some total return. Short-term buying and selling of securities only affects who gets what share of that total return.

One implication of the zero-sum nature of speculative trading is that the returns to the activity depend on the relative skill of competing traders. Skilled professional traders compete with each other to seek out profitable trading opportunities generated by investors who trade for non-speculative reasons and by other speculative traders. In order to profit systematically from trading, a trader must be better at predicting price movements than the counterparties with which she trades, which include other speculative traders. The firms that hire and effectively motivate the best traders will generally build profitable trading businesses. Firms that are unable to do so, however, engage in proprietary trading at their own peril.

Reflecting this, the second key market in which firms that engage in proprietary trading compete is the labor market for traders. Both banking entities covered by the Volcker Rule and financial institutions outside of its scope, such as hedge funds, compete to hire the best traders. A common incentive compensation regime used to attract and motivate traders—employed by both hedge funds and by proprietary trading desks at banks—pays the individual trader a fraction of her trading profits. Such incentive compensation serves both a screening and effort-inducing function. More talented traders are more willing to take such incentive contracts because they are more confident that they will produce the trading profits needed for a big payday; and traders will have strong incentives to exert effort to identify and exploit profitable trading opportunities on behalf of the firm.

To achieve the objectives of the Volcker rule, we propose that banks be prohibited from basing compensation on trading-based profits. Our prohibition would encompass both ex ante compensation on trading-based profits (such as contracts or non-legally binding representations that the individual’s pay will be tied to their trading profits) and ex post compensation (such as discretionary bonuses the amount of which set based on a trader’s trading profits). Violations of this rule would result in a fine to the entity, claw-back of the individual’s impermissible incentive pay, and potential criminal liability for intentional violations.

Our proposal is based on a simple insight that follows from the competition between proprietary trading firms. Prohibiting banking entities from paying individuals based on their trading profits would put them at a substantial disadvantage to unregulated entities like hedge funds in the labor market for traders. Because of the zero-sum nature of betting on short-term price movements, firms that can only attract sub-par traders—the “B-team”—do not merely stand to make lower profits than firms with traders in the A-team, they stand to make losses. Put simply, if a firm cannot attract and motivate the best trading talent, the firm is better off staying out of the speculative trading game altogether. Thus, banning banking entities from paying individuals based on their trading profits would create powerful incentives for banks to cease such trading.

Our simple compensation-based approach would likely be more effective at ending speculative trading at banks—and do so at lower cost—than the complex and loophole-ridden current approach. Under the define-and-ban approach, banks would still want to engage in speculative proprietary trading, but are constrained by the fear of liability if they engage in such trading that violates the rules and their activities are detected. Banks will thus have incentives to exploit gaps and ambiguities in the define-and-ban regime to engage in speculative trading that is, at least arguably, not prohibited as well as to conceal the true nature of any speculative trading from their regulators. These incentives, in turn, necessitate the complex regulation and costly enforcement that characterize the current regime.

Under our compensation-based approach, by contrast, banks will no longer want to engage in speculative trading. Banks will thus come up with their own schemes to control the trading activities in their market making, hedging, and underwriting operations. Moreover, if traders will not receive compensation based on their trading profits, they will likewise lack incentives to engage in underhanded speculative trading. Engaging in such trading, against bank guidelines, would not earn, say, a market maker higher pay, but may lead her to lose her job. A bank’s incentives and ability to inhibit speculative trading under a ban on profit-based compensation are thus much stronger than under the define-and-ban approach.

An additional advantage of our approach is that enforcement of the ban on compensation-based profits need not be absolute to achieve the Volcker rule’s objectives. As long as a trader does not anticipate receiving a share of her trading profits, even a compensation scheme in which traders turn out to receive a share of profits will not have the screening and effort-incentive functions the bank desires. And as long as the ban substantially reduces the percentage share of profits that a trader expects to receive, a bank will be at a significant competitive disadvantage in competing for the best traders with unregulated entities. Even a relatively simple enforcement regime that fails to deter some ex post profit-based compensation will suffice. Our compensation-based approach is hence likely to be both simpler and more effective than the current define-and-ban approach.

The complete paper is available for download here.

