Subject to Inquiry

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White Collar, Congressional, SEC, Energy Enforcement & Other Government Inquiries

Government, Regulatory & Criminal Investigations Group
Ethics Rules

A Question of Ethics: Are Members Permitted to Help Companies in Which They Own Stock?

Roll Call October 14, 2014

Q. I heard that Rep. Tom Petri, R-Wis., may face ethics discipline because he assisted companies in which he owned stock. I know that Members are not supposed to use their position for their own personal gain, but I didn’t realize that meant they are disqualified from taking action on behalf of any companies in which they might own stock. Is that really the rule?

A. No, it is not. A member’s mere ownership of stock in a company does not disqualify the member from taking official acts on the company’s behalf. But, as the Petri matter illustrates, members should take special care when they assist companies in which they happen to own stock. Exactly what that means, unfortunately, is less than clear.

In a report made public last month the Office of Congressional Ethics, which filters allegations of misconduct for review by the House Committee on Ethics, concluded there is substantial reason to believe Petri “improperly performed official acts on behalf of companies in which he had a financial interest.” The OCE therefore recommended further review by the House Committee on Ethics, which it is now considering.

There is no dispute that Petri took official acts for companies in which he owned stock. That is allowed. At issue in the Petri case is whether he did so “improperly.” That is not.

According to the House Ethics Manual, acts that involve a degree of advocacy above and beyond merely voting on legislation require special care. For these acts — such as sponsoring legislation, participating in committee action or contacting an executive agency — a decision that may affect the member’s personal financial interest requires what the Committee calls “added circumspection.”

The OCE concluded there is substantial reason to believe Petri failed to meet this standard when he helped Wisconsin companies in which he or his wife owned stock by contacting other government officials regarding government contracts and regulations impacting the companies.

While the OCE acknowledged that in many instances Petri’s office sought Ethics Committee guidance before assisting the companies, “he did not seek advice before taking all official acts.” Moreover, in some instances, the requests for Ethics Committee guidance included inaccurate information, the OCE report said. The OCE also noted it interviewed two Petri aides who said there were “no written office policies or training specifically related to handling requests for official action by companies in which Representative Petri owned stock.”

Petri’s counsel disputed the OCE’s conclusions in a letter to the Ethics Committee, and urged the committee to complete its investigation before the end of Petri’s term. (Petri has announced he is not seeking re-election.) The letter noted that the companies Petri assisted are two of the largest employers in his district which, as a congressman, he assisted for many years. Moreover, the type and degree of assistance he provided did not change after he purchased stock in the companies in the mid- to late-2000s. “In every instance,” the letter said, “Representative Petri has made a good faith effort to comply fully with both the letter and spirit of the rules and the guidance his staff received.” The OCE, the letter argued, “seeks to impose a novel standard of conduct that would undermine the ability of all Members to rely with confidence on the ethics advice they receive from Committee staff.”

So, who is right? Precedent in this area is unclear. On the one hand, a 2012 Ethics Committee report about a conflict of interest investigation stated: “If a Member seeks to act on a matter where he might benefit as a member of a large class, the Committee has taken the position that such action does not require recusal.” On the other hand, that same report also said this does not “permit Members free rein to act on behalf of a single entity … merely because there are numerous shareholders.” The report concluded “the time has come to engage in a comprehensive review of the House conflicts standards so that they are clearer and more easily digested by the House community.” An Ethics Committee report later that year did include additional conflicts of interest guidance but did not address specifically the issue of members assisting companies in which they own stock.

Ultimately, then, in an environment in which it is unclear exactly what precautions House rules require of members who own stock in a company they wish to help, the Petri matter may come down to whether the precautions he took are deemed adequate, ex post facto. The OCE report includes many examples of efforts by Petri and his staff to make sure they were complying with the rules and committee guidance. They were careful. It may be up to the Ethics Committee to determine if they were careful enough.


© Copyright 2014, Roll Call Inc. Reprinted with permission. Widely regarded as the leading publication for Congressional news and information, Roll Call has been the newspaper of Capitol Hill since 1955. For more information, visit www.rollcall.com.

Compliance, Dodd-Frank, Enforcement Actions, Financial Regulation, Regulation, SEC, SEC Enforcement, Whistleblowers

Taking Aim – the SEC’s Continued Focus on Hedge Funds

“It is difficult to overstate how much the regulatory landscape for hedge fund managers has changed over the past four years.” So said Norm Champ, director of the Securities and Exchange Commission’s Division of Investment Management, in a recent speech wherein he outlined how the SEC has built on its newfound authority to regulate private fund advisers, including by taking advantage of its increased access to information and new analytical tools. As we’ve previously reported, since Dodd-Frank, most investment advisers to private funds, such as hedge funds, now have to register with the SEC, thus subjecting them to SEC oversight and regulatory requirements.

