Securities Mosaic® Blogwatch
August 28, 2015
Should Agents Operating in the U.S. Financial Markets Have "Skin in the Game"?
by Asaf Eckstein

The Literature on agency theory is largely focused on relationships in which one party (the principal) engages another party (the agent) to perform some service on the principal's behalf, the performance of which involves delegating some decision making authority to the agent. This literature explains that when the principal and the agent do not share the same interests, a conflict may arise; an "agency problem."[1] Generally speaking, two main governance devices have been suggested to help align the interests of principals and agents in order to eliminate conflicts of interest and thereby enhance the welfare of principals. The first device, termed "monitoring," refers generally to any efforts exerted by the principal to track the agent's behavior and ensure that the agent is acting in the principal's interests. Such efforts, of course, generate monitoring costs, which can be significant. The second device, termed "bonding," refers to the placement of contractual restrictions on the agent's activities, or incentive structures somehow tied to the principal's value. In contrast to monitoring, described above, these bonding costs associated with tracking the agents' behavior are borne by the agents themselves through self-monitoring. Agents will typically bear these costs, since effective self-monitoring creates confidence on behalf of principals that the agents will not act inappropriately.[2] To complete the picture, there is another element called "residual loss," which reflects the costs that monitoring and bonding do not prevent. The sum of monitoring costs, bonding costs and residual loss represents the total agency cost.[3]

Traditionally, most corporate-law scholarship has been focused on agency problems in-house; that is, conflicts of interest between managers and shareholders, conflicts among shareholders, and conflicts between shareholders and the corporation's other constituencies.[4] However, scant literature and very little theory, if any at all, exist regarding potential agency problems between a corporation's stakeholders (mainly shareholders and bondholders) and "outside" agents of the corporation, such as credit rating agencies, proxy advisory firms, and a specific type of shareholder activists (widely known as "corporate gadflies",) that operate in today’s financial markets on behalf of stakeholders.

These outside agents dominate the U.S. capital market today, and the increasing reliance of public companies and their stakeholders on these agents has become a hotly debated topic in corporate governance. In particular, the endemic reliance on these agents, according to some commentators, results in significant agency problems arising when agents pursue personal interests at odds with stakeholders' interests. A major concern voiced by many is that while stakeholders possess an actual stake in public companies, the outside agents do not have a vested interest in the success or failure of the company, except to the extent that the company represents to them a source of revenue, so they largely do not bear the costs of their bad decisions. Therefore, the argument goes, when agents' incentives are not aligned with those of stakeholders, the stakeholders will be directly harmed by any loss in the value of their investment resulting from agents' bad decisions, while agents will frequently suffer no ill effects from a decline in a company’s value. This discrepancy is argued to result in a misalignment of interests between corporate stakeholders and outside agents. In other words, outside agents have been increasingly criticized for not having skin in the game – a device that is meant to incentivize agents to exert effort and to make the right decisions, ultimately for the sake of stakeholders. In this paper the skin in the game can be conceptualized as a bonding device; it is a mechanism that connects the principals to the agents through contractual and property interests, and does not rely upon the principals' ability to monitor the agents’ performance.

The skin in the game debate has been argued in reference to almost all of the outside agents in the U.S. capital market. Credit rating agencies have been persistently criticized for offering rating while having "only reputational capital at risk" based on their performance;[5] proxy advisory firms have been accused of significantly influencing shareholder voting in the companies about which they provide voting advice without "having an actual economic stake" in those companies, and therefore no pecuniary interest in the actual outcome of a shareholder vote;[6] and certain type of shareholders activists-equity shareholders who hold a relatively small number of shares (if any at all) for the purpose of gaining access to shareholder meetings and proxy materials in an effort to influence the corporation's activities, frequently termed "corporate gadflied"– have been heavily criticized for using the "loose rules" that allow them to act without sufficient economic stake in companies, to "hijack the shareholder proposal system,"[7] and to hold Corporate America "hostage."[8] Similar arguments have been raised with respect to external auditors,[9] mortgage originators (including S&Ls, commercial banks, mortgage banks or unregulated brokers);[10] and even financial regulators.[11] In short, all of these outside agents are subject to criticism because they have no stake in the corporations that are affected by their actions; they have no skin in the game.

I propose that the debate over the 'skin in the game' notion has suffered from the lack of a general theory describing when having skin in the game may be valuable to an agency relationship and when, in contrast, it may be worthless or even harmful. It seeks to help fill that void by attempting to answer the question:–When does giving agents skin in the game have significant value? Building upon agency theory foundations, combined with organizational and psychological perspectives and important theoretical extensions, I propose a set of criteria which could be used to predict the value of giving agents skin in the game in any particular circumstance.