August 18, 2017
"Token Sales" & ICOs: Food for Thought
by Broc Romanek

In response to my recent blog about "initial coin offerings" (also known as "token sales"), Margaret Rosenfeld of Smith Anderson sent me this interesting note:

1. It’s Real – The crypto-economy is a reality and this is not fringe anymore – but frontier. I can remember when I practiced outside the U.S. before Regulation S was adopted. As practitioners, we had to grapple with how to fit into the SEC regulation regime. There were many cowboys, there were many conservatives and there were many of us right down the middle, which is where Regulation S ended up being.

2. Bankers Are "In" – There are many people taking advantage of the crypto-economy. Bankers that will do an accredited investor ICO for you in exchange for 50% of the raise are using the SEC’s Section 21(a) Report to tell people that the SEC is coming down hard on ICO’s and everything done will be considered a "security." Why are they promoting this so strongly? Very obvious.

3. Millennials Love It – The driver of the crypto-economy is the millennial generation, which now has purchasing power. They want disruptive, socially conscious ways that differ from their elders.

4. SEC’s Position Is Howey Test Applies – Most of the law firm memos written about the SEC’s Section 21(a) Report note that it didn’t state that every ICO is a securities offering. The Howey test applies. Many digital assets are being sold primarily for non-economic purposes. Note that many of us active in the crypto-economy are working to use consistent nomenclature and call these "Tokens" and "Token Sales" rather than "Coins" and "Initial Coin Offerings."

By the way, here’s an example of a Token Sale that is trying to do it the right way after the SEC’s Section 21(a) Report.

5. Game Theory Involved – There is a lot of "game theory" involved in this economy. Millennials grew up on gaming.

6. The Securities Law Question – This is the most important question facing the cryptoeconomy right now on the regulator front: If the primary purpose for someone’s purchase of a Token is for a non-investment reason – but the Token’s value can increase or decrease, does that make it a security?

Think of Chuckie Cheese, a millennial breeding ground. Kids put money into machines to play the games. They got tickets. They compete with their friends to get tickets and to see who is the best at the game and has the most tickets at the end. The tickets end up having a value because they can be traded in for cheap trinkets. Are the kids putting the money into the machines to play the games, to compete and be the big winner or for the trinkets (which shows value)? My kids often went home with tickets in their pockets. My son actually stockpiled his tickets.

In the case of tokens, the Buyer is primarily buying for something other than a potential investment. For example, the Buyer may get a right to participate in a future event to vet and approve projects of the company (I purposefully use those words rather than voting). As a company builds a community of tokenholders and grows more successful, those tokens can increase in value. If there is a limited supply of tokens and a demand builds to have those tokens to join the community, a market develops to trade those tokens. So, will the SEC take the view that those tokens, which a buyer bought for a non-investment purpose, is a security because their value can increase?

Think of it this way. I buy a house in a nice community. It has a HOA and I have a vote to decide where HOA money is being spent and other HOA matters. If it is a good HOA, arguably the right I have to vote (my Token) and participate in community activities may be increasing the value of that community and my token. If my house goes up in value, is that a security?

7. Moving Outside the US Probably Doesn’t Solve – Does incorporating your company in the Caymans and stating that "US citizens cannot participate" work? Law firms out there are advising this and allowing securities to be offered. Really? These websites are not blocking ISP addresses in the US. Putting your company offshore and allowing offering materials flow into the US does not mean you are not subject to the US securities laws (uh, Regulation S anyone?).

Individuals may think they are protecting themselves – but if you are physically on the ground in Florida and doing this, I expect the SEC Staff will be calling you.

Six Possible Approaches

AND, the people participating in this economy from the beginning are trying to be disruptive. They want to make changes to the world and create a global currency that helps all. They don’t want to limit things to "accredited investors." So here are six approaches that I see:

– Structure it as a true utility sale – a Token Sale. It must be a product that has real rights and not a primary purpose for investment. And you must say that clearly and often in your disclosure.

– When you launch your pre-sale, you must already know clearly what those rights are and state them. You can add to those rights, but you must analyze before the pre-sale (which is a right to be converted into the eventual token sold at a discount) whether it is a utility or a security. Pretty obvious but many out there are diving in without doing this and being advised that it is okay.

– Anti-fraud applies. Duh. Don’t lie. Disclose risks.

