SEC Guidance on the Custody Rule

 In March, the SEC  issued a Risk Alert and an Investor Bulletin related to compliance with its custody rules for investment advisers.  The Risk Alert was issued following recent examinations of investment advisers which revealed various deficiencies related to compliance with the SEC’s custody rules.

 Custody by an investment adviser means holding client funds or securities, directly or indirectly, or having the authority to obtain possession of them. For example, an investment adviser has custody of its clients’ assets when an investment adviser has the power to withdraw funds or securities from its client’s accounts, including fees.  SEC-registered investment advisers who have custody of client assets must, subject to certain exceptions, (i) use qualified custodians to hold client assets, (ii) provide notice to their clients in writing of the qualified custodian’s name, address, and the manner in which the client’s funds or securities are maintained, (iii) have a reasonable basis to believe that the qualified custodian that maintains its clients’ funds and securities sends account statements at least quarterly to the adviser’s clients directly, (iv) must enter into a written agreement with an independent public accountant to examine client funds and  securities on a surprise basis every year to verify such funds and securities, and (v) comply with certain additional rules when the adviser uses a related qualified custodian.

The deficiencies identified in recent exams of investment advisers included:

  • failure of advisers to recognize that they had custody;
  • failure of advisers to comply with the custody rule’s surprise examination requirements;
  • failure of advisers to comply with the custody rule’s qualified custodian requirement; and
  • failure of advisers to comply with the audited fund exception to the surprise audit requirement for pooled investment vehicles.

 As a result of recent examinations, the SEC staff  has required advisers with custodial deficiencies to take various actions, including remedial measures, such as drafting, amending or enhancing their written compliance procedures, policies, or processes; changing their business practices; or devoting more resources or attention to the area of custody. In addition, in certain cases, the staff has made referrals to the SEC’s Division of Enforcement.  In connection with the annual review of their policies and procedures, investment advisers should pay particular attention to their custodial policies, procedures and actual business practices in light of this recently issued Risk Alert.


Take Care When Using Finders

With good reason, many securities lawyers, myself included, cringe when they hear that a business client has engaged a “consultant” or “finder” to help raise capital rather than a registered broker.  Under Section 15(a) of the Securities Exchange Act of 1934, as amended, with some limited exceptions, it is unlawful for any person to effect any transactions in, or induce or attempt to induce the purchase or sale of, any securities unless the person is registered as a broker or dealer under the Exchange Act or associated with a registered broker or dealer.  What activities will require a person to register?  Even the SEC admits in its guidance on registering as a broker or dealer that it is not always easy tell.  However, one clear indicator that a person is probably acting as a broker or dealer is the person’s receipt of transaction-based compensation, such as a percentage of invested capital.    

The SEC recently announced that it had charged William M. Stephens with soliciting investments for two related investment funds while not registered as a broker under the Exchange Act.  As described in the Cease-and-Desist Order, with respect to investors introduced by Mr. Stephens, Mr. Stephens was to be paid one percent of amounts investors committed to invest.  In addition, Mr. Stephens provided various investment materials to prospective investors, such as private placement memoranda and subscription documents.   

Why should a company raising capital care if a consultant or finder is acting as an unregistered broker?  The involvement of an unregistered broker could give investors a right of rescission, that is, the right to require the company to buy back the securities the investor purchased at the original purchase price.  Obviously, the consequences of having to repurchase a large number of securities could be catastrophic as they were for Neogenix Oncology, Inc.  As detailed in a surprisingly frank series of letters  from Neogenix’s management to shareholders and Neogenix’s SEC filings, Neogenix’s use of unregistered finders to secure investments gave rise to up to $31 million of potential rescission liabilities.  These potential liabilities, and their impact on Neogenix’s ability to raise additional capital, ultimately contributed to  Neogenix’s decision to file for bankruptcy.

2 Good Reads

The staff of the SEC issued two useful publications this week. 

The first publication “Accessing the U.S. Capital Markets – A Brief Overview for Foreign Private Issuers” summarizes federal securities law and additional issues applicable to foreign private issuers wishing to access the U.S. capital markets. More specifically, the publication discusses the following matters: qualification as a foreign private issuer; registration and ongoing reporting obligations; exemptions from Securities Act registration (private and limited offerings, offshore sales and resales of restricted securities) and using American Depositary Receipts.

The second publication outlines the staff’s examination priorities for 2013.  Such publication first reveals issues that the staff has identified that span the entire market, including: fraud detection and prevention; corporate governance and enterprise risk management; conflicts of interest and technology controls.  In addition, the publication discusses priorities related to particular businesses, including: investment advisers and investment companies; broker-dealers; clearing and transfer agents and market oversight.   It should be noted that the priorities identified by the staff are not exhaustive, as the staff will conduct examinations in 2013 focused on risks, issues, and policy matters that are not set forth in the examination priorities publication.