In recent months, the SEC has actively engaged with the industry through speeches, guidance updates, and examinations to counsel advisers on their newfound obligations and to gain a better understanding of the industry. Director Champ’s speech is one of the latest examples of this outreach. But, as we’ve reported, the SEC also has clearly conveyed that its increased scrutiny of private funds likely will lead to an increasing number of enforcement investigations and actions. Champ’s speech and other recent events confirm this trend.

Advisers must Provide Significant Data to the SEC

Advisers to most private funds must not only register with the SEC, but also provide significant information to the SEC, including through a new Form PF, which seeks information on an adviser’s investment strategy. As the staff of the Investment Management Division recently reported to Congress, Form PF, which must be completed by advisers to funds with greater than $150 million in regulatory assets under management, requires advisers (depending on the size of the funds they manage) to provide information such as the types of funds advised (e.g., hedge funds, private equity funds), the funds’ size, the use of leverage, the types of investors, liquidity, performance, fund strategy, counterparty credit risk, and the use of trading and clearing mechanisms. Advisers to large funds must provide more details and must do so more often.

The SEC Actively Uses this Data in Connection with Examinations and Enforcement Actions

Dodd-Frank requires the SEC to treat this information confidentially, and the staff of the Investment Management Division has confirmed that the SEC has designed and implemented controls for handling Form PF data. Yet, while the SEC must treat Form PF data confidentially, fund advisers should take heed that the SEC and other regulators, such as the Commodity Futures Trading Commission, are actively using this information in their examination and enforcement duties.

As the staff of the Investment Management Division confirmed in a recent report to Congress, although Form PF’s “primary aim” is to compile data on private funds to help the Financial Stability Oversight Council (FSOC) assess systemic risk in the economy, the SEC also is “using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers.” Likewise, Director Champ explained in his speech that the SEC’s Office of Compliance Inspections and Examinations (OCIE) not only reviews Form PF data before examining an adviser to better understand the adviser’s business, it also “reviews information contained in the Form PF filing for inconsistencies with an adviser’s publicly available documents, the investment strategies disclosed to investors, and other information obtained during an examination.” Even more importantly, he confirmed that the SEC’s Enforcement Division reviews Form PF filings during investigations, and that the SEC uses the data in connection with its “Aberrational Performance Inquiry, which seeks to identify hedge fund advisers that report aberrational returns relative to certain benchmarks for further investigation, and has resulted in the identification of fraudulent or improper conduct.” The SEC previously confirmed that the Aberrational Performance Inquiry has led to numerous enforcement actions against hedge fund advisers.

In sum, advisers to private funds must ensure accuracy in their Form PF submittals and consistency between the Form PF and information disclosed in other public and private documents, such as the Form ADV, marketing brochures and the adviser’s website. Failure to do so may lead to examination deficiency letters and quite possibly an enforcement action.

Increased Examination and Enforcement

The SEC also is continuing to pursue its initiatives to examine a significant proportion of newly registered advisers. In his recent speech, Director Champ again confirmed that OCIE’s National Examination Program (NEP) has pledged to visit 20 percent of advisers who have been registered for three or more years but who have not yet been examined. Such a visit may involve a “risk assessment” to better understand the adviser’s firm, but it also may entail a more “focused” review involving “comprehensive, risk-based examinations of one or more higher-risk areas, which could include, among others, the compliance program, portfolio management, or safety of client assets.”

Meanwhile, since 2012 the NEP has pursued an initiative to conduct “presence” examinations of 25 percent of private fund advisers who registered following Dodd-Frank’s expansion of registration requirements. In these examinations, the NEP is focusing on marketing, portfolio management, conflicts of interest, safety of client assets, and valuation. SEC Chair Mary Jo White advised Congress earlier this year that the NEP was on track to complete its goal of conducting presence exams of 25 percent of advisers by the end of 2014. Finally, as Champ mentioned in a speech last June, and as confirmed by recent reporting, OCIE has launched a sweep examination of fund complexes that offer “alternative mutual funds,” which are described by Champ as funds whose primary strategy focuses on nontraditional asset classes (e.g., currencies), nontraditional strategies (e.g., long/short equity positions), and/or illiquid assets (e.g., private debt).

