Securities Mosaic® Blogwatch
July 6, 2015
Preparing Financial Regulation for the Second Machine Age: The Need for Oversight of Digital Intermediaries in the Futures Markets
by Gregory Scopino

Humanity is entering the Second Machine Age, in which artificially intelligent computers and software programs (artificial agents) will become involved in almost every aspect of society. Computers and software programs now drive and park cars, fly drones, compose music, sell insurance, manage investments, and even write news stories. Indeed, computers and software programs are far better--and quicker--than humans at jobs that involve looking at numbers and drawing conclusions from them, which would include jobs such as investment advisors and futures traders. The rise of automated trading systems ("ATSs") that use high-frequency trading strategies in the futures markets is but one example of how technology is fundamentally changing the nature of the financial markets. As a result, humans who are operating as futures market intermediaries (such as commodity trading advisors or introducing brokers) are likely to be displaced by digital intermediaries, that is, artificial agents that perform critical roles related to enabling customers to access the futures and derivatives markets. For example, commodity trading advisors are persons who are compensated to advise others about placing trades in futures and derivatives. Some commodity trading advisors receive authority to direct trades in client accounts. Existing technology has created computers and software programs that are fully capable of suggesting when a client should place trades in futures contracts or making the trading decisions in a client's futures trading account. In other words, there are computers and software programs that could, as digital intermediaries, perform the role of commodity trading advisors.

The Commodity Exchange Act ("CEA") governs the U.S. derivatives markets and requires specified categories of intermediaries––such as commodity trading advisors and their associated persons––to register with the Commodity Futures Trading Commission ("CFTC"). Compulsory registration has been called "the kingpin" of the CEA's "statutory machinery" because it serves to identify the persons acting as market professionals, and provides a mechanism for such persons to undergo background ethics screenings for fitness to work in the industry, as well as proficiency testing and ethics training. The registration requirement only applies to humans and business entities that are considered "persons" under the law. Because the current laws and regulations focus on humans and legal "persons," but not digital intermediaries (i.e., the computers and software programs operating as artificial agents), the existing laws and regulations may very well be failing to comprehensively oversee all entities whose activities otherwise would place them within the CFTC's regulatory ambit. For example, the law and regulations require certain human (but not artificial) futures trading professionals to undergo mandatory competency testing and ethical screening. In the futures industry, ethical screening applies only to humans and operates under a statutory disqualification framework in which prior misconduct can cause a person to be barred from working as a futures (or derivative) trading professional. The current ethical screening process would ban a human with a history of engaging in disruptive trading practices from the industry but would not capture a digital intermediary (say, a misconduct-prone algorithmic trading program) with a similar track record. Because these requirements only apply to humans (and in some cases business entities that are legal persons), but not digital intermediaries, they fail to cover some of the entities that are actually making trading decisions for clients or otherwise operating as intermediaries in the derivative markets.

Because technological advances are enabling artificial agents to perform many of the intermediary roles that previously were done by humans, Congress and the CFTC should modify the CEA and CFTC Regulations (1) to expand the scope of persons who must register to include, among other things, persons who use ATSs and who have trading privileges on, or direct electronic access to, derivatives exchanges (or trading venues), and (2) to implement an identification program for ATSs and algorithms.

Lastly, Congress and the CFTC should look to research by academics in philosophy and law concerning (1) ways to ensure that digital intermediaries are built not just to be intelligent but also to be ethical, and (2) methods for allocating liability for wrongdoing by digital intermediaries.

The preceding post comes to us from Gregory Scopino, Adjunct Professor of Law at Cornell Law School and Special Counsel with the U.S. Commodity Futures Trading Commission (CFTC). It is based on his recent paper, "Preparing Financial Regulation for the Second Machine Age: The Need for Oversight of Digital Intermediaries in the Futures Markets," which is forthcoming in The Columbia Business Law Review and available here. The positions expressed here and in Mr. Scopino's paper are his own, and do not represent the views of the CFTC, its Commissioners, or other staff members.

July 6, 2015
Sullivan & Cromwell discusses Senate Regulatory Relief Proposal: Banking Committee Chairman Releases Discussion Draft of "The Financial Regulatory Improvement Act of 2015"
by H. Rodgin Cohen

Yesterday afternoon, Senate Banking Committee Chairman Richard Shelby (R-AL) released a discussion draft of "The Financial Regulatory Improvement Act of 2015" (the "Discussion Draft"). This proposed legislation would significantly amend certain aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), in particular the current regulatory framework for designating and regulating so-called systemically-important financial institutions, or "SIFIs." In addition, the 216-page Discussion Draft would substantially broaden the Dodd-Frank safe harbor for "qualified mortgages" and includes a number of other notable provisions relating to the regulation of insurance companies, the structure and operation of the Federal Reserve System, and housing finance, among other matters.

In a statement accompanying the release of the Discussion Draft, Chairman Shelby described it as a "working document intended to initiate a conversation with all members of the Committee who are interested in reaching a bipartisan agreement to improve access to credit and to reduce the level of risk in [the] financial system." The Committee's Ranking Minority Member, Sen. Sherrod Brown (D-OH), issued a statement maintaining that, "[r]ather than focusing on issues that enjoy bipartisan support," the Discussion Draft is a "sprawling industry wish list of Dodd-Frank rollbacks," but he pledged to "work with provide small financial institutions the help they need without undermining important financial safeguards." Similarly, the Treasury Department commented that the Discussion Draft "appears to roll back and undermine significant portions of Wall Street reform," but stated that Treasury "stand[s] ready to work with the Committee on targeted efforts that would strengthen reforms, building on the tiered and tailored regulatory framework established by [Dodd-Frank]." The Committee is scheduled to hold a mark-up of the legislation on May 21, 2015.