– Don’t fuss around with the offshore and limits. Pillar did this and found that the limits killed its raise. It restructured. Folks are smart and wonder why are you putting this in the Caymans.

– If it is not a utility, structure is as a security. Do it right. And let’s as a community try to find bankers who will not gouge the companies with crazy fees.

– Right now, 506(c) approach is what is being done for the private placements. This is good. BUT I would like to work with the SEC to see if we can use Form 1-A to come up with a standard ICO approach. I think it could work but the SEC has to be willing to be nimble about review on this.

I have been around a bit – practicing securities law since 1997 – and seen many trends. This is a paradigm shift in the economy. I was in Jakarta a month ago and watched a waiter pull out his phone so that he could buy into an ICO. I got to talking with him and learned that the stability of cyber-currency was a huge attraction for Indonesians.

I am usually a debunker of trends – but I predict in 10 years there will be a global crypto-currency that dominates. Remember how we grew up and there were just three channels on TV! Could you imagine sitting in front of a TV with 300 when you were 10? The future is now. Believe it or not, there are already 10 token/coin offerings that are targeted to be announced at Burning Man at the end of the month…

Broc Romanek

August 18, 2017
This Week In Securities Litigation (Week ending August 18, 2017)
by Tom Gorman

The SEC filed an insider trading case this week based on three separate trading chains that netted $5 million in trading profits, all back to a New York City bank official. The Manhattan U.S. Attorney’s Office filed a parallel case in which the tipper and the father of his girlfriend have pleaded guilty. A 54 count indictment was filed against the others.

KMPM and one of the firm’s engagement partners were named as Respondents in an administrative proceeding. The action centered on the failure of the firm to properly audit the main asset of Miller Energy, the defendant in a settled enforcement action based on the improper valuation of the asset which was the subject of the audit. The firm agreed to adopt an extensive series of undertakings and pay a $1 million penalty as part of the resolution of the case.

The Commission also filed two offering fraud actions last week, two proceedings against investment advisers, one of which was based on the improper allocation of certain expenses while the other was involved overcharging fees and expenses. Two proceedings named as Respondents COOs of advisers for failing to maintain the proper records. Finally, an "all in the family" insider trading case was brought, centered on an insider wife and trading by her husband, his father and brother and a family friend.

SEC Enforcement – Filed and Settled Actions

Statistics: Last week the SEC filed 4 civil injunctive case and 5 administrative proceeding, excluding 12j and tag-along proceedings.

Insider trading; SEC v. Rivas, Civil Action No. 1:17-cv-06192 (S.D.N.Y. Filed August 16, 2017) names as defendants Daniel Rivas, formerly an employee in the capital markets technology group of a bank in New York City, James Moodhe, the father of Mr. Rivas’ girlfriend and Roberto Rodriguez, Rodolfo Sablon and Jhonathan Zoquier, all friends of Mr. Rivas, and Michael Siva and Jeffrey Rogier, respectively a friend of Mr. Moodhe and a friend of Mr. Zoquier. Over a period from October 2014 through April 2017 the complaint alleges an insider trading scheme involving tips on 30 corporate deals that resulted in over $5 million in illegal trading profits. Generally, the scheme involved three tipping chains. In the first chain tips went from Mr. Rivas to James Moodhe who had about $2 million in trading profits; he in turn tipped Michael Siva who had about $880,000 in profits; he tipped a client who had about $300,000 in profits; the second involved tips from Mr. Rivas to Roberto Rodriguez and Rodolfo Sablon who together made about $2 million in trading profits; Mr. Rodriguez tipped a friend; the third involved tips from Mr. Rivas to Jhonatan Zoquier who had about $30,000 in trading profits; he in turn tipped his friend Jeffrey Rogiers who had about $50,000 in trading profits and tipped two others. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. The Manhattan U.S. Attorney’s office filed a parallel criminal action. There a 54 count indictment was brought against Messrs. Siva, Rodriguez, Sablon, Zoquier and Rogiers. It charges conspiracy, wire fraud and multiple counts of securities fraud and fraud in connection with a tender offer. Previously, Messrs. Rivas and Moodhe pleaded guilty to charges of conspiracy, securities fraud, fraud in connection with a tender offer, wire fraud and making false statements to law enforcement officials. See Lit. Rel. No. 23911 (Aug. 16, 2017).