Predictably, the SEC’s increased scrutiny of hedge fund and private fund advisers has led to new enforcement actions. For example, the SEC has advised the private fund industry repeatedly over the past few years that it is paying close attention to potential conflicts of interest between fund advisers and their fund clients. In discussing these concerns yet again, Champ cited the SEC’s recent settled enforcement action against an adviser to a hedge fund wherein the SEC charged the adviser and its owner with failing to provide effective written disclosure regarding transactions between its hedge fund client and a firm-affiliated broker-dealer. While the firm established a conflicts committee to review the transactions, the SEC found that the members of that committee were themselves conflicted. This matter was also notable as the SEC’s first action against an entity for retaliating against a whistleblower for exposing the issue to the SEC. The firm and its owner agreed to pay $1.7 million in disgorgement, prejudgment interest of over $180,000 and a penalty of $300,000.

In a more recent matter postdating Director Champ’s speech, the SEC settled an enforcement action with an adviser to two private equity funds regarding charges of breach of a fiduciary duty and failure to adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act. The SEC alleged that the adviser misallocated expenses between the two portfolio companies it managed. Although the firm integrated the companies to capitalize on synergies between the two, the firm charged certain expenses to one company despite the fact that those expenses applied to the other company or benefitted both companies. The SEC order noted that, when the adviser registered on March 28, 2012, it became subject to the Advisers Act requirements to adopt and implement adequate policies and procedures, and concluded that the adviser violated the Act by failing to adopt and implement such procedures. The adviser agreed to pay $1.5 million in disgorgement, over $350,000 in prejudgment interest and a $450,000 penalty.

As these examples demonstrate, the SEC is not only scrutinizing whether fund advisers are implementing effective policies and sufficiently disclosing information to their fund clients, but also actively pursuing enforcement actions for failures to comply. With the proliferation of newly registered private fund advisers, the dramatic increase in data those advisers are required to report, and the SEC’s goal of promptly examining a significant number of newly registered advisers, it is almost certain that we will continue to see increasing numbers of enforcement actions. Therefore, it is imperative that advisers to private funds ensure that they have adequate compliance programs (which they review and update often), and that all disclosures, public and private, are consistent and accurate. Sooner or later, the SEC will visit. Advisers must be prepared.

 

Anti-Corruption, FCPA, FCPA Investigations

Update: Supreme Court Declines to Define Instrumentality under FCPA

On October 6, 2014, the U.S. Supreme Court denied an August 14, 2014, petition for writ of certiorari by Joel Esquenazi and Carlos Rodriquez, former owners of Terra Communications (Terra). The petition asked the court to define who counts as a foreign official under the Foreign Corrupt Practices Act (FCPA).

In 2011, Esquenazi and Rodriquez were convicted under the FCPA for making payments to foreign officials. On May 16, 2014, their convictions were upheld by the 11th U.S. Circuit Court of Appeals.

The Supreme Court did not explain why it denied the petition. The Supreme Court’s denial leaves intact the definition in the 11th Circuit ruling, which provided the following list of factors to determine if an entity is an instrument of a foreign government.

• Does the government control the entity? Consider:

  • the nature of the foreign government’s formal designation of the entity;
  • whether the government has a majority interest in the entity;
  • the government’s ability to hire and fire entity principals;
  • the extent to which the entity’s profits, if any, go directly to the government;
  • the extent to which the government funds the entity if it fails to break even; and
  • the length of time these indicia have existed.

• Is the entity an instrumentality of a foreign government? Consider:

  • whether the entity has a monopoly over the function it exists to perform;
  • whether the government subsidizes the costs associated with the entity providing services;
  • whether the entity provides services to the public at large; and
  • whether the public and the government of the foreign country generally perceive the entity to be performing a governmental function.

Until another circuit rules on the issue, domestic companies must be aware that, if a foreign company is state-owned, that can be enough to trigger anti-bribery statutes.

CFPB, Compliance, Enforcement Actions

A Harbinger of Things to Come – CFPB Announces First Action for Violations of New Mortgage Servicing Rules

In what is certainly an indication of its enforcement priorities as well as a warning to mortgage servicers, the CFPB recently announced its first enforcement action for violations of its Mortgage Servicing Rules, which went into effect last January and impose a variety of requirements on mortgage servicers.

In a consent order issued against Flagstar Bank, F.S.B., the CFPB cited multiple legal violations by Flagstar in its default servicing practices, all in the area of loss mitigation. The order requires the bank to pay $27.5 million in damages, at least $20 million of which will be distributed to foreclosed customers. In addition, the CFPB assessed a $10 million civil money penalty and placed a temporary prohibition on the bank’s right to acquire servicing or sub-servicing rights on defaulted loans until it implements a compliance plan as set forth in the consent order.