Beware Inside Traders: SEC has “57 Varieties” of Ways to Get You!

The SEC announced last Friday that it had obtained an emergency court order to freeze assets in a Zurich, Switzerland-based trading account that allegedly was used to reap more than $1.7 million in insider trading profits in advance of the February 14th announcement of the acquisition of the H.J. Heinz Company by Berkshire Hathaway and 3G Capital Partners. The case is noteworthy because of the speed of the SEC’s action and the fact that there is only the suspicion of insider trading.

According to the SEC complaint, “certain unknown traders engaged in highly suspicious and highly profitable trading in Heinz calls through an omnibus account located in Zurich, Switzerland.” The traders purchased 2,533 out-of-the-money June $65 call options, each of which would enable the holder to purchase 100 shares of Heinz stock for $65 per share before the calls expired on June 22, 2013. The SEC complaint termed this trade “highly suspicious” for several reasons, including:
• at the time preceding the June $65 call option purchase, Heinz stock had typically traded around $60 per share;
• the general historical lack of trading in the June $65 calls;
• the fact that the trading account had no prior trading history in Heinz stock or options; and
• the timing of the investment of nearly $90,000 in risky call options the day prior to the Heinz acquisition announcement.

The SEC alleged that the trades were effected while the traders were in possession of material, nonpublic information about the contemplated Heinz acquisition and, therefore, were in violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5.

According to Sanjay Wadhwa, Senior Associate Director of the SEC’s New York Regional Office, “Despite the obvious logistical challenges of investigating trades involving offshore accounts, we moved swiftly to locate and freeze the assets of these suspicious traders, who now have to make an appearance in court to explain their trading if they want their assets unfrozen.”

Guess that leaves the “suspicious traders” in a pickle!

SEC Intensifies Scrutiny on Stock Sales by Insiders and 10b5-1 Plans

On February 5, 2013, the Wall Street Journal published the third in a series of articles discussing trading by public company executives in their companies’ securities, including trading pursuant to Rule 10b5-1 trading plans.  A 10b5-1 trading plan is a plan for buying or selling securities meeting the requirements of Securities Exchange Act Rule 10b5-1(c).  A properly adopted and implemented Rule 10b5-1 trading plan provides an affirmative defense against accusations of insider trading and allows the purchases and sales of securities even when the person who adopted the plan is aware of material nonpublic information. 

This latest Wall Street Journal article, “SEC Expands Probe on Executive Trades,” reports that the Securities and Exchange Commission has expanded its investigation into trading by corporate executives beyond the seven companies named in the first article in the series.  This latest article also refers to “shortcomings of the regulations” and “loopholes in the rules . . . known as a 10b5-1 plans.”  Whether or not you agree with the characterization of 10b5-1 plans as “loopholes” (I don’t), the Wall Street Journal’s recent reporting makes clear that trading by executives pursuant to 10b5-1 trading plans is likely to be subject to intense scrutiny in the coming months.  If you have not done so recently, now may be a very good time to review your company’s policies with respect to 10b5-1 trading plans and other insider trading policies to be sure they are adequate for today’s environment.  For some tips on what you may wish to consider in such a review, please see our December 2012/January 2013 Up to Date newsletter.

Netflix’s CEO Facebook Post Triggers a Debate

We have previously blogged about and covered in our Up to Date newsletter the fact that Netflix and its CEO, Reed Hastings, each received a “Wells Notice” from the SEC Staff over Hastings’ Facebook post in July 2012, in which Mr. Hastings wrote that Netflix’s members had enjoyed over one billion hours in June 2012.  The SEC Staff indicated in the Wells Notice its intent to recommend to the SEC that it institute a cease and desist proceeding and/or bring a civil injunctive action against the company and Mr. Hastings for violations of Regulation FD, Section 13(a) of the Securities Exchange Act and Rules 13a-11 and 13a-15.

Mr. Hastings continues to post on Facebook and said in an interview last week referring to his July post, “I’m not going to back down and say it’s inappropriate. I think it’s perfectly fine. Sometimes you’re just the example that triggers the debate.”  Mr. Hastings post has indeed triggered the debate of what constitutes “public disclosure” of material information under Regulation FD. 

Regulation FD requires a public company to publicly disclose material, non-public information (oral or written) that is selectively disclosed to market professionals and securityholders.  Under the regulation, the required public disclosure may be made by filing or furnishing a Form 8-K, or by another method or combination of methods that is reasonably designed to effect broad, non-exclusionary distribution of the information to the public.  