Offering fraud: SEC v. Vergeous LLC, Civil Action No. 1:17-cv-23116 (S.D. Fla. Filed August 16, 2017) is an action which names as defendants Vergeous LLC, Dream Team Partners LLC and Paul Renfroe. Both entity defendants were founded by Mr. Renfroe who is a securities law recidivist barred by FINRA. The complaint alleges that over a three year period beginning in June 2013 defendants raised about $1.2 million from 33 investors. Investors were told that the money would be used to fund video game projects undertaken initially by Vergeous and later by a joint venture between the two entities. Misrepresentations were made to investors during the offerings regarding Mr. Renfroe’s disciplinary history, the use of the investor funds and Dream Team’s 100% ownership of the intellectual property rights for all of the joint video game projects. The complaint alleges violations of Securities Act Sections 5(a) and 5(c), each subsection of Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23909 (Aug. 16, 2017).

Expense allocation: In the Matter of Capital Dynamics, Inc., Adm. Proc. File No. 3-18113 (August 16, 2017) names the registered investment adviser as a Respondent. The adviser acted as the manager of two funds. From March 2011 to July 2015 the adviser improperly allocated $1,273,148 in expenses to one of the funds, contrary to its organizational documents. The Order alleges violations of Advisers Act Sections 206(2) and 206(4). To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, the adviser will pay a penalty of $275,000. Previously, the adviser reimbursed the fund. The Commission considered the cooperation and remedial acts of the adviser in resolving this action.

Financial fraud: SEC v. DiMaria, Civil Action No. 15-cv-07035 (S.D.N.Y.) is a previously filed action which names as defendants Edward DiMaria and Matthew Gamsey, two former executives of Bankrate Inc. The complaint alleged that defendants manipulated the financial results of the company to meet analyst expectations. It also claimed that Mr. DiMaria sold shares in the firm while they were at an artificial price. The Court entered final judgments by consent. Mr. DiMaria was enjoined from future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2) and 13(b)(5). He will also pay a penalty of $231,158.56 and is barred from serving as an officer or director of a public company for five years. Mr. Gramsey was enjoined from future violations of Securities Act Section 17(a)(3) and Exchange Act Sections 13(a) and 13(b)(2). He will pay a penalty of $60,000. Each defendant agreed to the entry of an order suspending him from appearing or practicing before the Commission as an accountant. Mr. DiMaria may apply for reinstatement after five years while Mr. Gramsey can apply after three years.

Audit violations: In the Matter of KPMG LLP, Adm. Proc. File No. 3-18110 (Aug. 15, 2017) is an action which names as Respondents the audit firm and John Riordan, CPA, who served as the engagement partner on the review and audit of the financial statements of Miller Energy Resources, Inc. During fiscal 2010 Miller Energy acquired certain oil and gas interests in Alaska for about $4.5 million. The assets were booked at a value of $480 million. That valuation was improper and the subject of a now settled SEC enforcement action. In auditing the financial statements of Miller Energy Respondents failed to properly assess the risk associated with the engagement or properly staff the engagement. They also overlooked certain evidence regarding the valuation of the assets and failed to exercise the requisite degree of professional care and skepticism. When the firm’s national office became aware of the issue it failed to take the proper steps. The Order alleges violations of Exchange Act Section 13(a). To resolve the proceeding each Respondent agreed to a series of undertakings. The firm also consented to the entry of a cease and desist order based on the Section cited in the Order and to a censure. The firm will pay disgorgement of $4,675,680, prejudgment interest and a penalty of $1 million. Mr. Riordan is denied the privilege of appearing or practicing before the Commission as an accountant with the right to apply for reinstatement after two years. He will pay a penalty of $25,000.