This memorandum is based on our preliminary review of the legislative text and the accompanying section-by-section summary, also released yesterday by Chairman Shelby's staff. Key provisions of the Discussion Draft include:

  • Revisions to Dodd-Frank's $50 Billion "SIFI Threshold": Perhaps most notably, the Discussion Draft would amend the current $50 billion statutory asset threshold, codified in Sec. 165 of Dodd-Frank, under which bank holding companies ("BHCs"), including foreign banking organizations that are treated as BHCs under the International Banking Act of 1978, are subject to "enhanced prudential standards" and SIFI regulation by the Board of Governors of the Federal Reserve System (the "Federal Reserve").[1] Specifically, the current $50 billion BHC threshold for "automatic" SIFI regulation would be raised to $500 billion. Any BHC with total consolidated assets equal to or greater than $50 billion but less than $500 billion would have to be individually designated by the Financial Stability Oversight Council (the "FSOC") to become subject to the full range of Sec. 165 enhanced prudential standards. This designation would be based on criteria that include size, interconnectedness, substitutability, cross-border activity, and complexity.[2] Importantly, however, these $50B – $500B BHCs would remain subject to the Dodd-Frank risk committee and company-run stress testing ("DFAST") requirements[3] and would not automatically be exempt, by virtue of the legislation, from the Federal Reserve's CCAR capital planning rule. In addition, because the intermediate holding company ("IHC") requirement in the Federal Reserve's Enhanced Prudential Standards for Foreign Banking Organizations was not tied to a particular provision in Dodd-Frank, that requirement would appear to continue to apply, unless modified by the Federal Reserve. The FSOC would be required to provide any BHC under review for possible designation with (1) a "detailed explanation" for any proposed or final designation, (2) opportunities to meet with FSOC members and staff, and (3) the opportunity to submit a "remedial plan" prior to final designation. Although the Discussion Draft would authorize the Federal Reserve to recommend that the FSOC evaluate a particular BHC for designation, the FSOC could also initiate the process on its own. The FSOC would be required to reevaluate existing BHC SIFI designations at least once every five years or at the request of the Federal Reserve. BHCs with more than $500 billion in total consolidated assets would not be subject to this reevaluation requirement.
  • Nonbank Financial Company SIFI Designations: Although the increase in the BHC SIFI threshold would not establish an asset floor for the designation of "nonbank financial companies" (such as savings and loan holding companies ("SLHCs"), insurance companies, and asset managers, among others), the Discussion Draft would introduce a number of modifications intended to provide "greater transparency" regarding the FSOC's nonbank financial company designation process. Among other things, the FSOC would be required to provide companies under consideration for designation with greater information during the review process (including the opportunity to submit a "remedial plan") and afford the company's primary regulator an opportunity to "assess and respond to [the FSOC's] analysis of the company and take regulatory action, if appropriate" in lieu of designation. The FSOC would be required to vote annually on whether to rescind a company's designation and, if it chose not to rescind the designation, would be required to provide the company with "meaningful information about why [the company] should continue to be designated, why any remedial plan submitted is unsatisfactory, and what the company can do to no longer be designated." In addition, at least once every five years, the FSOC would have to provide a designated company the opportunity to appear at a hearing to contest its designation, after which the FSOC would be required to vote to renew the designation. In the absence of such a vote, the company's SIFI designation would be automatically rescinded.
  • Federal Reserve: The Discussion Draft includes a number of provisions addressing the operations and structure of the Federal Reserve System, including the required submission of quarterly monetary policy reports to Congress by the Federal Open Market Committee. In addition, the Federal Reserve would be required to vote, on a non-delegable basis, on "whether to settle any civil money penalty assessment order or other enforcement action if the settlement of such order or action involves the payment" of more than $1 million and to "promptly post the results of such votes" on the Federal Reserve's website. The proposal would also authorize each Federal Reserve Board Governor to hire a "maximum of four staff members to serve and advise such governor"; require that the President of the Federal Reserve Bank of New York be appointed by the president and confirmed by the Senate; and establish an "independent commission" to conduct a study and make recommendations to Congress on "whether it is appropriate to restructure the Federal Reserve districts, including an analysis on potential benefits and costs of restructuring." Moreover, the Government Accountability Office would be directed to assess the "effectiveness" of the Federal Reserve's supervision of both BHC SIFIs and nonbank SIFIs in order to "best address systemic risk and prevent regulatory capture," while the Federal Reserve would be charged with conducting a study and preparing a report to Congress every two years on its plan to "regulate and supervise nonbank institutions."
  • Insurance Regulation: The Discussion Draft includes several provisions relating to the regulation of the insurance industry, including a "[s]ense of the Congress that the McCarran-Ferguson Act...remains the preferred approach to regulating the business of insurance." It also contains provisions, which are substantively identical to legislation recently introduced by Senators Dean Heller (R-NV) and Jon Tester (D-MT), that would (1) establish, within the Federal Reserve, a new "Insurance Policy Advisory Committee on International Capital Standards and Other Insurance Issues"; (2) require the Federal Reserve and Treasury Department to issue an annual report to Congress on global insurance regulatory activities at "global insurance or international standard-setting regulatory or supervisory forums"; and (3) direct the Federal Reserve, Treasury Department, and the Federal Insurance Office, in consultation with National Association of Insurance Commissioners, to complete a study on the impact on U.S. consumers and markets "before supporting or consenting to the adoption of any key elements in any international insurance proposal or international insurance capital standard." Also included is a provision that would limit the circumstances in which an insurance company could be required to serve as a "source of strength" to its insured depository institution subsidiaries.
  • Volcker Rule Exemption for Small Banks: Depository institutions with $10 billion or less in total consolidated assets and a CAMELS composite rating of 1 or 2 would be exempted from the Volcker Rule (Sec. 619 of Dodd-Frank).
  • Mortgage Finance: The Discussion Draft contains a provision, originally authored by Senator Bob Corker (R-TN), that would prohibit the "sale, or other disposition, of preferred stock in Fannie Mae or Freddie Mac, by the U.S. Treasury, unless it is directed to do so by Congress." In addition, the mortgage finance-related title would prohibit the use of increases in Fannie Mae or Freddie Mac guarantee fees to offset federal budgetary outlays or reductions in revenues for any purposes other than "enterprise business functions or housing finance reform as passed by the Congress in the future."
  • Regulatory Relief: Finally, Title I of the Discussion Draft includes a variety of "regulatory relief" proposals that would, among other things: (1) substantially broaden the scope of the Dodd-Frank "Qualified Mortgage" safe harbor to cover certain mortgages held in portfolio; (2) expand the availability of the 18-month exam cycle for smaller insured depository institutions; (3) require the federal financial regulators to "perform a comprehensive review of regulations to identify outdated or otherwise unnecessary regulatory requirements imposed on financial institutions"; and (4) establish in the Federal Financial Institutions Examination Council an Office of Examination Ombudsman to "investigate complaints concerning examinations, examination practices, or examination reports" and to "ensure that the written examination policies of the agencies are being followed in practice," among other responsibilities.