The consent order cites four main violations by the bank since the rules went into effect:

  1. Failure to provide the required loss mitigation acknowledgement letter to a consumer within five business days of receiving an application pursuant to 12 C.F.R. § 1024.41(b);
  2. Failure to evaluate loss mitigation applications within the 30-day period prescribed in 12 C.F.R. § 1024.41(c);
  3. Failure to properly notify borrowers of their right to appeal under 12 C.F.R. § 1024.41(c) and (h), specifically by incorrectly informing borrowers that the right to appeal exists only in certain states and by failing to provide some borrowers the required appeal form; and
  4. Failure to maintain reasonable policies and procedures under 12 C.F.R. § 1024.38, including vague and contradictory guidance in the bank’s procedure manual and the policies’ practical failure to ensure the bank’s compliance with the Mortgage Servicing Rules.

In addition, the consent order encompasses many violations of the Consumer Financial Protection Act (CFPA) that occurred before the CFPB’s Mortgage Servicing Rules became effective.

The enforcement action comes as no surprise, but it gives servicers a clear indication of the kinds of issues attracting CFPB scrutiny and sends a clear message that strict adherence to these rules is the expectation. Indeed, CFPB Director Richard Cordray has described it as “a new era of enforcement.” Expect to see more CFPB enforcement activity on mortgage servicing issues in the future.

Broker-Dealer Defendants, Compliance, Regulation, SEC

One Year Later: SEC Sanctions Under Rule 105 of Regulation M

On September 16, 2014, the Securities and Exchange Commission announced enforcement actions against 19 firms and an individual trader for short sales in violation of Rule 105 of Regulation M. The SEC’s latest crackdown on short-selling violations in advance of stock offerings came one day shy of the one-year anniversary of enforcement actions against 23 firms for Rule 105 violations and the issuance of the SEC’s National Examination Program (NEP) Risk Alert highlighting observations on Rule 105 compliance issues. The most recent enforcement actions resulted in the imposition of cease-and-desist orders and more than $9 million in civil penalties, disgorgement and interest.

The Rule

Rule 105 exists to promote offering prices that are set by natural forces of supply and demand, rather than manipulation, by discouraging short selling that could artificially depress market prices. Rule 105 generally prohibits the purchasing of securities in follow-on and secondary offerings from an underwriter or broker-dealer participating in the offering when the purchaser has conducted short sales in the securities within a specified time period before the pricing of the offering. This “restricted period” is the shorter of: 1) the period beginning five business days before a public offering and ending with such pricing, or 2) the period beginning with the initial filing of such registration statement or notification on Form 1-A or Form 1-E and ending with the pricing. There is no intent or “scienter” requirement, so this rule applies regardless of whether a trading strategy was intended to manipulate the price of the security. There are, however, three specific exceptions to the rule.

Bona Fide Purchase Exception

An individual can purchase equity securities in the offering regardless of selling short during the restricted period so long as the individual makes a bona fide purchase equivalent in quantity to the amount of the restricted period short sale prior to the pricing. In order to qualify under this exception, individuals must make sure they are in compliance with the specific timing and trade reporting requirements that are in place to ensure that the purchasing activity in the equity security is visible to the market prior to the pricing of the offering.

Separate Accounts Exception

This exception allows a purchase of an offered equity security in an individual’s account in situations where that individual sold short in another account during the restricted period. The SEC has provided several factors to help show that accounts are indeed separate:

  • Investment and trading strategies and objectives are separate and distinct.
  • Personnel for each account do not coordinate trading among or between the accounts.
  • Information barriers separate the accounts, and information about securities positions or investment decisions is not shared between accounts.
  • Each account maintains a separate profit-and-loss statement.
  • There is no allocation of securities between or among accounts.
  • Personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and account owners of multiple accounts, do not have authority to execute trading in individual securities in the accounts and, in fact, do not execute trades in the accounts. Likewise, they do not have the authority to preapprove trading decisions for the accounts and, in fact, do not preapprove trading decision for the accounts.

Investment Company Exception

The third exception permits an individual, registered fund – or a series of such fund − to participate in an offering of an equity security regardless of whether another series of the registered fund or an affiliated registered fund sold short during the restricted period.1

Robust Compliance

During this most recent announcement, Andrew Ceresney, director of the SEC’s Division of Enforcement, stated:

Rule 105 is an important preventive measure designed to protect issuers from downward pressure on their stock price in advance of offerings. These charges should remind investment advisers and others of the need for robust and comprehensive compliance programs covering Rule 105 compliance.