In brief summation, skin in the game is typically needed when two factors are present: First, the agent's behavior and amount of effort are unobservable by the principal, or when information about the agent's work is difficult and costly to obtain. Second, the outcome of an agent's behavior is not difficult to measure. My article identifies several other factors which tend to indicate that skin in the game would be beneficial: when the agent's competitiveness is not significantly dependent on its reputation, when the corporation (and not the stakeholders themselves) is responsible for selecting and compensating the agent, when the agent is not expected to act as a completely objective and disinterested third party, and when the agent is expected to exercise a significant amount of proactivity and discretion. It is only after analyzing all of these potential factors that a complete picture emerges of the potential efficacy of employing a skin in the game device with regard to an outside agent; my article's explanation and application of those factors is intended to guide corporations and policy makers in their own efforts to determine whether to give outside agents skin in the game.

To demonstrate how such an analysis should be undertaken, my article applies these factors to determine whether skin in the game would generally be appropriate with regard to two kinds of outside agents: credit rating agencies and proxy advisory firms. The article concludes that while skin in the game would likely be beneficial in the context of credit rating agencies, it should probably not be employed with regard to proxy advisory firms.

It is worth noting at the outset that in general, skin in the game can be any direct economic interest of the agent. It can be the agent’s ownership of the shares or debt of a public company, the value or success of which may be affected by the agent's behavior and output;[12] or some kind of requirement that an agent must disgorge profits that the agent received in exchange for subpar services.[13] It is important to note that in much of the economic literature the notion of skin in the game can also include potential indirect economic interests, such as reputational damage resulting from poor performance.[14] This is because such harm to an agent's indirect economic interests can cause the agent to suffer significant loss.[15]

My treatment of the subject, however, restricts the definition of "skin in the game" to situations in which the agent has an actual ownership interest in the principal company. The definition is restricted in this manner to focus analysis on the most frequent criticism leveled at outside agents: that they are not accountable because they have no vested interest in their principal's value. The extent to which an outside agent's indirect economic interests will tend to keep it acting in the corporation's interests, and the relative effectiveness of such indirect interests in comparison to the direct interests discussed in this article, are important topics for further research but are beyond the scope of the present inquiry.


[1] Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 308 (1976). In fact, the notion of "agency theory" can be traced back to Adolf Berle & Gardiner Means, The Modern Corporation and Private Property (1932) (concerning the separation of ownership and control), and in its most general, undeveloped form, to Adam Smith, The Wealth of Nations 741 (1776) ("...[B]eing the managers rather of other people's money than of their own, it cannot well be expected, that they will watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own").

[2] Jensen & Meckling, supra note 1.

[3] Id.

[4] See, e.g., Kathleen M. Eisenhardt, Agency Theory: An Assessment and Review, 14(1) Academy of Mgmt. Rev. 57, 59 ("Also, positivist researchers have focused almost exclusively on the special case of the principal-agent relationship between owners and managers of large, public corporations."); John Armour et al., What is Corporate Law, in The Anatomy of Corporate Law 1,2 (Reinier Kraakman et al. eds., 2d ed., 2009); Zohar Goshen & Richard Squire, Principal Costs and Governance Structures in the Theory of the Firm, ("Most corporate-law scholarship focuses on conflict between managers (broadly defined to include directors) and shareholders"). Recently, a progress has been made by Ronald J. Gilson and Jeffrey N. Gordon, who has extended corporate discipline to include "a new agency problem that results from the gap between the interests of institutional record owners and beneficial owners." See Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Colum. L. Rev. 863 (2013).

[5] Daniel Bergstresser, Randolph Cohen & Siddharth Shenai, Skin in the game: The performance of insured and uninsured municipal debt (2010), See also Credit Rating Agency Survey Results, CFA Institute (June, 2014), (This is a summary of a survey that was conducted among 20,379 CFA Institute members on 20 May 2014, that agreed that rating agencies need to have skin in the game).

[6] SEC Concept Release on the U.S. Proxy System (Release Nos. 34-62495, IA-3052, IC-29340; File No. S7-14-10, 75 Fed. Reg. 42,982) 43,011 (July 14, 2010) [hereinafter: SEC Concept Release], available at See also Examining the Market Power and Impact of Proxy Advisory Firms, Hearing before the Subcommittee on Capital Markets and Government Sponsored Enterprises of the Committee on Financial Services U.S. House of Representatives 9 (June 5, 2013) [hereinafter Hearing before the House of Rep.], available at ("It feels like we are giving power over the board to a consultant without a horse in the race.").

[7] Commissioner Daniel M. Gallagher, Remarks at the 26th Annual Corporate Law Institute, Tulane University Law School: Federal Preemption of State Corporate Governance (March 27, 2014), [hereinafter: Gallagher speech] ("Requiring a sufficient economic stake in the company could lead to proposals that focus on promoting shareholder value rather than those championed by gadflies with only a nominal stake in the company [...] This could be an opportunity to address the practice of 'proposal by proxy' where the proponents of the resolution – typically one of the corporate gadflies – has no skin in the game, but rather receives permission to act 'on behalf' of a shareholder that meets the threshold [...] Making adjustments along these lines will go a long way towards ensuring that the proposals that make it onto the proxy are brought by shareholders concerned first and foremost about the company – and the value of their investments in that company – not their pet projects.").