As noted above, the Senate Banking Committee is expected to consider this legislation at a mark-up scheduled for May 21, although modifications are likely to be made to the Discussion Draft prior to the mark-up and/or during the Committee amendment process. We will continue to monitor this situation and provide additional information and analysis, as appropriate.


[1] The Sec. 165-mandated enhanced prudential standards include risk-based capital requirements and leverage limits, liquidity requirements, overall risk management requirements, supervisory stress-testing, resolution planning and credit exposure reporting, and concentration/credit exposure limits. Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking Organizations, 79 Fed. Reg. 17240 (Mar. 27, 2014), available at See our Client Memorandum, "Enhanced Prudential Standards" for Large U.S. Bank Holding Companies and Foreign Banking Organizations, dated Feb. 24, 2014, available at

[2] The Basel Committee on Banking Supervision, in its international framework for identifying global systemically-important banks, or "G-SIBs," that are subject to a G-SIB capital surcharge, and the Federal Reserve, in its proposed rules to implement the G-SIB surcharge, apply these same criteria for identifying banking organizations as G-SIBs subject to the surcharge. See Basel Committee on Banking Supervision, Global systemically important banks: updated assessment methodology and the higher loss absorbency requirement, dated July 2013, available at and Risk-Based Capital Guidelines: Implementation of Capital Requirements for Global Systemically Important Bank Holding Companies, 79 Fed. Reg. 75473 (Dec. 18, 2014), available at

[3] The Discussion Draft would raise the threshold for DFAST applicability from $10 billion to $50 billion in total consolidated assets.

The full and original memorandum was published by Sullivan & Cromwell on May 13, 2015 and is available here.

July 6, 2015
Proxy Access: The 2015 Proxy Season and Beyond
by See Editor's Note
Editor's Note:

Marc S. Gerber and Richard J. Grossman are partners in the Mergers & Acquisitions practice at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden alert.

Although the 2015 annual meeting season is still winding down, there is no doubt that proxy access has gained considerable momentum and will remain a front-and-center corporate governance issue for the foreseeable future. For the boards of directors of the many companies who were bystanders on this issue for the 2015 proxy season, the question will be whether to act now or wait and watch for further developments. In any event, as proxy access is likely to be a topic of discussion during companies' "off season" shareholder engagement efforts, companies and their boards should understand how the proxy access landscape has evolved.

The Lead-Up to 2015

In important ways, the groundwork for the 2015 proxy access campaign was carefully laid in the 2012-14 proxy seasons. Targets of proxy access shareholder proposals modeled on the vacated SEC proxy access rule-granting holders of 3 percent of a company's shares for three years access to the company's proxy statement for nominees for up to 25 percent of the board-were carefully selected, and a coalition of institutional investors came together to provide majority support for most of these proposals. As a result, a small number of large companies-including Hewlett-Packard, Western Union, CenturyLink and Verizon Communications-walked through the proxy access door, making it only a matter of time before other companies-willingly or unwillingly-would have to follow.