The announcement also noted that the Enforcement Division’s assistance from the Financial Industry Regulatory Authority (FINRA) helped “to quickly identify potential violations.”

Market participants would be well-served to take notice of the SEC’s continued pursuit of violations of Rule 105 of Regulation M. In this regard, firms and individuals who engage in short-selling activities should familiarize themselves with the guidance set forth in the NEP Risk Alert to ensure that they are in accord with the requirements of Rule 105. Such efforts should include:

  • promoting training to employees regarding the application of Rule 105,
  • developing and implementing policies and procedures specifically tailored to the particulars of the firm’s business and that are designed to achieve compliance with Rule 105, and
  • monitoring and enforcing compliance with those policies and procedures.

 


1For example, an individual fund within a fund complex is generally not prohibited by Rule 105 from purchasing an offered security if another fund within the same complex (i.e., an affiliate) sold short the same security within the restricted period. Exchange Act Release No. 56206, 72 Fed. Reg. 45,094 (August 10, 2007) at 45,100.

CFPB

Higher Education Facing Scrutiny from CFPB

Colleges, universities and anyone offering postsecondary education, take note: The Consumer Financial Protection Bureau (CFPB) continues to target alleged unfair and deceptive practices related to the student loan and financial aid process. A few weeks ago, the CFPB filed suit against Corinthian Colleges in U.S. District Court for the Northern District of Illinois, alleging violations of the Consumer Financial Protection Act of 2010 (CFPA) by:

induc[ing] students to enroll in its programs through false and misleading representations about its graduates’ career opportunities, including representations suggesting Corinthian would provide assistance in helping students find a job, and that students were likely to obtain a permanent job upon graduation.1

According to the complaint, Corinthian allegedly inflated its job placement rates and induced students to sign up for private student loans with substantially higher interest rates.2 The CFPB also asserts that school staff used unacceptable tactics in collecting on past-due loan amounts, including pulling students from class, preventing registration and terminating computer access.3

The place of filing and the timing of the suit are notable. While Corinthian is headquartered in Santa Ana, California, and is one of the largest for-profit, postsecondary eduaation companies with campuses throughout the country,4 the CFPB filed suit in the Northern District of Illinois. Filing suit in that particular district was no coincidence. The filing came on the heels of a favorable decision to the CFPB’s position, Illinois v. Alta Colleges, Inc., issued out of the Northern District of Illinois on September 4, 2014.5

In that case, the Illinois Attorney General sued Alta Colleges and Westwood College for similar issues and representations made in the student loan process.6 The court in Alta denied defendants’ motion to dismiss the case. With little analysis, the court made clear its belief that defendant colleges are “covered persons” under the CFPA through operation of the student loan program, and thus, the Illinois Attorney General has jurisdiction to sue. The court dismissed the defendants’ assertion that the colleges may fall under the merchant-retailer-seller jurisdictional exception, which generally applies to those who are not significantly engaged in offering consumer financial products or services. The court also rejected defendants’ arguments that the CFPA’s prohibition of unfair, deceptive or abusive acts is unconstitutionally vague and acknowledged the similarity to prohibitions outlined in the Federal Trade Commission Act, which courts consistently have upheld.

In its efforts to regulate actions of colleges and universities in the student loan and financial aid process, the CFPB is already trying to convince other courts to adopt the Alta decision. The CFPB filed a Notice of Supplemental Authority on September 8, 2014, in its suit against ITT Educational Services, citing Alta.7 Meanwhile, ITT continues to mount a strenuous defense to the CFPB’s jurisdiction over it, by distinguishing Alta, who ran an in-house student loan program, from ITT, who had no financial interest in the student loans and simply referred students to a third-party lender.8 ITT’s motion to dismiss is pending in the Southern District of Indiana.9 With little case law on the scope of the CFPB’s jurisdiction and reach in this area, the outcome is certainly one to watch.

