SEC Adopts New Rules Addressing Identity Theft

Not long after being sworn in as the new Chairman of the Securities and Exchange Commission, Mary Jo White presided over her first open SEC meeting on April 10, 2013.  At that meeting, the SEC adopted rules requiring certain businesses regulated by the SEC to adopt and implement programs to detect and respond to indicators of possible identity theft.  The rules were adopted jointly by the SEC and the Commodity Futures Trading Commission (CFTC), but they aren’t exactly new.

In 2003, Congress amended the Fair Credit Reporting Act (FCRA) to require certain federal agencies to issue joint rules and guidelines on detecting, preventing and mitigating identity theft.  At that time, the FCRA did not require the SEC or the CFTC  to adopt such rules.  However, the FCRA gave the Federal Trade Commission (FTC) the authority to adopt and enforce identity theft rules related to entities regulated by the SEC and CFTC.  The Dodd-Frank Act amended the FCRA and effectively transferred rulemaking responsibility and enforcement authority with respect to identify theft rules to the SEC and CFTC with respect to those entities that are subject to each agency’s enforcement authority.  

The SEC indicates in its press release that the proposed SEC/CFTC rules relating to identify theft were largely identical to the rules that the FTC and the other federal agencies adopted under the FCRA (see our Up to Date article regarding proposed rules).  The SEC’s rules apply only to SEC-regulated entities that meet the definition of “financial institution” or “creditor” in the FCRA, such as broker-dealers, mutual funds and investment advisers.  The rules generally require these entities to adopt an identity theft prevention program designed to (i) identify relevant types of identity theft red flags, (ii) detect the occurrence of those red flags, (iii) respond appropriately to those red flags, and periodically update the identity theft program.  The rules go into effect 30 days after publication in the Federal Register and compliance is required six months after the effective date.

Land of Honest Abe – Not So Honest?

In March, the SEC announced that it had charged the State of Illinois with securities fraud for misleading municipal bond investors about the state’s approach to funding its pension obligations. This marks the second time that the SEC has charged a state with violating federal securities laws in their public pension disclosures. The SEC charged New Jersey in 2010 with misleading municipal bond investors about its underfunding of the state’s two largest pension plans. Given the general problems facing state government pensions systems, hopefully the SEC’s action will serve as a wake-up call to the other 48 states and their counsel in drafting municipal bond offering documents.

Interestingly, the SEC’s order did make any direct findings that any investors had actually lost money, other than statements that, as more information became available, the state’s bond ratings were lowered and that the risk premium associated with Illinois bonds rose, which presumably would cause the price of outstanding bonds to fall.

An SEC investigation revealed that Illinois failed to inform investors about the impact of problems with its pension funding schedule as the state offered and sold more than $2.2 billion worth of municipal bonds from 2005 to early 2009. Illinois failed to disclose that its statutory plan significantly underfunded the state’s pension obligations and increased the risk to its overall financial condition. The state also misled investors about the effect of changes to its statutory plan. Illinois, which implemented a number of remedial actions and issued corrective disclosures beginning in 2009, agreed to settle the SEC’s charges.

According to the SEC’s order, the state established a 50-year pension contribution schedule in the Illinois Pension Funding Act that was enacted in 1994. The schedule proved insufficient to cover both the cost of benefits accrued in a current year and a payment to amortize the plans’ unfunded actuarial liability. The statutory plan structurally underfunded the state’s pension obligations and backloaded the majority of pension contributions far into the future. This structure imposed significant stress on the pension systems and the state’s ability to meet its competing obligations – a condition that the SEC determined worsened over time.

The SEC’s order found that Illinois misled investors about the effect of changes to its funding plan, particularly pension holidays enacted in 2005. Although the state disclosed the pension holidays and other legislative amendments to the plan, Illinois did not disclose the effect of those changes on the contribution schedule and its ability to meet its pension obligations. The state’s misleading disclosures resulted from various institutional failures. As a result, Illinois lacked proper mechanisms to identify and evaluate relevant information about its pension systems into its disclosures. The SEC cited, for example, that Illinois had not adopted or implemented sufficient controls, policies, or procedures to ensure that material information about the state’s pension plan was assembled and communicated to individuals responsible for bond disclosures. The state also did not adequately train personnel involved in the disclosure process or retain disclosure counsel.