In November 2014, the Office of the New York City Comptroller, in its capacity as trustee of various pension funds, launched the "Boardroom Accountability Project" by submitting proxy access proposals to 75 companies. The recipients were selected on the basis of investor concerns over excessive CEO compensation, a lack of board diversity or a perceived failure to address climate change. Combined with proposals from other institutional investors, as well as from individual investors who conformed their proxy access proposals to the "3-3-25" model favored by institutional investors, over 100 proxy access proposals were submitted for 2015 annual meetings.

At the same time, Whole Foods Market attempted to exclude a 3-3-25 proxy access shareholder proposal by submitting its own proxy access proposal to a shareholder vote-albeit with much more restrictive terms, 9 percent ownership for five years and limited to the nomination of one director. Whole Foods' approach was entirely consistent with the SEC staff's no-action letters on conflicting proposals (not relating to proxy access), and its no-action request was granted on December 1, 2014. Whole Foods' success was short-lived when, in response to investor outcry, SEC Chair Mary Jo White directed the staff to review its application of the relevant rule, and the Whole Foods no-action letter was withdrawn. Nevertheless, the episode galvanized many institutional investors to vocally support 3-3-25 proxy access over alternative formulations and to warn companies of repercussions in director elections if companies attempted to pre-empt shareholder votes on 3-3-25 proxy access.

These events were followed in short order by statements from BlackRock supportive of 3-3-25 proxy access and by Vanguard, supportive of proxy access but expressing a preference for proxy access terms of 5 percent share ownership for three years and 20 percent of the board. In February, TIAA-CREF sent letters to many of the companies in which it had investments, supporting 3-3-25 proxy access and asking them to take voluntary action in 2015. CalPERS, CalSTRS, ISS and others also expressed support for 3-3-25 proxy access.

Company Responses and 2015 Voting Results

As shown in Figure 1, company responses have varied. Approximately half of the companies simply opposed the shareholder proposal as usurping the power of the nominating and governance committee and presenting an inappropriate or unnecessary governance reform. On the other end of the spectrum, approximately 15 percent of the companies either adopted 3 percent proxy access, announced an intention to do so or agreed with the proponent to submit a company 3 percent proxy access proposal for shareholder approval at the 2015 or 2016 annual meeting.

Whether influenced by Vanguard's announced preference for 5 percent proxy access or by their own shareholder engagement efforts, another 15 percent of companies took the approach of adopting a 5 percent proxy access bylaw, announcing an intention to do so or submitting to a shareholder vote a company proposal for 5 percent proxy access-in competition with the shareholder proposal for 3 percent access. Finally, about 10 percent of companies opposed the shareholder proposal but, to varying degrees, expressed a willingness to continue to engage with shareholders to determine appropriate proxy access terms.

The voting results (Table 1) show that 3 percent proxy access has enjoyed significant but not universal support in the 2015 proxy season. Overall, to date, the shareholder proposal has achieved majority support at 60 percent of the companies where it was opposed. In some cases, the shareholder proposal failed to achieve majority support in the face of "straight" or "soft" opposition. However, the most likely path to defeating 3 percent proxy access was by adopting or proposing 5 percent proxy access, with almost half of those shareholder proposals failing to achieve majority support. Nevertheless, there is no guaranteed way to defeat the proposal and, absent a controlling or significant shareholder, almost all of the shareholder proposals failing to achieve majority support still had meaningful support at 40 percent or higher.

When the dust settles, more than 60 companies will have either adopted or announced 3 percent proxy access, will have agreed to submit a company 3 percent access proposal to a shareholder vote, or will have had a 3 percent shareholder proposal receive majority support. Where a 3 percent proposal received majority support, boards will face pressure to fully implement the majority-supported proposal, especially in light of ISS and investor policies to recommend or vote against directors if a majority-supported proposal is not implemented. Monsanto, which was the first proxy access vote of 2015 and where the proposal received majority support, recently announced its adoption of a 3-3-20 proxy access bylaw. A handful of other companies will have 5 percent proxy access (having defeated the 3 percent shareholder proposal) or will have already expressed some willingness to adopt access at a level of ownership still to be determined. Some companies will have defeated the proxy access proposal, but with significant support at many of those companies, such that the proposal is likely to be submitted again.

Going Forward

As the proxy season concludes, many companies will begin to transition to a period of "off season" shareholder engagement, a review of 2015 developments and consideration of corporate governance enhancements to implement in advance of the 2016 proxy season. For most companies, proxy access should be on the agenda for discussion.

Companies and boards of directors will face the question of whether to act in advance of possibly receiving a proxy access shareholder proposal or wait as long as possible and act only once the company receives a shareholder proposal or after shareholders vote on one. As the voting results show, majority support for 3 percent proxy access is likely but is not a foregone conclusion. Some companies may be tempted to oppose the shareholder proposal. Of course, any determination requires an informed analysis based on a company's shareholders and their voting patterns and preferences, as well as a company's particular facts and circumstances. There is no single right answer.

At the margins, proxy access may increase a company's vulnerability to an election contest. But in the current age of shareholder activism, the marginal risk may be negligible. Proxy access election contests are not predicted to become commonplace and are not expected to be used by "true" shareholder activists. Also, the circumstances that would motivate an access nomination also might trigger an activist investor to nominate (not using proxy access) a short slate of directors.