Filings/books, records: In the Matter of Diane W. Lamm, Adm. Proc. File No. 3-18112 and 3-16463 (Aug. 15, 2017). Respondent Lamm served as the COO for Aegis Capital, Circle One and Capital L Group, LLC, all of whom were formerly registered with the Commission as investment advisers. The three entities failed to file timely and accurate reports with the Commission while registered. Each had outsourced its compliance obligations to Strategic Counseling Advisors, LLC. Between 2010 and 2011 Aegis Capital and Circle One failed to keep the required books and records. In August 2011 the staff requested that the three entities produce certain books and records. The firms were not able to comply. Respondent Lamm, as COO was responsible for keeping the books and records. Previously, Ms. Lamm pleaded guilty to two counts of securities fraud. The Order alleges violations of Advisers Act Sections 204 and 207. To resolve the proceeding Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. She is also subject to an association bar regarding the securities business. See also In the Matter of David L. Osunkwo, Adm. Proc. File No. 3-16463 (Aug. 15, 2017)(Respondent Osunkwo was designated at the CCO of Aegis and Circle One through a consulting firm; the underlying conduct is essentially the same as above; resolved with a cease and desist order based on Advisers Act Sections 204 and 207, an a suspension from the securities business and the right to engage in penny stock offerings for twelve months and payment of a $30,000 penalty).

Fee disclosure: In the Matter of Coachman Energy Partners LLC, Adm. Proc. File No. 3-18109 (Aug. 14, 2017) names as Respondents the registered investment adviser and Randall Kenworthy, its sole owner and CEO. From 2011 through 2014 the firm served as an adviser to four private oil and gas funds. It failed to properly disclose the manner in which it calculated fees, overcharging the entities by about $1.1 million on management fees and $449,000 for expenses. Respondents also failed to properly advise one of the funds regarding a transaction with an affiliated entity about the conflict. The Order alleges violations of Advisers Act Sections 206(2) and 207. To resolve the matter each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. The firm will pay disgorgement of $2,088,087 along with prejudgment interest subject to certain offsets and credits and a penalty of $50,000. Mr. Kenworthy will also pay a penalty of $50,000.

Offering fraud: SEC v. Tennstar Energy, Inc., Civil Action No. 4:17-cv-00151 (S.D. Ga. Filed Aug. 11, 2017) is an action which names as defendants the firm and David Greenlee, David Stewart and Richard Underwood. Over a three year period beginning in January 2016 Messrs. Greenlee and Stewart, with assistance from Defendant Underwood, sold more than 150 investors at least $15 million in interests in various limited partnerships and joint ventures through Tennstar and another entity. Investors were told that their funds would be used to acquire working interests in certain wells and to employ certain enhanced oil recovery techniques. They were also told that the entities involved would be managed by an experienced person. The claims were false. Much of the money was diverted to fees and other expenses and Tennstar was not managed by an experienced person. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The action is pending. The U.S. Attorney’s Office for the Southern District of Georgia filed a parallel criminal action.

Insider trading: SEC v. Hovannisian, Civil Action No. 1:17-at-00617 (E.D. Ca. Filed Aug. 10, 2017) is an action which names as defendants Damon Hovannisian, Vernon Hovannisian, Vincent Hovannisian and Eddie Arakelian. Damon Hovannisian’s wife was employed at International Rectifier Corp. She learned that the firm would be acquired by Infineon Technologies AG. Prior to the deal announcement Damon learned about the deal from his wife. He traded through the account of a friend and told his father Vernon, brother Vincent and family friend Eddie Arakelian. Each traded and sold after the deal announcement. The complaint alleges violations of Exchange Act Section 10(b). To resolve the case each defendant consented to the entry of a permanent injunction prohibiting future violations of the Section cited in the complaint. In addition, Damon will pay disgorgement of $3,194.49, prejudgment interest and a penalty of $155,756.04; Vernon will pay disgorgement of $111,756.23, prejudgment interest and a penalty equal to the amount of the disgorgement; Vincent will pay disgorgement of $5,635.12, prejudgment interest and a penalty equal to the amount of the disgorgement; and Mr. Arakelian will pay disgorgement of $35,781.20, prejudgment interest and a penalty equal to the amount of the disgorgement. See Lit. Rel. No. 23901 (Aug. 11, 2017).