[8] The New York Times, Grappling With the Cost of Corporate Gadflies (Aug. 19, 2014). It is worth noting that while many of the outside agents mentioned above work directly for either the corporation or on behalf of corporate stakeholders, the loyalties of shareholder activists as corporate gadflies are less clear. Ostensibly, these people advocate on behalf of other stakeholders, attempting to persuade them to take certain initiatives. However, they often act in their own interests as well, pursing personal agendas or pushing for corporate action that will benefit them disproportionately to, or even at the expense of, their fellow stakeholders. It is nonetheless appropriate to consider this group of extremely influential corporate constituents when analyzing the concept of "skin in the game" because, as will be demonstrated, that particular bonding device may have similar implications in the context of corporate gadflies as in the cases of the other outside agents examined in this Article.

[9] Sharon Hannes, Compensating for Executive Compensation: The Case for Gatekeeper Incentive Pay, 98 Cal. L. Rev. 385, 390 (2010).

[10] Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, Submitted by the Financial Crisis Inquiry Commission xxiv (Jan. 2011), [hereinafter: The Crisis Inquiry Report]. See also Securities and Exchange Commission, Skin in the Game: Aligning the Interests of Sponsors and Investors (Oct. 22, 2014), (with regard to asset-backed sponsors).

[11] Todd Henderson & Frederick Tung, Pay for Regulator Performance, 85 S. Cal. L. Rev. 1003 (2012) (offer a pay-for-performance approach for bank regulators in order to help reducing the incidence of future regulatory failures).

[12] Such an interest could be, for instance, ownership of shares in the principal corporation. In the case of a proxy advisory firm, for example, skin in the game could be ownership of shares in the company for which the firm provides voting advice. In the case of a credit rating agency, skin in the game could be ownership of debt securities issued by a company that the agency is rating. See infra Section I.

[13] See, e.g., John Patrick Hunt, Credit Rating Agencies and the "Worldwide Credit Crisis": The Limits of Reputation, The Insufficiency of Reform, and a Proposal for Improvement, Colum. Bus. L. Rev. 109 (2009) (suggesting that credit rating agencies’ incentive problem could be corrected by "requiring an agency to disgorge profits on ratings that are revealed to be of low quality by the performance of the product type over time, unless the agency discloses that the ratings are of low quality."). It should be noted in advance that although the majority of outside agents provide services for a fee, corporate gadflies represent a unique class of outside agents who do not receive revenue-at least from the principal corporation-in exchange from their activities. They will be discussed infra.

[14] See, e.g., Jensen & Meckling, supra note 1, at 308 (refer to bonding costs as both "non-pecuniary as well as pecuniary" costs); Nassim N. Taleb & Constantine Sandis, The Skin in the Game Heuristic for Protection Against Tail Events, 1 Review of Behavioral Economics 1, 4 (2014) ("Note that our analysis includes costs of reputation as skin in the game...").

[15] In fact, reputational damage—considered secondary to the primary risk—can be more costly than direct damage. See, e.g., Jonathan M. Karpoff, D. Scott Lee & Gerald S. Martin, The Cost to Firms of Cooking the Books, 43 J. Fin. & Quant. Analysis 581, 582 (2008).

The preceding post comes to us from Asaf Eckstein, a post-doctoral fellow at Bar Ilan University Law School and Bar-Ilan University Business Administration School.

August 28, 2015
Dodd-Frank Turns Five, What's Next?
by Bruce Heiman, Daniel Crowley, Giovanni Campi, Sean Donovan-Smith, K&L Gates
Editor's Note:

Daniel F.C. Crowley is a partner at K&L Gates LLP. This post is based on a K&L Gates publication by Mr. Crowley, Bruce J. Heiman, Sean P. Donovan-Smith, and Giovanni Campi.

The 2008 credit crisis was the beginning of an era of unprecedented government management of the capital markets. July 21, 2015 marked the fifth anniversary of the hallmark congressional response, the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). Dodd-Frank resulted in an extraordinary revamp of the regulatory regime that governs the U.S. financial system and, consequently, has significant implications for the U.S. economy and the international financial system.

Members of Congress recognized the fifth anniversary of Dodd-Frank in markedly different ways. House Financial Services Committee Chairman Jeb Hensarling (R-TX) has held two of a series of three hearings to examine whether the United States is more prosperous, free, and stable five years after enactment of the law. In contrast, Senator Elizabeth Warren (D-MA)-one of the leading proponents of the law-and other members of Congress have criticized the slow pace of implementation by the regulatory agencies. Meanwhile, Senate Banking Committee Chairman Richard Shelby (R-AL) is advancing the "Financial Regulatory Improvement Act of 2015," which seeks to amend a number of provisions of Dodd-Frank.

Five years after enactment of this landmark law, financial regulators continue to work to implement many of its provisions, and Congress has taken a number of steps to both assess the effectiveness of Dodd-Frank and to consider measures to amend it. As such efforts continue, one thing seems certain: the evolving regulatory responses to perceived shortcomings on one side of the Atlantic are likely to be echoed on the other.