Importantly, companies may be in a unique window of time where they retain some flexibility when considering proxy access terms beyond the 3-3-25 or 3-3-20 headline terms. For example, precedent varies on the number of shareholders permitted to come together to form a group to satisfy the ownership requirements. In addition, there are various formulations to account for "creeping control"-limits on the use of proxy access in successive years to prevent a majority of the board consisting of members nominated through proxy access. Another important question is whether and when to suspend proxy access in the event nonaccess nominations are made by shareholders. Adopting a proxy access bylaw sooner may permit companies to adopt a bylaw with a number of favorable provisions and, at the same time, significantly reduce the likelihood of receiving a shareholder proposal in the first place.

Another factor to consider is that shareholder proposals, as well as shareholder views, sometimes evolve. Today's proxy access proposals focus on the 3-3-25 headline requirements. Will the next generation of proposals become more prescriptive and, if so, will that impact the level of shareholder support? If a more prescriptive proposal is received, there is no guarantee that adopting the headline provisions but including other terms that vary from those proposed will induce a proponent to withdraw the proposal or satisfy the SEC staff that a proposal has been substantially implemented and should be excluded. Similarly, shareholders' views on proxy access are not uniform at the moment, and it is quite possible that shifting views could result in proxy access proposals receiving even greater support in future years.

Both companies and proponents will be assessing the results of the 2015 proxy season and determining their approaches to proxy access for the next round of shareholder proposals. Depending on one's assessment, including the company's vulnerability to receiving a proxy access shareholder proposal in the near term, there may be advantages for companies to move quickly.

July 6, 2015
Supreme Court Interprets Advance Notice Bylaws
by Francis Pileggi

Hill International, Inc. v. Opportunity Partners L.P., , Del. Supr., 305, 2015 (Del. July 2, 2015). This Delaware Supreme Court opinion should be read by anyone interested in the latest iteration of Delaware law on advance notice bylaws. A few bullets points about this decision should help readers decide if they want to read the whole ruling linked above.

  • The original notice of the annual meeting did not provide a precise date; rather, it described the meeting to be held "on or about" June 10.
  • Not until a date certain was made public, were various timetables and deadlines triggered-especially because the actual date certain of June 9 was different than the first date given as "on or about June 10″
  • The Supreme Court based its analysis on contract interpretation principles applied to the applicable provisions of the bylaws, which of course are treated as a contract within the framework of the Delaware General Corporation Law.
  • The procedural posture was an appeal from the Court of Chancery's grant of a mandatory injunction preventing the company from conducting business at the annual meeting other than adjourning the meeting, which allowed the court to consider more fully the arguments that the company improperly refused to consider nominees for two director positions that the company argued were not timely submitted in accordance with the advance notice bylaws
  • No security was required by the Court of Chancery when the mandatory injunction was imposed and the last footnote of this opinion "dodges" that issue in some respect by finding that the issue was not adequately presented in order for it to be considered on appeal. Nonetheless, in dicta Delaware's high court, in a panel decision, observed that, in essence, the Court of Chancery was not in error on that point for reasons explained in the final footnote of the decision.
  • After the June 5 injunction was ordered, based on a complaint and motion for preliminary injunction filed on May 14, the Court of Chancery granted a partial final judgment under Rule 54(b) on June 16, at which time an expedited appeal was filed with the Supreme Court, which held oral argument on July 1. This decision of July 2 affirming the Chancery decision deserves to be exalted as an example of very fast decision making in a formal written opinion, after full briefing, on complicated issues of corporate litigation (by both the Court of Chancery and the Supreme Court.)

The post Supreme Court Interprets Advance Notice Bylaws appeared first on Delaware Corporate and Commercial Litigation Blog.

July 6, 2015
The SEC's Clawback Rule
by David Zaring

The rule, authorized by Dodd-Frank, would permit companies to claw back compensation from executives if things go south. Or, more specifically, the rule will "require national securities exchanges and national securities associations to establish listing standards that would require each issuer to implement and disclose a policy providing for the recovery of erroneously paid incentive-based compensation." Clawbacks would happen when, well: "the trigger for the recovery of excess incentive-based compensation would be when the issuer is required to prepare an accounting restatement as the result of a material error that affects a financial reporting measure based on which executive officers received incentive-based compensation."

The rule had the usual two dissenters, independent statements by each of the commissioners. The SEC is a divided agency. But I'm interested in how the staff hope to close the deal, assuming that the rule will be litigated.

First, even though this is a proposed rule, the agency is already responding to plenty of comments from prior concept releases, &c. Second, 50 of the 198 pages of the rule are devoted to the cost benefit analysis that so stymied the SEC when the DC Circuit had a majority of Republican judges. But the analysis isn't heavy on quantitative cost-benefit, but rather an assessment of the implications on a variety of affected components in the agency. I think the agency thinks it doesn't need to blow the court of appeals away with some numbers to survive, though of course the agency can do more cost-benefit analysis in the final rule.

July 6, 2015
Audit Committee Disclosures: SEC's New Concept Release!
by Randi Morrison

As expected (see my earlier blog and the SEC's latest Reg Flex Agenda), the SEC issued a concept release last week on audit committee disclosure, fairly concurrently with the PCAOB's release of its Supplemental Request for Comment about disclosure of the audit engagement partners.