Cooperation: SEC v. Balaszczah, Civil Action No. 17-cv-03919 (Aug 8, 2017) is an insider trading case based on political intelligence regarding Medicare and Medicaid information improperly disclosed from Medicare & Medicaid Services or CMS. One of the defendants who is alleged to have received the information is Jordan Fogel, an analysis for an undisclosed adviser. Mr. Fogel entered into a cooperation agreement with the SEC. In connection with that agreement he consented to the entry of a permanent injunction based on Securities Act Section 17(a) and Exchange Act Section 10(b). The Court will determine the amount of disgorgement, prejudgment interest and penalties. The U.S. Attorney’s office has a parallel criminal case pending. See, Lit. Rel. No. 23899 (Aug. 8, 2017).

August 18, 2017
No-Action Letter for Deere & Company Permitted Exclusion of Emissions Elimination Proposal
by Allison Takacs

In Deere & Co., 2016 BL 406370 (Dec. 5, 2016), Deere & Company (“Deere”) requested the staff of the Securities and Exchange Commission (“SEC”) permit omission of a proposal submitted by Christine Jantz (“Shareholder”) requesting the board of directors generate a plan to reach net-zero greenhouse gas emissions by the year 2030. The SEC agreed to issue the requested no-action letter allowing for exclusion of the proposal under Rule 14a-8(i)(7).

Shareholder submitted a proposal stating:

  • RESOLVED: Shareholders request that the Board of Directors generate a feasible plan for the Company to reach a net-zero [greenhouse gas] emission status by the year 2030 for all aspects of the business which are directly owned by the Company, including but not limited to manufacturing and distribution, research facilities, corporate offices, and employee travel, and to report the plan to shareholders at reasonable expense, excluding confidential information, by one year from the 2017 annual meeting.

Deere argued the proposal may be excluded from its proxy materials under Rule 14a-8(i)(7).

Rule 14a-8 provides shareholders with the right to insert a proposal in the company’s proxy statement. 17 CFR 240.14a-8. The shareholders, however, must meet certain procedural and ownership requirements. The Rule includes thirteen substantive grounds for exclusion. For a more detailed discussion of the requirements of the Rule, see The Shareholder Proposal Rule and the SEC.

Under Rule 14a-8(i)(7), a company may exclude proposals that relate to the company’s “ordinary business” operations. The SEC understands “ordinary business” to mean the issues that are fundamental to a company’s management abilities on a day-to-day basis. If the proposal, however, raises a significant social policy issue, the proposal may not be excluded as long as a “sufficient nexus exists between the nature of the proposal and the company.” For additional explanation of this exclusion see Megan Livingston, The “Unordinary Business” Exclusion and Changes to Board Structure, 93 DU Law Rev. Online 263 (2016), and Adrien Anderson, The Policy of Determining Significant Policy under Rule 14a-8(i)(7), 93 DU Law Rev. Online 183 (2016).

Deere argued for omission under Rule 14a-8(i)(7) because the proposal detailed how the board of directors should plan to reduce emissions and would “transfer responsibility for critical operational and production decision-making from the board and management to the shareholders”.  Deere further argued the social policy exception should not apply given the absence of a clear nexus between climate change and the machinery manufacturing business. Even if the SEC determined the nexus sufficient, the proposal sought to micromanage by imposing a time frame for complex policy implementation, thus the social policy exception still would not apply.

In response, the Shareholder argued catastrophic climate change implicated a significant policy issue with a clear nexus to Deere because large manufacturing companies had energy-intensive operations. The Shareholder further asserted the proposal did not micromanage as it gave Deere the flexibility to determine the means of greenhouse gas elimination and only provided an overall goal.

The SEC agreed with Deere’s reasoning, and concluded Deere may exclude the proposal under subsection (i)(7). The staff noted the proposal sought to micromanage the company by probing too deeply into complex matters beyond the shareholders purview. Therefore, the staff concluded it would not to recommend enforcement of action for the proposal’s omission from proxy materials.

The primary materials for this case may be found on the SEC website.

View today's posts

8/18/2017 posts

CLS Blue Sky Blog: PwC Explains Why Fraud Governance Means More Than Just Compliance
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Losing Stockholder Standing to Assert and Enforce Corporate Inspection Rights
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Regulating Motivation: A New Perspective on the Volcker Rule Blog: "Token Sales" & ICOs: Food for Thought
SEC Actions Blog: This Week In Securities Litigation (Week ending August 18, 2017)
Race to the Bottom: No-Action Letter for Deere & Company Permitted Exclusion of Emissions Elimination Proposal

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