According to the SEC’s order, Illinois took multiple steps beginning in 2009 to correct process deficiencies and enhance its pension disclosures. The state issued significantly improved disclosures in the pension section of its bond offering documents, retained disclosure counsel, and instituted written policies and procedures as well as implemented disclosure controls and training programs. The state designated a disclosure committee to assemble and evaluate pension disclosures. In reaching a settlement, the Commission considered these and other remedial acts by Illinois and its cooperation with SEC staff during the investigation. Without admitting or denying the findings, Illinois consented to the SEC’s order to cease and desist from committing or causing any violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933.

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!

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.

Say What? Smaller Reporting Companies Subject to Say-on-Pay in 2013.

Smaller reporting companies are subject to say-on-pay and say-on-frequency votes for the first time this year.  In January 2011, the SEC adopted final rules implementing the say-on-pay and say-on-frequency requirements of the Dodd-Frank Act. Under such rules, public companies are required to conduct shareholder advisory votes (i) to approve the compensation of executives, as disclosed pursuant to Item 402 of Regulation S-K, and (ii) to determine how often an issuer will conduct a shareholder advisory vote on executive compensation. Public companies, other than smaller reporting companies, were required to conduct such votes starting with the 2011 proxy season. Smaller reporting companies did not have to conduct such votes until their first annual or other meeting of shareholders occurring on or after January 21, 2013.

In drafting their proxy statements for this year’s annual meeting, smaller reporting companies should look to strategies utilized by other public companies during the past two proxy seasons to avoid a failed say-on-pay vote. For example, public companies have been using their proxy statements, especially their Compensation Discussion and Analysis section, as an opportunity to explain their executive compensation practices to shareholders. Although smaller reporting companies are not required to include a CD&A in their proxy statements, they may want to include disclosure similar to the CD&A or, at a minimum, a summary of executive compensation practices in their proxy statements this year to discuss the company’s compensation philosophy and how executive compensation is aligned with performance.

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.

The SEC Approved PCAOB Rules on Communications with Audit Committees

On December 17, 2012, the SEC approved PCAOB proposed rules on Auditing Standard No. 16, Communications with Audit Committees.  Auditing Standard No. 16 supersedes PCAOB’s interim standards AU section 380, Communication with Audit Committees, and AU section 310, Appointment of the Independent Auditor.  Auditing Standard No. 16 is effective for audits of financial statements for fiscal years beginning on or after December 15, 2012 and applies to the audits of all issuers, including emerging growth companies established under the JOBS Act and foreign private issuers.

It is interesting to note that, among other matters, Auditing Standard No. 16 expands the inquiries of the audit committee required by Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, which requires the auditor to inquire of the audit committee regarding its knowledge of the risks of material misstatements, including fraud risks.  The inquiry required by Auditing Standard No. 16 goes beyond material misstatements and fraud risks and provides that the auditor “should inquire of the audit committee about whether it is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations.” 

 In light of this inquiry, audit committees will need to discuss procedures for evaluating violations, including possible violations, of laws and regulations, especially considering the fact that this requirement does not include any materiality threshold.