The SEC's concept release, which focuses on independent auditor oversight, acknowledges that some companies already exceed the minimum audit committee-related disclosure requirements. In fact, presumably prompted in part by the Audit Committee Collaboration's 2013 Call to Action, as discussed in my previous blog and the CAQ's Transparency Barometer, many companies already disclose more than the minimum across a broad spectrum of potential disclosures.

The SEC's concept release seeks comment on whether disclosure of the audit engagement partner and additional members of the engagement team should be made by the audit committee and included in the proxy statement. In contrast, the PCAOB's proposal would require that audit firms publicly disclose the name of the audit engagement partner and information about certain other audit participants in a new form filed with the PCAOB. The PCAOB's proposal purportedly seeks to be responsive to concerns raised by auditors and others specifically regarding the risks of liability and litigation associated with disclosure of such information in the auditor’s report, as had been previously proposed; however, concerns expressed about the implications of identifying the engagement partner were not limited to risks of liability/litigation.

Here is an excerpt from Ning Chiu's blog on the areas of potential additional disclosure included in the SEC's release:

Audit committee's oversight of the auditor:

1. Additional information regarding communications between the audit committee and the auditor, which could include all communications required under the PCAOB rules, the nature of the committee's communication with the auditor related to the auditor's overall audit strategy, timing, significant risks, nature and extent of specialized skill used in the audit, planned use of other firms or persons, planned use of internal audit, the basis for determining that the auditor can serve as principal auditor, the results of the audit, and how the audit committee considered these items in its oversight of the auditor
2. How often the audit committee met with the auditor
3. The audit committee review of and discussion about the auditor's internal quality review and most recent PCAOB inspection report
4. Whether and how the audit committee assesses, promotes and reinforces the auditor’s objectivity and professional skepticism. It is unclear what the SEC is expecting in this regard and in fact, the SEC itself questions what type of disclosures would satisfy this possible requirement.

The audit committee's process for appointing or retaining the auditor:

1. Whether and how it assesses the auditor and its rationale for retaining the auditor
2. The process for selecting the auditor through any requests for proposals (RFPs)
3. The board's policy, if any, for a shareholder vote on auditor ratification and the consideration of the vote in selecting the auditor

Qualifications of the audit firm and members of the engagement team:

1. Disclosure of the name of the engagement partner and key members of the engagement team and their experience
2. The audit committee's input in selecting the engagement partner
3. The number of years that the auditor has audited the company
4. Other firms involved in the audit

Both the SEC release and PCAOB releases are tagged with 60-day comment periods.

See also Dorsey's memo, and Cydney Posner's and Bob Lamm's blogs. We're posting memos about the SEC's release in our "Audit Committees" Practice Area, which includes, among other things, helpful resources specifically pertaining to audit committee disclosure.

SEC Charges Deloitte with Auditor Independence Violations

Coincidentally (presumably), on the same date that the SEC issued the audit committee concept release, it charged Deloitte with violating auditor independence rules when its consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds it audited. Deloitte agreed to pay more than $1 million to settle the charges. The SEC also charged the trustee with causing related reporting violations by the funds, and charged the funds' administrator with causing related compliance violations. SEC Division of Enforcement Associate Director Stephen Cohen noted:

"The investing public depends on independent auditors like Deloitte to test the reliability of publicly-reported financial statements, and they have front-line responsibility for ensuring their own independence. But they are not alone in safeguarding the audit process, and the other fiduciaries charged in this case failed to fulfill their roles and preserve investor confidence."

Access heaps of helpful resources in our "Auditor Independence" Practice Area.

More on "The Mentor Blog"

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

– Audit Committee Survey: Workload at Tipping Point?
– 2015 Cyber Risk Agenda
– Navigating Corporate Governance Hot Topics
– Study: Data Breach Preparedness
– Survey: Current (& Future) State of Compliance

– by Randi Val Morrison

July 5, 2015
SEC and CFTC Turn to Swaps and Security-Based Swaps Enforcement
by See Editor's Note
Editor's Note:

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. This post is based on a Davis Polk client memorandum.

The week of June 15, 2015 saw two of the first publicly announced enforcement actions brought by the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC") to enforce security-based swap and swap regulatory requirements under Title VII of the Dodd-Frank Act. The SEC accepted an offer of settlement from a web-based "exchange" for, among other things, offering security-based swaps to retail investors in violation of the Securities Act of 1933 and the Securities Exchange Act of 1934. In a separate action, the CFTC obtained a federal court order against a Kansas City man in a case alleging violations of the antifraud provisions of the swap dealer external business conduct rules in Part 23 of the CFTC regulations. [1] Swap dealers and security-based swap market participants may wish to consider these orders and the agencies’ approach to enforcement as firms further develop, review and update their compliance programs.

Illegal Transactions in Security-Based Swaps

On June 17, 2015, the SEC entered into an enforcement order with a web-based exchange that allowed its members to buy and sell contracts in the form of "fantasy stock" based on the value of private companies in advance of expected liquidity events, such as initial public offerings, mergers or dissolutions. In February 2015, the exchange's operators introduced a platform through which members could buy and sell "smart contracts," the value of which related to actual, privately owned start-up companies. The returns on these contracts would be based on the expected future value of these companies; if a company experienced a liquidity event, the buyer of the corresponding contract would receive one dollar for every $1 billion that the company was valued at the time of the event.