Despite this broad approach, from the time of the adoption of Regulation FD in 2000 until August 2008, a press release or a Form 8-K was practically the only form of distribution of information under Regulation FD.  In August 2008, when the SEC issued its Guidance on the Use of Company Web Sites (2008 Guidance) it officially acknowledged that a company website could serve as a broad, non-exclusionary method of distribution of the information to the public under Regulation FD, provided (i) such website is a recognized channel of distribution, (ii) posting of information on a company website disseminates the information in a manner making it available to the securities marketplace in general, and (iii) there has been a reasonable waiting period for investors and the market to react to the posted information.

The debate started by Mr. Hastings has revealed that there are two unofficial “camps” on this issue: one camp believes that CEOs and other public company executive officers should refrain from posting company information on social media to ensure that Regulation FD and other securities rules and regulations are not violated, and the other camp encourages the SEC to take a clear position on which social media postings would be considered Regulation FD compliant given the role that social media is playing in our society today.

It seems that Joseph A. Grundfest, Stanford Law School professor and former SEC commissioner, is in the second camp.  On January 30, 2013, Stanford Law School and The Rock Center for Corporate Governance published his article, Regulation FD in the Age of Facebook and Twitter:  Should the SEC Sue Netflix? This article is in the form of an amicus Wells Submission and suggests that the SEC should proceed by rulemaking to address issues raised by the evolution of social media instead of initiating enforcement proceedings against Netflix and Mr. Hastings.  Professor Grundfest’s article stated that any prosecution on these facts would constitute a “dramatic divergence from precedent” and would violate the SEC’s commitments not to “second guess” good faith attempts to comply with Regulation FD. Professor Grundfest also believes that while the posting was not “inconsistent with the Commission’s 2008 Guidance regarding the implementation of Regulation FD and the use of company websites, that guidance is, in any event, outdated because it fails to account for the evolution of social media.”  

Other interesting arguments outlined in Professor Grundfest’s article include the following:

  • Regulation FD is vulnerable as an unconstitutional restraint on truthful speech, particularly as applied on the facts of this case.
  • The Staff’s Wells Notice has already had a chilling effect on the use of social media without a contemporaneous Form 8-K filing. The Staff has thus obtained much of the remedy it seeks without subjecting its action to SEC review.
  • The proposed enforcement action is a questionable allocation of limited agency resources.
  • The SEC’s regulatory solution should emulate many practices that are now common in the social media rather than challenge information dissemination through the social media.

Generally, I give conservative advice to executives to stay away from the social media posts until the SEC comes out with additional rulemaking on this issue.  But I have to confess that now I am one of Reed Hastings’ 200,000 + followers on Facebook to be able to follow firsthand posts that may lead the SEC to extend permissible broad non-exclusionary forms of distribution of information under Regulation FD to social media.

Chief of SEC’s Asset Management Unit Provides Compliance Tips for Private Equity Funds

On January 23, 2013, Bruce Karpati, Chief of the Asset Management Unit (“AMU”) of the Enforcement Division of the Securities and Exchange Commission, addressed the Private Equity International Conference held in New York.  The transcript of his presentation discusses potential compliance issues in the private equity industry on which the AMU may focus.  This presentation also serves as a useful guide for legal compliance professionals and executives serving the private equity industry highlighting certain areas on which they should focus.

In his comments, Mr. Karpati discussed the organization of the AMU and how the AMU has gained an expertise in the private equity industry.  Mr. Karpati explained that it is “not unreasonable to think that the number of cases involving private equity will increase” and he described a number of recent enforcement actions which highlight certain issues that may arise  at private equity firms.  Mr. Karpati stated that the AMU has found that some of the main industry stressors are fundraising and capital overhang.  In addition, Mr. Karpati indicated that many of the potential compliance issues in the private equity industry arise from conflicts of interest, such as the conflict between the profitability of the management company and the interests of investors, the shifting of expenses from one fund to another fund, and charging of additional fees to portfolio companies, especially where the permitted fees may be poorly defined by the fund’s limited partnership agreement.  In discussing conflicts of interests, Mr. Karpati stated that “Although conflicts of interest are a natural part of the private equity business, it is up to each manager to identify, control, and appropriately disclose material conflicts so that investors are informed and not harmed or disadvantaged.”     Finally, Mr. Karpati explained that private equity COOs and CFOs are critical in making sure that investors’ interests are paramount to the interests of the management company and its principals and discussed various ways that COOs and CFOs could reduce the risk of inquiry by the Division of Enforcement and ensure that their private equity firm and its principals are meeting their fiduciary responsibilities.