OTC Derivatives

Among the over 315 regulatory rulemaking requirements contained in Dodd-Frank are several key rules related to cross-border security-based swaps that have not yet been finalized. Under Title VII of Dodd-Frank, the Securities and Exchange Commission ("SEC"), jointly with the Commodity Futures Trading Commission, is required to adopt new rules to heighten the regulation of swap markets. Pursuant to this requirement, the SEC recently proposed rules that would apply certain registration and disclosure requirements to non-U.S. companies engaging in security-based swap activities in the United States. Although these proposed rules have not yet been completed, the SEC has indicated that they were "designed to try to achieve greater transparency and oversight in cross-border security-based swap transactions." European Union ("EU") regulators continue to engage with these U.S. counterparts in hopes of achieving parity and recognition of the new regulatory regimes.

Systemically Important Financial Institutions

Another controversial area exemplifying the nature of the challenges that persist for U.S. and international financial regulators in regulating global financial activity is the designation of Systemically Important Financial Institutions ("SIFIs") and Global Systemically Important Financial Institutions ('G-SIFIs").

In the United States, Congress continues to debate the role of the Financial Stability Oversight Council ("FSOC") and its exercise of its authority under Dodd-Frank to designate SIFIs. Although the systemic risk posed by large, interconnected financial institutions is a perennial concern shared by both Democrats and Republicans in Congress, differences remain about how and whether certain institutions should be designated. For example, Senator Shelby's financial reform legislation includes provisions that would increase the threshold for the automatic designation of SIFIs from $50 billion in assets to $500 billion. These provisions have been roundly criticized by some Democrats in Congress and have been met with firm resistance from Obama Administration officials.

On the international front, earlier this year the Financial Stability Board ("FSB") and the International Organization of Securities Commissions ("IOSCO") published their second public consultation, which outlines a methodology to assess whether to designate asset managers as G-SIFIs. More recently, the FSB announced its decision to wait to finalize the assessment methodologies for nonbank, non-insurer G-SIFIs until its work on financial stability risks from asset management activities is completed. The influence of international developments on domestic financial services policy is a new dimension post-Dodd-Frank, as Republican members of the House Financial Services Committee have also raised concerns about the extent to which the FSB influences the FSOC's SIFI designation process. This will undoubtedly continue to be an area of congressional interest in the future. A key issue going forward is whether global regulators will diverge on the question of whether asset managers pose systemic risk.

Investor Protection

The SEC recently approved a pay ratio disclosure rule that it proposed in 2013, which will require public companies to disclose the ratio of the annual total compensation of the chief executive officer to the median of the annual total compensation of the company's employees. In addition, the SEC has proposed so-called "claw back" rules that would require corporate executive officers to pay back incentive-based compensation that had been awarded erroneously. Since a federal court threw out the SEC's so-called "proxy access" rule in 2011, there has been renewed discussion among shareholder advocates, regulators, and lawmakers about whether the SEC should write a new proxy access rule to make it easier for shareholders to nominate corporate directors. While members of Congress have recently pressed the SEC to do more about proxy access reforms, SEC Chair Mary Jo White suggested in a March 24, 2015 House Financial Services Committee hearing that the SEC does not currently intend to try to rewrite such a rule. Moving forward, members of Congress will likely continue to monitor the pace of rulemaking and examine on a substantive basis the potential effect of proposed rules. Institutional investors will continue to press for reforms on both sides of the Atlantic.

Consumer Financial Protection Bureau

Among the most controversial Dodd-Frank issues that remains a subject of considerable debate in Congress is the organizational and funding structure of the Consumer Financial Protection Bureau ("CFPB"). Senator Warren and the authors of Dodd-Frank envisioned the CFPB as the equivalent of the Consumer Product Safety Commission for financial products. While Democrats have touted the CFPB as a strong consumer watchdog that has returned billions of dollars to consumers, Republicans are pursing legislation that would subject the CFPB to the congressional appropriations process and that would put in place a bipartisan five-member commission, instead of the existing single director, to lead the agency. Opponents argue that these measures would weaken the CFPB and impede its ability to carry out its mandate under Dodd-Frank. Congress will likely continue to consider these and similar measures to modify the CFPB in the future.

Other International Developments

Just as Dodd-Frank implementation and debate continues, so too do comprehensive reform efforts in the EU. Notably, the European Commission ("EC") is expected to release an "Action Plan" in September 2015 to follow up on its ambitious "Green Paper" consultation launched earlier this year for a Capital Markets Union ("CMU"). An essential objective of the CMU, which is loosely modeled on U.S. capital markets but taking firmly into account European specificities, is to create a single market for capital by removing barriers to cross-border investments and diversifying funding of the European economy.

In addition to efforts to address systemic risk, the FSB also recently published a report that analyzes progress toward its recommendations for reforms to existing major interest rate benchmarks (such as LIBOR, EURIBOR, and TIBOR). Moreover, the report examines progress on the development and introduction of near risk-free interest rate benchmarks (or RFRs). Like the FSB, the EC, IOSCO, and others have focused on trying to ensure the integrity of benchmarks and have proposed to make benchmarks more reliable and less vulnerable to manipulation. The European Parliament and the EU member states are currently discussing a new EU regulatory regime for "benchmarks," including indexes. There is an open question as to whether U.S. regulators will consider the regulation of indexes.