In bringing the enforcement order, the SEC characterized these "smart contracts" as security-based swaps, stating that the contracts were swaps based on events relating to a single issuer, each underlying start-up company. As a result, the exchange and its operators are alleged to have violated Section 5(e) of the Securities Act of 1933 and Section 6(l) of the Securities Exchange Act of 1934, which make it unlawful to offer to enter into or to enter into a security-based swap with any person who is not an eligible contract participant without an effective registration statement for the offering or unless the transaction is conducted on a national securities exchange, respectively. The exchange was ordered to cease and desist from any future violations of the securities laws and ordered to pay a civil monetary penalty of $20,000. The size of this penalty appears to be based on the small size and scope of the exchange's operations.

This action is noteworthy for several reasons. First, it represents the first time that the SEC has publicly wielded its newly acquired authority under Title VII of the Dodd-Frank Act over security-based swaps. Even though the SEC has yet to finalize the majority of its substantive rulemakings under Title VII, this action shows that the SEC is willing to exercise its statutory authority over security-based swaps. In addition, it shows the SEC's willingness to bring enforcement actions, even in situations where the volume of transactions is relatively small. In the press release accompanying the order, the SEC signaled its intention to particularly scrutinize attempts to offer these products to retail investors.

A security-based swap is, generally, and subject to certain exceptions: any agreement, contract, or transaction that:

  • is a swap, as defined in Section 1a(47) of the Commodity Exchange Act; and
  • is based on:
    • an index that is a narrow-based security index, including any interest therein or on the value thereof;
    • a single security or loan, including any interest therein or on the value thereof; or
    • the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer.
The CFTC Enforces Swap Dealer External Business Conduct Rules

On June 16, 2015, the CFTC entered into and released a consent order that addressed the actions of a former employee and associated person ("AP") of a provisionally registered swap dealer. The employee is alleged to have violated CFTC regulation 23.410(a)(3), which prohibits a registered swap dealer from engaging in fraudulent conduct and is part of the CFTC's suite of swap dealer external business conduct requirements. [2] Though the CFTC has entered into enforcement orders related to swap activity over the past few years, this is the first time the agency has publicly brought an action for violations of the new regulations specifically applicable to swap dealers.

The employee was responsible for negotiating and trading commodity swaps on behalf of two customers of the swap dealer. The employee was designated as an AP of the swap dealer for these activities. The fraud allegations stem from the employee's entering into unauthorized swap transactions for the clients' accounts, with an intent to recoup losses in those client accounts resulting from earlier, authorized swap and futures trading conducted by the employee. In addition, the order alleges that the employee's conduct was fraudulent because he willfully omitted material facts relating to the swap trading activity for one client's account, including the unauthorized swap transactions, the profits and losses incurred by those transactions, and the magnitude of the risks to which the client account was subject.

The CFTC has long brought enforcement actions against registered firms and their employees for alleged fraudulent conduct under a variety of Commodity Exchange Act antifraud provisions. The type of conduct that is the subject of this order is typical of past enforcement actions in the context of futures, foreign exchange, and other trading activities that are the subject of long-standing CFTC jurisdiction. This consent order is noteworthy, however, in that it describes the first publicly available enforcement action taken by the CFTC under the relatively new Title VII swap dealer regulations. In addition, the order makes clear that the antifraud provisions of the swap dealer external business conduct rules apply not only to the registered swap dealers but also separately and directly to the APs and other employees of swap dealers. Finally, in addition to a lifetime ban from engaging in commodity interest trading, the order levies a significant monetary penalty against the employee-in excess of $1 million, the amount of losses incurred by the client accounts-despite the swap dealer having already reimbursed the clients for those losses.


The SEC action shows that the SEC is monitoring actively the security-based swap market, even in advance of final rules implementing the majority of the security-based swap regulatory regime. The CFTC action highlights the CFTC's focus on the activities of swap dealers and their personnel, particularly when those activities may be fraudulent or misleading to customers. While these orders are the first publicly announced actions taken by the SEC and CFTC to enforce the new security-based swap provisions and swap dealer regulations, respectively, they are unlikely to be the last.


[1] See Order Instituting Cease-And-Desist Proceedings Pursuant To Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-And-Desist Order. In the Matter of Sand Hill Exchange, Gerrit Hall, and Elaine Ou, No. 3-16598 (SEC June 17, 2015), available here; and Consent Order of Permanent Injunction, Civil Monetary Penalty, and Other Equitable Relief Against Gregory Christopher Evans. U.S. Commodity Futures Trading Commission v. Gregory Christopher Evans, No. 14-0839-CV-W-ODS (W.D. Mo. June 16, 2015), available here.
(go back)

[2] The consent order also included allegations of violations of other antifraud provisions of the Commodity Exchange Act and CFTC regulations, including CFTC regulations 180.1 and 166.2.
(go back)

July 4, 2015
Fed's Volcker Relief for Foreign Funds
by See Editor's Note
Editor's Note:

Dan Ryan is Leader of the Financial Services Advisory Practice at PricewaterhouseCoopers LLP. This post is based on a PwC publication by Mr. Ryan, Mike Alix, Adam Gilbert, and Armen Meyer.