 


1Complaint, Consumer Financial Protection Bureau v. Corinthian Colleges, Case No. 1:14-cv-07194, Doc. No. 1, ¶ 2 (N.D. Ill. Sept. 16, 2014).
2Id. at ¶¶ 3, 15, 38, 49, 51, 58-83, 117.
3Id. at ¶¶ 9, 132, 173, 181.
4Id. at ¶¶ 25-26; see also Corinthian Colleges, Inc. “Company History.”
5Memorandum Opinion and Order, Illinois v. Alta Colleges, Inc., Case No. 1:14-cv-3786, Doc. No. 53 (N.D. Ill. Sept. 4. 2014).
6The attorney general of any state is given express authority to sue under the Consumer Financial Protection Act, but the CFPB may intervene in the action if it so chooses.  See 12 U.S.C. § 5552(a)(1).
7Consumer Financial Protection Bureau v. ITT Educational Services, Inc., Case No. 1:14-cv-292, Doc. No. 41 (S.D. Ind. Sept. 8, 2014).
8Consumer Financial Protection Bureau v. ITT Educational Services, Inc., Case No. 1:14-cv-292, Doc. No. 42 (S.D. Ind. Sept. 19, 2014).
9Consumer Financial Protection Bureau v. ITT Educational Services, Inc., Case No. 1:14-cv-292, Docs. Nos. 15 and 23 (S.D. Ind. Sept. 19, 2014).

Dodd-Frank, SEC, Whistleblowers

SEC Announces Record-Breaking Award for Foreign Whistleblower in the Wake of Liu v. Siemens

Recently, the SEC announced its largest whistleblower award to date − an expected award of $30-35 million − to be issued to a foreign resident. Notably, the award would have been even larger if the tipster had not unreasonably delayed in reporting the violations.

This award to a foreign resident is of particular interest because it was announced in the wake of Liu v. Siemens, 763 F.3d 175 (2d Cir. 2014). As we recently discussed, in Liu, the United States Court of Appeals for the Second Circuit followed Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010), in ruling that Dodd-Frank’s anti-retaliation provision, 15 U.S.C. § 78u-6(h), does not apply extraterritorially. In affirming the dismissal of Liu’s claim, the court also concluded that Liu failed to plead facts constituting a domestic application of the provision to a foreign worker employed by a foreign corporation when all events related to the disclosure occurred abroad. In its opinion, the court specifically rejected Liu’s reliance on Dodd-Frank’s whistleblower bounty provision, 15 U.S.C. § 78u-6(b), to support the argument for foreign application of the anti-retaliation provision. Among other reasons, the court noted that the extraterritorial application of the bounty and anti-retaliation provisions have “far different international ramifications.”

Less than a month after the Liu opinion was entered, the SEC announced this record-breaking whistleblower award, which is the fourth award to a whistleblower living in a foreign country. In an extensive footnote in its Order Determining Whistleblower Award Claim, the SEC addressed the issue of extraterritoriality, explaining:

In our view, there is a sufficient U.S. territorial nexus whenever a claimant’s information leads to the successful enforcement of a covered action brought in the United States, concerning violations of the U.S. securities laws, by the Commission, the U.S. regulatory agency with enforcement authority for such violations. When these key territorial connections exist, it makes no difference whether, for example, the claimant was a foreign national, the claimant resides overseas, the information was submitted from overseas, or the misconduct comprising the U.S. securities law violation occurred entirely overseas.

The SEC then specifically acknowledged Liu, finding that the decision was not controlling because “the whistleblower award provisions have a different Congressional focus than the anti-retaliation provisions, which are generally focused on preventing retaliatory employment actions and protecting the employment relationship.”

This award and the SEC’s pronouncement on the issue of extraterritoriality demonstrate the SEC’s continued interest in maintaining foreign tipsters as significant sources of information for potential violations of U.S. securities laws. Chief of the SEC’s Office of the Whistleblower, Sean McKessy, reaffirmed this interest when the award was announced. Highlighting the international reach of the whistleblower program, he noted that “[w]histleblowers from all over the world should feel similarly incentivized to come forward with credible information about potential violations of the U.S. securities laws.”

Financial Regulation, Legislation, Regulation

New CME Rule Governing Disruptive Trading Practices

On August 28, 2014, the Chicago Mercantile Exchange Inc., the Board of Trade of the City of Chicago Inc., the New York Mercantile Exchange Inc. and the Commodity Exchange Inc. (collectively, the “Exchanges”) announced that they were going to adopt new Rule 575, called Disruptive Practices Prohibited. Rule 575 was implemented on September 15, 2014. While the new Rule 575 merely codifies the Exchanges’ existing rules, the new rule illustrates exactly what the Exchanges view as constituting disruptive order entry and trading practices. The Exchanges also released Market Regulation Advisory Notice RA 1405-5 (RA1405-5), which provides more guidance on what actions and behaviors will be deemed disruptive order entry and trading practices.

Generally, Rule 575 prohibits market participants from spoofing, violating bids or offers, or demonstrating intentional or reckless disregard for the orderly execution of transactions during the closing period. Spoofing refers to the practice of bidding or offering with the intent to cancel the bid or offer before final execution.