Under Basel III, a comprehensive set of capital measures, the Basel Committee on Banking Supervision has moved to implement several notable financial reforms. In particular, the Basel Committee issued a final standard to require banks to maintain a net stable funding ratio ("NSFR") in relation to their on- and off-balance sheet activities. The NSFR is expected to become a minimum standard by January 1, 2018. Importantly, the Basel Committee has also issued a Liquidity Coverage Ratio to help ensure that banks have a sufficient level of high-quality liquid assets that can be readily converted to cash in private markets to meet the institution's liquidity needs for a 30-calendar-day liquidity stress situation.

Recently, calls for a financial transactions tax in the EU have reverberated in the United States, with several members of Congress publicly expressing support for such a tax to curb excessive risk-taking in the financial sector.


Five years after enactment of Dodd-Frank, the policy debates among policymakers continue to echo on both sides of the Atlantic. These debates center on the proper balance between the efficient allocation of capital through informed assumption of risk by investors on the one hand, and preserving the safety and soundness of the financial system by controlling risk on the other. The tension between these regulatory considerations not only helps to explain many of the transatlantic debates, but also presents opportunities for impacted stakeholders to influence them by advocating for sound and responsive policy solutions. In the United States, several Republican members of Congress have publicly noted their intent to actively pursue a strategy of attaching measures to amend Dodd-Frank to "must pass" legislation (on the heels of successfully repealing the so-called "swaps pushout" rule late last year). Toward that end, Senator Shelby recently included his financial reform legislation in a spending measure that cleared the full Senate Appropriations Committee on a party-line vote. Regardless of whether such efforts are ultimately successful, five years after enactment of Dodd-Frank, it is clear that the global debate over the scale and scope of financial regulation will continue.

August 28, 2015
This Week In Securities Litigation (Week ending August 28, 2015)
by Tom Gorman

The Sixth Circuit last week concluded that Morrison, which held that Section 10(b) does not have extraterritorial reach, is inapplicable to Advisers Act Section 10(b). The DC Circuit, on rehearing, reaffirmed its prior holding that a portion of the Commissions Dodd-Frank conflict rules violates the First Amendment.

SEC enforcement prevailed on a summary judgment motion in an action centered on false statements made by an issuer regarding a claimed cancer treatment. In addition, two new offering fraud actions were filed along with an insider trading case and another action centered on the misappropriation of funds in connection with an EB-5 program.


Statement: Commissioner Luis A. Aguilar issued a statement titled Enhancing the Commission’s Waiver Process (August 27, 2015). The statement calls for more transparency in the waiver process and a flexible approach while discussing a process adopted last year regarding conditional waivers (here).

SEC Enforcement - Litigated cases

False statements: SEC v. Cook, Civil Action No. 1:13-cv-01312 (S.D. Ind.) is an action against Timothy Cook, Xytos, Inc. and Asia Equities. The complaint alleged that beginning in 2010 Mr. Cook made materially misleading statements regarding the company, supposedly in the biomedical business, and a claimed cancer treatment. The SEC also alleged that he sold unregistered shares in the firm. In fact there was no treatment. The court granted summary judgment in favor of the Commission, concluding that Mr. Cook violated Securities Act Sections 5(a) and 5(c) and 17(a) and Exchange Act Section 10(b). The court imposed a permanent injunction, an officer and director bar, a penny stock bar and ordered disgorgement in the amount of $642,828. The Court will consider the amount of a civil penalty. Default judgments were entered against the two entities. See Lit Rel. No. 23328 (August 25, 2015).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 3 civil injunctive cases and 1 administrative actions, excluding 12j and tag-along proceedings.

Offering fraud: SEC v. Schumacher, Civil Action No. 15-6388 (C.D. Cal. Unsealed August 26, 2015) is an action which names as defendants Harrison Schumacher and his two firms, Quantum Energy LLC and Quaneco LLC. Since 2010 the defendants have raised $12.3 million through a series of five offerings from over 300 investors. Those investors were told the funds would be used to explore for and develop oil and gas properties. Instead they were diverted to other uses by the defendants. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending. See Lit. Rel. No. 15-6388 (August 27, 2015).

Insider trading: SEC v. Aggarwal, Civil Action No. 2:15-cv-06460 (C.D. Cal. Filed August 25, 2015). Defendant Ashish Aggarwal worked as an analyst at J.P. Morgan Securities LLC in its San Francisco office. His friend, defendant Shahriyar Bolandian, worked for an e-commerce company founded by Kevan Sadigh, also a defendant in the SEC's action. Each defendant declined to testify during the staff's investigation. The case involved trading in two deals. The first involved Integrated Device Technology, Inc. and PLX Technology, Inc. The second involved the ExactTarget, Inc., a provider of email and cloud marketing services, and, Inc., a provider of enterprise cloud computing services. Following the retention of JPM in each instances there were multiple text messages between Messrs. Aggarwal and Bolandian and multiple trades by Mr. Bolandian and Mr. Sadigh. After the first deal announcement Messrs. Bolandian and Sadigh sold their interest in PLXT, yielding, respectively, gains of $36,200 and $41,200. After the second Mr. Bolandian's accounts had profits of about $317,000. Mr. Sadigh had profits of about $178,000. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. See Lit. Rel. No. 23327 (August 25, 2015).