New General Counsel for SEC

The SEC today announced that Geoffrey F. Aronow had been appointed as the agency’s General Counsel. Mr. Aronow comes to the SEC from the law firm of Bingham McCutchen LLP, where he is a partner in the Washington D.C. office. Mr. Aronow has prior federal government leadership experience as the Director of the Division of Enforcement at the Commodity Futures Trading Commission (CFTC) for nearly four years. He will begin his new role later this month.

Are Your Executives Posting Company Information on Facebook or Other Social Media Websites? The SEC Is Watching.

Yesterday, Netflix filed a Form 8-K announcing that, on December 5, 2012, Netflix and its CEO, each received a “Wells Notice” from the SEC Staff indicating its intent to recommend that the SEC institute a cease and desist proceeding and/or bring a civil injunctive action against Netflix and its CEO for violations of Regulation FD, Section 13(a) of the Securities Exchange Act of 1934 and Rules 13a-11 (Current Reports on Form 8-K) and 13a-15 (Controls and Procedures) under the Exchange Act.  The 8-K itself represents an interesting piece of disclosure, but the CEO’s follow-up Facebook post attached to it is even more interesting to read.    

 Please see below a few quotes from Reed Hastings’ (Netflix’ CEO) Facebook post attached to the 8-K, which describes Mr. Hastings’ prior posts and his reaction to the SEC’s Wells Notice.

 “We use blogging and social media, including Facebook, to communicate effectively with the public and our members.  In June we posted on our blog that our members were enjoying “nearly a billion hours per month” of Netflix, and people wrote about this. We did not also issue a press release or 8-K filing about this.  In early July, I publicly posted on Facebook to the over 200,000 of you who subscribe to me that our members had enjoyed over 1 billion hours in June, highlighting how strong our content was.  There was press coverage as there are many reporters and bloggers among you, my public followers.  Some of you re-posted my post.  Again, we did not also issue a press release or file an 8-K about this.”

 “First, we think posting to over 200,000 people is very public, especially because many of my subscribers are reporters and bloggers.  Second, while we think my public Facebook post is public, we don’t currently use Facebook and other social media to get material information to investors; we usually get that information out in our extensive investor letters, press releases and SEC filings.  We think the fact of 1 billion hours of viewing in June was not “material” to investors, and we had blogged a few weeks before that we were serving nearly 1 billion hours per month.  Finally, while our stock rose the day of my public post, the increase started well before my mid-morning post was out, likely driven by the positive Citigroup research report the evening before.”  

 Netflix’ debacle highlights the disparity between current news dissemination channels and Regulation FD rules, which date back to 2000 and are designed to address the problem of selective disclosure of material information by companies.  In 2000, the SEC took a narrow view as to what constituted a broad, non-exclusionary distribution of material nonpublic information.  For example, at such time, the SEC took the position that a company’s website alone would not satisfy broad dissemination for Regulation FD purposes.  In 2008, the SEC backed off of this position and provided guidance in an interpretative release on when information posted just on a company website would be considered public enough to serve as an alternative method for distribution of material information about the company under Regulation FD.  

 Assuming the information is viewed as material, it is unclear whether the SEC would extend its guidance set forth in its 2008 interpretative release to Facebook or other social media posts.  If the SEC did apply such guidance to social media, a company would need to evaluate whether (i) the company’s or executive’s presence on these social media websites is viewed as a recognized channel of distribution of information about the company, its business, financial condition and operations and (ii) disclosure of information through social media tools makes it available to the securities marketplace in general.   

 While it still remains to be seen whether the SEC will recognize social media websites as appropriate Regulation FD disclosure vehicles, companies should consider revisiting the adoption of social media policies to establish parameters for appropriate social media disclosures of company information.

SEC and DOJ Issue Joint Guidance on FCPA Interpretation

On November 14, 2012, the Enforcement Division of the United States Securities and Exchange Commission and the Criminal Division of the United States Department of Justice announced the issuance of A Resource Guide to the U.S. Foreign Corrupt Practices Act.  The 130 page guide addresses various topics that will be of interest to any company with activities outside the United States, including who and what is covered by the FCPA’s anti-bribery provisions; the definition of  a “foreign official”; what constitute proper and improper gifts, travel and entertainment expenses; facilitating payments and a host of other topics as well.  The SEC, in its press release, said that “the guide takes a multi-faceted approach toward setting forth the statute’s requirements and providing insights into SEC and DOJ enforcement practices.” 

As previously noted by my colleagues Shawn M. Wright and James R. Billings-Kang in an article appearing in The National Law Journal, the DOJ and the SEC continue to be very active in enforcing the FCPA and as previously discussed in this blog, companies with operations outside the United States should consider their SEC disclosure obligations relating to the FCPA.  As such, the guide is sure to be a great resource to both companies with international operations and the legal community advising them with respect to the FCPA.  For additional resources relating to the FCPA, please visit our website.