The text of Rule 575.A-575.D expressly prohibits market participants from engaging in the following, specific actions:

  • 575.A prohibits participants from entering orders “with the intent, at the time of order entry, to cancel the order before execution or to avoid execution.”
  • 575.B prohibits participants from entering “an actionable1 or non-actionable2 message or messages with intent to mislead other market participants.”
  • 575.C prohibits participants from entering “an actionable, or non-actionable message or messages with intent to overload, delay, or disrupt the systems of the Exchange or other market participants.”
  • 575.D prohibits participants from entering “actionable or non-actionable message[s] with intent to disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.”

With the exception of Rule 575.D, which applies to intentional and reckless conduct, Rule 575(A-C) applies to intentional conduct. The Exchanges view intentional conduct as conduct that “more likely than not was intended to produce a prohibited disruptive consequence without justification.” Given this definition, it is important for market participants to understand that they cannot defend themselves against alleged violations of Rule 575 by claiming ignorance, negligence or lack of knowledge.

For more information and to view the entire text of Rule 575, click here.


1“Actionable” messages are “messages that can be accepted by another party or otherwise lead to the execution of a trade.”  An order message is an actionable message.
2“Non-actionable” messages are “messages submitted to the Exchange that relate to a non-actionable event.  Requests for Quotes, creation of User Defined Spreads (UDS) and administrative messages are example of non-actionable messages.

CFPB

CFPB Proposes New Rule Expanding Oversight to NonBank Auto Finance Companies

In a move that should come as no surprise to anyone who has been following the Consumer Financial Protection Bureau (CFPB), the agency issued a proposed rule last week that would expand its oversight, supervision and enforcement jurisdiction to include nonbank automobile finance companies.

Established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), the CFPB has authority to oversee and regulate entities, such as banks and credit unions, that provide consumer financial products and services. The agency’s jurisdiction extends to certain nonbank entities that the CFPB defines through rulemaking as “larger participants” in a market for “other” consumer financial products or services. 12 U.S.C. § 5514.

On September 17, 2014, the CFPB issued a proposed rule that would allow it to begin regulating an estimated 38 nonbank auto finance companies that it considers to be “larger participants” (per the rule, companies that originate, acquire or refinance at least 10,000 loans per year) in the consumer “automobile financing market.”According to the CFPB, these 38 companies originate roughly 90 percent of nonbank auto loans and leases, and last year provided service to approximately 6.8 million borrowers.

Under the proposed rule, the “automobile financing market” encompasses entities that grant credit for automobile purchases, refinance such obligations, purchase or acquire such obligations, or issue or purchase automobile leases. Id. These entities include specialty finance companies, captive nonbanks (subsidiary finance companies owned by automobile manufacturers), and “buy here, pay here” finance companies. Id. The “automobile financing market” does not encompass title lending or the securitization of loans or leases.

The CFPB says its move to regulate and supervise nonbank auto finance companies is part of its larger effort to curtail discrimination in the auto-lending market. In a press release and report issued concurrently with the proposed rule, the CFPB stated that over the past two years, it discovered that a number of banks subject to agency regulation “had discretionary pricing policies that resulted in discrimination against African-American, Hispanic, and Asian and Pacific Island borrowers.”According to the agency, these discriminatory policies resulted in affected borrowers “paying more for their auto loans than similarly situated non-Hispanic white borrowers.” Id. The CFPB already supervises the auto lending practices of banks with more than $10 billion in assets. According to the CFPB, “[t]his proposal is needed to level the playing field for banks and nonbanks in the auto lending market,” because “every auto lender should be following the law and be subject to the same level of oversight.”

If the proposed rule becomes final, it will be the fifth rule to expand the CFPB’s oversight authority pursuant to the Dodd-Frank Act’s provisions concerning “larger participants” in markets for “other consumer financial products or services.” The four other rules include markets for consumer reporting, consumer debt collection, student loan servicing and international money transfers. It seems clear that the CFPB’s efforts to stretch the boundaries of its jurisdiction won’t be ending any time soon.