Offering fraud: In the Matter of Randy E. Olshen, Adm. Proc. File No. 3-16549 (August 25, 2015) is a proceeding naming as a Respondent Mr. Olshen, the founder and President of Innovative Health Solutions, LLC, a sports hydration drinks company. Beginning in 2009 Mr. Olshen is alleged to have implemented a plan to sell unregistered shares in the company using fabricated accounting records. Over $7 million was raised from about 50 investors. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). To resolve the matter Mr. Olshen consented to the entry of a cease and desist order based on the Sections cited in the complaint. In addition, an order was entered barring him from the securities business and from participating in any penny stock offering. In view of the requirement that he pay restitution in the related criminal matter in which he pleaded guilty, no restitution or penalty was ordered.

Misappropriation: SEC v. Path America, LLC, Civil Action No. 2:15-cv-01350 (W.D. Wash. Filed August 24, 2015). Named as defendants in this action are Lobsang Dargey and seven LLCs he controls including Path America, LLC, Path America SnoCo, LLC and five other similarly named entities. Mr. Dargey also controls the bank account for each entity through with the program funds flowed. The action centers around two projects, the Tower Project and the Farmer's Market Project. For the Tower Project, beginning in November 2013 Mr. Dargey, Path America and three other controlled entities raised about $85 million from 170 Chinese nationals as investments in real estate developments in Seattle. Investors acquired a limited partnership interest for $500,000 plus an administrative fee of $45,000.For the Farmer's Market project, beginning in 2012 Mr. Dargey, Path America and other related entities raised about $41 million from 82 Chinese nationals as investments in a residential real estate development in Everett, Washington. The PPM was substantially similar to the one for the Tower Project. Both PPMs were false and misleading, according to the complaint. Both represented that the funds would only be used in accord with the business plans provided to USCIS. In fact they were not. Overall defendants are alleged to have misappropriated about $17.6 million of investor funds. The complaint alleges violations of Exchange Act Section 10(b) and each subsection of Securities Act Section 17(a). The Commission secured an emergency freeze order. The case is pending. See Lit. Rel. No. 23326 (August 25, 2015).


Net capital: The regulator fined Charles Schwab & Co. $2 million and censured the firm in connection with net capital violations between May 15, 2014 and July 1, 2014. The violations arose because on certain dates the inflows of cash to the firm exceeded the amounts it could invest so it made large, unsecured loans to its parent resulting in net capital violations. In doing that the firm failed to consult with its regulatory group, demonstrating a lack of procedures.

Court of Appeals

Extraterritorial reach: Lay v. U.S., Case No. 13-4021 (6th Cir. August 17, 2015). Defendant Mark Lay was a registered investment adviser. He operated two funds, one on shore and the other off shore, in which he invested funds for the Ohio Bureau of Workers' Compensation. The off-shore fund suffered losses after he leveraged it, contrary to the rules of the Bureau. Although he concealed the losses and the leverage eventually the Bureau found out and withdrew its funds. Only $9 million of its $225 million investment was returned. Mr. Lay was convicted of securities fraud and other charges. He argued, however, that the securities fraud conviction, based on Advisers Act Section 206, was barred by Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). There the Court held that Exchange Act Section 10(b) did not have extraterritorial reach based on a presumption against such reach absent Congressional intent to the contrary. The Court rejected this contention, concluding that "The problem with defendant's argument is two-fold: (1) the Securities Exchange Act and the Investment Advisers Act seek to regulate different aspects of securities transactions, and (2) unlike Morrison, the only aspect of this case not tied to the United States is that the fund in question is based in Bermuda. All other aspects of the case are centered in the United States." In addition, the focus of the Advisers Act is the prevention of wrongful practices by the adviser, the Court determined. This contrasts sharply with the Exchange Act which is centered on the purchase or sale of a security. According, the court concluded that Morrison does not apply to Section 206 of the Advisers Act.

Conflict mineral rule: National Association of Manufactures v. SEC, No. 13-5252 (D.C. Cir. Opinion issued August 18, 2015). This suit challenged the SEC’s conflict minerals rules, written under Dodd-Frank. The initial decision upheld the rules but rejected one provision as contrary to the First Amendment (here). On rehearing by the panel, the result was the same. The rehearing was granted because the en banc court, in another case, reinterpreted the Supreme Court’s decision in Zander v. Office of Disciplinary Counsel of the Supreme Court of Ohio, 471 U.S. 626 (1985) which governed the standard of review in compelled speech cases regarding misleading advertising and broadened it to include labeling for country of origin for meat cuts. That standard is more relaxed than the one applied in the prior decision based on Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). Nevertheless, the court refused to apply Zander.