On Friday, June 12, 2015, the Federal Reserve (Fed) began addressing the question of whether foreign funds should be considered "banking entities" under the Bank Holding Company Act (BHCA), and therefore be subject to the Volcker Rule's proprietary trading restriction. The Fed's guidance (provided in the form of a "Frequently Asked Question," or FAQ) clarifies that foreign public funds (e.g., UCITS [1]) will not be considered banking entities merely due to their boards being controlled by an affiliate (i.e., an affiliate within the BHC capable of holding a majority of a fund’s director seats). [2]

However, with only weeks to go before the July 21, 2015 deadline, the FAQ does not resolve two other questions that have vexed foreign banks regarding the application of "banking entity" to foreign funds. First, the board control provision still applies to foreign private funds (i.e., foreign funds that are privately offered to institutional or high net worth investors in a manner similar to US hedge fund offerings). Second, another BHCA provision which establishes control when 25% or more of a fund's voting shares are owned by an affiliate still applies to foreign private funds, and to a lesser extent to foreign public funds.

The big question of whether foreign funds would be subjected to Volcker’s proprietary trading restriction as a result of being controlled by an affiliate became the major remaining interpretive issue facing foreign banks after the Fed provided a conformance extension for legacy covered funds (i.e., funds in place prior to December 31, 2013) in December 2014 [3] and clarified the "solely outside the US" exception's marketing restriction in February 2015.

  1. No relief is provided for foreign private funds: While US private funds (i.e., "covered funds" under the Volcker Rule [4]) are exempt from the control provisions of the BHCA, foreign private funds are not exempt and have been afforded no relief. As a result, these funds-which are set up for the purpose of taking risk through securities investments that are often long term (and fall outside of the “covered funds” definition)-will be unable to execute on their business model if Volcker’s proprietary trading ban is applied to them.
  2. Limited relief is provided for foreign public funds whose affiliate owns 25% or more of their voting shares: While foreign private funds receive no relief from the 25% ownership control provision, foreign public funds gain relief during the fund seeding period. Like the rules applied to US mutual funds, under the FAQ affiliates may own 25% or more of a foreign public fund during the initial one year seeding period (with the possibility of two additional years upon Fed approval). This limited relief will challenge the industry since banks often own more than 25% of foreign funds beyond a three year seeding period in order to develop a sufficient track record (which is also true of BHC investments in US mutual funds) or in order to facilitate hedging activities related to fund-linked notes.
  3. Legacy foreign funds (public and private) likely have an additional two years before conformance is required: The conformance extension provided to legacy foreign funds remains intact, [5] thus limiting disruption to foreign banks' fund businesses on July 21, 2015. For non-legacy foreign funds, as a practical matter, we do not believe that foreign banks will be able to restructure their control by July 21st.
  4. The industry will advocate for more relief: Advocacy from foreign banks and industry groups will continue in order to obtain additional relief. They will argue that it makes little sense to have excluded foreign funds from the Volcker Rule's definition of covered funds, only to then pull them back into Volcker by treating them as banking entities.
  5. Additional regulatory relief by July 21st is an unlikely priority: It would be difficult for regulators to provide more relief by July 21st, given the Fed's desire to reach consensus with the four other agencies overseeing Volcker (the SEC, CFTC, FDIC, and OCC) and given bandwidth issues at the agencies. However, since legacy foreign funds (i.e., most foreign funds) are not impacted until well after July 21st, hope remains that there will be more helpful relief. The Fed's response to banks' foreign fund extension requests filed in January 2015 did not close the door on this possibility, and several are still pending. It is likely that the Fed limited its relief to foreign public funds because it was easier to gain consensus for them by July 21st, and because the agencies were closer to the issue given its applicability to US banks. But only one thing really is certain: the Volcker theme of hurry-up-and-wait will continue as the industry continues to press its case and the regulators slowly take their next step.


[1] The EU's UCITS are similar to US mutual funds.
(go back)

[2] This has not been a concern for US funds because US law generally requires that boards of mutual funds and other registered investment companies (RICs) be independent from affiliates.
(go back)

[3] See PwC's First take, Ten key points from the Fed’s Volcker Rule covered funds extension (December 2014).
(go back)

[4] See PwC's Regulatory brief, Volcker Shrugged (December 2013).
(go back)

[5] See note 3.
(go back)

View today's posts

7/6/2015 posts

CLS Blue Sky Blog: Preparing Financial Regulation for the Second Machine Age: The Need for Oversight of Digital Intermediaries in the Futures Markets
CLS Blue Sky Blog: Sullivan & Cromwell discusses Senate Regulatory Relief Proposal: Banking Committee Chairman Releases Discussion Draft of "The Financial Regulatory Improvement Act of 2015"
HLS Forum on Corporate Governance and Financial Regulation: Proxy Access: The 2015 Proxy Season and Beyond
Delaware Corporate and Commercial Litigation Blog: Supreme Court Interprets Advance Notice Bylaws
Conglomerate: The SEC's Clawback Rule Blog: Audit Committee Disclosures: SEC's New Concept Release!
HLS Forum on Corporate Governance and Financial Regulation: SEC and CFTC Turn to Swaps and Security-Based Swaps Enforcement
HLS Forum on Corporate Governance and Financial Regulation: Fed's Volcker Relief for Foreign Funds

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