Dodd-Frank, SEC, Whistleblowers

Second Circuit Decides Dodd-Frank Does Not Apply Extraterritorially, Skips Addressing Whistleblower Protection for Internal Reporting

The Dodd-Frank Act prohibits employers from retaliating against employees who act as whistleblowers by providing information related to a violation of the securities laws to the Securities and Exchange Commission (SEC) in a manner established by the SEC. Dodd-Frank Act, 15 U.S.C. § 78u-6(h)(1). The jurisdiction and scope of this law have been tested recently in the U.S. Courts of Appeals for the Second and Eighth Circuits. In the Eighth Circuit, the court was asked to take up an interlocutory appeal to determine whether individuals who do not provide information directly to the SEC qualify as “whistleblowers” under Dodd-Frank. The Eighth Circuit declined to take up the appeal. The Second Circuit also was asked to weigh in on whether whistleblowers are protected if they report violations only internally, but the court did not need to reach that question. Instead, the Second Circuit held that Dodd-Frank does not apply extraterritorially, and because the plaintiff failed to allege that any of the events took place within the United States, Dodd-Frank did not apply. Liu v. Siemens AG, Docket No. 13-4385, (2d Cir. Aug. 14, 2014).

In Liu v. Siemens AG, the Second Circuit was presented with multiple issues, including whether the Dodd-Frank Act applied outside of the United States and whether Dodd-Frank’s definition of whistleblower included an individual who reported violations only internally, within his or her company. The court did not need to reach the internal reporting issue, as it followed the Supreme Court’s decision in Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010), in concluding that the Dodd-Frank Act was not intended to apply extraterritorially. Morrison stands for the proposition that a law will not be applied extraterritorially unless Congress affirmatively indicated that the law was meant to be so applied. Id. at 265. Relying on this precedent, the Second Circuit rejected Liu’s arguments that the broad language of the Dodd-Frank Act could be read to imply extraterritorial application. The Second Circuit held that “there is no explicit statutory evidence that Congress meant for the antiretaliation to apply extraterritorially . . . . Thus ‘we must presume [that the antiretaliation provision] is primarily concerned with domestic conditions.’ ” Liu, Docket No. 13-4385, at 20 (quoting Norex Petroleum Ltd. v. Access Industries, Inc., 631 F.3d 29, 32 (2d Cir. 2010)

By affirming the lower court on the extraterritoriality question, the Second Circuit did not reach the issue of whether the Dodd-Frank Act protects would-be “whistleblowers” who do not report violations directly to the SEC. While Liu did not result in an opinion on that subject, the proceeding did provide insight into the SEC’s point of view, as the SEC filed an amicus brief urging the court to defer to the SEC’s interpretation of Dodd-Frank’s whistleblower protection, discussed in additional detail on this blog . In its brief, the SEC argued that Dodd-Frank’s anti-retaliation provisions apply to any individual engaging in protected whistleblowing activities, including reporting internally to the company as Liu did. The SEC reasoned that it had crafted its rules to provide “strong incentives” to report internally in the first instance, and pointed out that “if internal compliance and reporting procedures are not utilized or working, our system of securities regulation will be less effective.”

The Eighth Circuit also had the opportunity to address the internal reporting question in Bussing v. COR Clearing, LLC. In Bussing, the district court denied COR Clearing’s motion to dismiss a former executive’s claim under the Dodd-Frank Act based on retaliatory termination after the executive reported potential violations to COR Clearing’s top executives and to FINRA, but not to the SEC. COR Clearing argued that because the executive did not report directly to the SEC, Dodd-Frank did not apply. U.S. District Court Judge John Gerrard rejected this argument but allowed COR Clearing to pursue an interlocutory appeal to the Eighth Circuit. The court of appeals did not take COR Clearing up on its invitation and the case presumably will proceed at the district court level.[1]

With the Second Circuit sidestepping the issue and the Eighth Circuit refusing to take it up, the Fifth Circuit, in Asadi v. G.E. Energy (USA) LLC, 720 F.3d 620 (5th Cir. 2013), is the only appellate court to have spoken on the issue, holding that the Dodd-Frank Act’s protection of whistleblowers does not apply to individuals who do not provide the SEC with information relating to securities law violations. While not binding outside the Fifth Circuit, the court’s opinion in Asadi is at least persuasive, and at odds with the SEC’s point of view as articulated in its amicus brief in Liu. Against this backdrop, an employee seeking to guarantee protection under Dodd-Frank should provide information of securities violations directly to the SEC. In addition, employers should assume that an employee reporting internally also will be making a report with the SEC, and the employer should act quickly to investigate the claims. Employers should take great care when dealing with potential whistleblowers to avoid any actions that may appear to be retaliatory in nature, particularly in light of the SEC’s view.


1. Stephanie Russell-Kraft, 8th Circ. Denies Appeal on Dodd-Frank Whistleblower Limits, Law360.com, http://www.law360.com/articles/574043/8th-circ-denies-appeal-on-dodd-frank-whistleblower-limits, (Sept. 4, 2014 4:03 PM ET).