To bolster its decision, the Court added an alternate holding keyed to three points. First, under Central Hudson the court must assess the interest motivating the disclosure requirement. The SEC noted that it is ameliorating the humanitarian crisis in the DRC. This is sufficient. Second, the effectiveness of the measure in achieving that goal must be assessed. The SEC offered little on this point the Court noted. A review of various materials, including the potential costs, lead the Court to conclude that there was little but speculation. "[T]his presents a serious problem for the SEC because...the government must not rest on such speculation or conjecture...Rather the SEC had the burden of demonstrating that the measure it adopted would 'in fact alleviate' the harms it recited ..." "This in itself dooms the statute and the SEC's regulations" the Court concluded.

Finally, the Court considered if the compelled disclosures were "purely factual and uncontroversial." The descriptions of "conflict free" or "not conflict free" are hardly factual and non-ideological. This requires an issuer to tell consumers if its goods are ethically tainted." "By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment."

August 28, 2015
SEC's Filing Fees Going Down 13% for Fiscal Year 2016!
by Broc Romanek

Yesterday, the SEC issued this fee advisory that sets the filing fee rates for registration statements for 2016. Right now, the filing fee rate for Securities Act registration statements is $116.20 per million (the same rate applies under Sections 13(e) and 14(g)). Under the SEC's new order, this rate will dip to $100.70 per million, a 13.3% drop. Nice to see another reduction after last year's 10% drop (which combined with a drop in the rate two years ago, offsets a hefty price hike from three years ago).

As noted in the SEC's order, the new fees will go into effect on October 1st like the last four years (as mandated by Dodd-Frank) – which is a departure from years before that when the new rate didn't become effective until five days after the date of enactment of the SEC's appropriation for the new year – which often was delayed well beyond the October 1st start of the government's fiscal year as Congress and the President battled over the government's budget.

Board Succession Planning Databases

In this podcast, Equilar's David Chun discusses the latest in Equilar's line of services – BoardEdge, including:

– What is "BoardEdge"?
– How does it compare to a company hiring a recruiter?
– Any surprises since you launched?

Our "Q&A Forum": The Big 8500!

In our "Q&A Forum," we have blown by query #8500 (although the "real" number is much higher since many of the queries have others piggy-backed on them). I know this is patting ourselves on the back, but it's over 14 years of sharing expert knowledge and is quite a resource. Combined with the Q&A Forums on our other sites, there have been well over 28,000 questions answered.

You are reminded that we welcome your own input into any query you see. And remember there is no need to identify yourself if you are inclined to remain anonymous when you post a reply (or a question). And of course, remember the disclaimer that you need to conduct your own analysis and that any answers don't contain legal advice.

– Broc Romanek

August 28, 2015
Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 8)
by J Robert Brown Jr.

As all of this plays out, the SEC did win a major victory in the 7th Circuit in Bebo v. SEC.  

The case did not involve a challenge to the system of ALJs under the Appointments Clause but did raise other issues in a collateral challenge to the administrative hearing process.  See Id. ('Bebo contends that § 929P(a) of Dodd-Frank is facially unconstitutional under the Fifth Amendment because it provides the SEC "unguided" authority to choose which respondents will and which will not receive the procedural protections of a federal district court, in violation of equal protection and due process guarantees. She also contends that the SEC's administrative proceedings are unconstitutional under Article II because the ALJs who preside over SEC enforcement proceedings are protected from removal by multiple layers of for-cause protection."). 

The 7th Circuit held that the district court did not have jurisdiction to hear the collateral challenge.  Instead, the issues needed to be raised in the administrative hearing where they would be reviewed (assuming the case got that far) by the US Court of Appeals.  As the court reasoned: 

  • We affirm. It is "fairly discernible" from the statute that Congress intended plaintiffs in Bebo's position "to proceed exclusively through the statutory review scheme" set forth in 15 U.S.C. § 78y. See Elgin v. Dep't of Treasury, 567 U.S. -, 132 S. Ct. 2126, 2132–33 (2012). Although § 78y is not "an exclusive route to review" for all types of constitutional challenges, the relevant factors identified by the Court in Free Enterprise Fund v. Public Company Accounting Oversight Board, 561 U.S. 477, 489 (2010), do not adequately support Bebo's attempt to skip the administrative and judicial review process here. Although Bebo's suit can reasonably be characterized as "wholly collateral" to the statute's review provisions and outside the scope of the agency's expertise, a finding of preclusion does not foreclose all meaningful judicial review. If aggrieved by the SEC's final decision, Bebo will be able to raise her constitutional claims in this circuit or in the D.C. Circuit. Both courts are fully capable of addressing her claims. And because she is already a respondent in a pending administrative proceeding, she would not have to "'bet the taking the violative action' before 'testing the validity of the law.'" Id. at 490, quoting MedImmune, Inc. v. Genentech, Inc., 549 U.S. 118, 129 (2007). Unlike the plaintiffs in Free Enterprise Fund, Bebo can find meaningful review of her claims under § 78y. As a result, she must pursue judicial review in the manner prescribed by the statute. 

The reasoning would seem to apply with equal vigor to the cases challenging the SEC's system for appointing ALJs.  This is only one circuit and, for administrative law purposes, not the critical DC Circuit.  Nonetheless, the reasoning will at a minimum need to be addressed in other cases where the SEC appeals (Hill for example) and argues that the district court never should have heard the case in the first instance.

To the extent that the appellate courts fall into line with Bebo, the approach takes the matter out of the hands of the district courts and gives the SEC the first crack at taking a substantive position on the issue.  Moreover, the approach ultimately delays a determination of the constitutionality of the ALJ appointment process until the matter can make it through the SEC's AP process and it can get to the court of appeals.

Finally, once the SEC has ruled in one case (the matter is before the SEC in Timbervest) and assuming the Commission finds the system of appointment constitutional (because the ALJs are employees and not inferior officers), courts may, at least psychologically, be more open to collateral challenges.  After all, forcing a party through an administrative process when the outcome has already been determined may be viewed as an unnecessary burden.

August 27, 2015
Final Musings: What the Crisis Teaches about the Meaning of Law and the Future of Legitimacy
by Philip Wallach

After stepping away to enjoy the pleasures of a summer virus, courtesy of my local one-year-old, I'm back for one last post to finish out my guest-blogging here, which I hope has been edifying or thought-provoking or at least mildly amusing for some readers. (Any and all thoughts, about my posts here or about To the Edge, would be greatly appreciated: pwallach at For this last post, I want to return to the theme of "So Now What?"-this time not in the sense of policy prescriptions, but for the way we think about the law and how it relates to the legitimacy of crisis actions.

What I was driving at in my second AIG post, and what I explain in a number of contexts in the book, is that when Treasury and Fed officials adopt the role of financial crisis responders, they are unlikely to be subject to our stereotypical notion of the rule of law that centers on judges as the key enforcers of statutory and constitutional restraint. In this sense, I am in agreement with Eric Posner and Adrian Vermeule's The Executive Unbound-though I reject their further inference that law itself becomes nothing more than a distraction for the nostalgic or naive, for reasons I've explained.

I like to think of this as a realist turn of thought: when we think about what the law means in practice, we ought to look at the evidence of what it does rather than starting with any hard and fast interpretive rules. But, like other uses of legal realism, this one is likely to generate backlash. Some of that will come from steadfast practitioners of legal dogmatics, who resent the heresy. But since I have no hopes of ever impressing the Senate Judiciary Committee, that doesn't worry me much.

But ordinary people have their own reverence for the idea that our government and its instrumentalities are strictly creatures of law (see the fascinating Law’s Quandary, by Steven D. Smith). Their offense at deviation from this norm (perhaps rallied and organized by the professional formalists) is a far more troubling affair. Since the people's judgment of the legitimacy of government's actions is the ultimate determinant of legitimacy, that broader impression of lawlessness matters a great deal; indeed, it hangs like a cloud over future crisis responses.

Posner and Vermuele's view is that in crises, "legality and legitimacy diverge, and legitimacy prevails." In other words, our government and polity together slide over into a non-legal regime in which direct political checks are the only ones that matter. My contention is that this transition is likely to be much messier than they let on, in part because political channels are ill-defined.

This is especially the case for the Fed. American anxieties about paper money are older than the republic, not to mention fears of the "creature from Jekyll Island." So the Fed will always face resistance in legitimizing its operations, especially in crises, when it is most visible. The Fed's imposing presence can be accepted most readily as a valid delegation from Congress—but most such logic relies on confidence in the force of legal bonds. In other words, the Fed must at least seem legally accountable. This is all the more true because of the Fed's perceived independence from politics. If we think the Fed is rightly insulated from sudden political passions, then we cannot count on direct-to-the-people accountability to substitute for legality.

In short, the central bank must style itself as a more accountable organ of government in some way that convinces at least some portion of skeptics; that is what legitimacy seems to require today. Discussion with Peter Conti-Brown has partially convinced me of the anachronistic nature of this view—but expectations are not necessarily any less influential because they are anachronistic. The political environment of America in 2015 is very different from what it was a century ago, and the Fed's weirdness has become an obstacle to legitimacy today more than it may have been in the past. Keep America weird...but realize that the American people probably don't have much patience for weirdness in their key policymaking institutions, and act accordingly. In some ways, Peter's proposals about normalizing the appointment of the regional Fed presidents (which I've shied away from to this point) fit well into this mold.

Well, I could ramble on, but perhaps that charming fever hasn't left entirely yet and so I'm better off cutting my losses. My sincere thanks to the Conglomerate for providing me an outlet for thinking out loud over the past few weeks, and especially to David for inviting me and engaging with my book. Hope that everyone enjoys the waning days of our crisis-free summer, as long as they last...

View today's posts

8/28/2015 posts

CLS Blue Sky Blog: Should Agents Operating in the U.S. Financial Markets Have "Skin in the Game"?
HLS Forum on Corporate Governance and Financial Regulation: Dodd-Frank Turns Five, What's Next?
SEC Actions Blog: This Week In Securities Litigation (Week ending August 28, 2015) Blog: SEC's Filing Fees Going Down 13% for Fiscal Year 2016!
Race to the Bottom: Duka v. SEC and the Constitutionality of Administrative Law Judges (Part 8)
Conglomerate: Final Musings: What the Crisis Teaches about the Meaning of Law and the Future of Legitimacy

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