New Staff Legal Bulletin 14G Addresses Rule 14a-8 Shareholder Proposal Issues

The Division of Corporation Finance released Staff Legal Bulletin 14G on October 16, 2012 providing additional guidance for excluding shareholder proposals under Rule 14a-8 based on proof of ownership and references to websites:
• The SEC clarified that for purposes of verifying whether a beneficial owner is eligible to submit a proposal under Rule 14a-8, a proof of ownership letter from an affiliate of a DTC participant satisfies the requirement to provide a proof of ownership letter from a DTC participant.
• A shareholder who holds securities through a securities intermediary that is not a broker or bank can satisfy Rule 14a-8’s documentation requirement by submitting a proof of ownership letter from that securities intermediary. If the securities intermediary is not a DTC participant or an affiliate of a DTC participant, then the shareholder will also need to obtain a proof of ownership letter from the DTC participant or an affiliate of a DTC participant that can verify the holdings of the securities intermediary.
• The SEC said that it will not concur in the exclusion of a proposal under Rules 14a-8(b) and 14a-8(f) on the basis that a proponent’s proof of ownership does not cover the one-year period preceding and including the date the proposal is submitted unless the company provides a notice of defect that identifies the specific date on which the proposal was submitted and explains that the proponent must obtain a new proof of ownership letter verifying continuous ownership of the requisite amount of securities for the one-year period preceding and including such date to cure the defect. The SEC views the proposal’s date of submission as the date the proposal is postmarked or transmitted electronically. In addition, companies should include copies of the postmark or evidence of electronic transmission with their no-action requests.
• If a shareholder proposal or supporting statement refers to a website that provides information necessary for shareholders and the company to understand with reasonable certainty exactly what actions or measures the proposal requires, and such information is not also contained in the proposal or in the supporting statement, the SEC believes the proposal would raise concerns under Rule 14a-9 and would be subject to exclusion under Rule 14a-8(i)(3) as vague and indefinite. However, if shareholders and the company can understand with reasonable certainty exactly what actions or measures the proposal requires without reviewing the information provided on the website, then the SEC believes that the proposal would not be subject to exclusion under Rule 14a-8(i)(3) on the basis of the reference to the website address.
• The SEC will not concur that a reference to a website may be excluded as irrelevant under Rule 14a-8(i)(3) on the basis that it is not yet operational if the proponent, at the time the proposal is submitted, provides the company with the materials that are intended for publication on the website and a representation that the website will become operational at, or prior to, the time the company files its definitive proxy materials.
• If information on a website changes after submission of a proposal and the company believes the revised information renders the website reference excludable under Rule 14a-8, the SEC may concur that the changes to the referenced website constitute “good cause” for the company to file its reasons for excluding the website reference after the 80-day deadline under Rule 14a-8(j) and grant the company’s request that the 80-day requirement be waived.

The Bulletin is available at


We previously blogged about the Securities and Exchange Commission’s announcement that starting October 1, 2012, certain emerging growth companies and foreign private issuers would be able to voluntarily submit to the SEC draft registration statements for non-public and confidential review via a modified EDGAR system instead of via the current secure e-mail submission process.  Filing such draft registration statements via EDGAR will become mandatory when the new EDGAR Filer Manual becomes effective next Monday, October 15, 2012. Therefore, beginning October 15, 2012, draft registration statements and amendments as well as related correspondence must be submitted or filed via the EDGAR system.

NYSE Proposes New Rules Related to Compensation Committee and Committee Adviser Independence

Earlier this week, the NYSE filed proposed rule changes with the SEC related to compensation committee independence and the hiring of compensation advisers.  The NYSE proposed such rules to comply with Exchange Act Rule 10C-1 adopted in June.  Rule 10C-1 requires national securities exchanges to adopt listing standards which effectuate the compensation committee and committee adviser independence requirements of Section 952 of the Dodd-Frank Act.   The NYSE’s proposed rules do not expand upon or vary much from the SEC rules.  The NYSE proposed to have its new listing standards effective on July 1, 2013; however, companies would have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the such new standards.  Set forth below is a summary of the NYSE’s proposed rules:

 Compensation Committee Independence

The NYSE proposed rules do not establish any new bright line standards specific to compensation committee independence.  Instead, the NYSE proposed rules require that, in affirmatively determining the independence of any director who will serve on a compensation committee, a listed company’s board “consider all  factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to, the two factors explicitly enumerated in Rule 10C-1(b)(ii)”:

  • the source of the director’s compensation, including any consulting, advisory or other compensatory fee paid by the listed company to such director; and
  • whether the director has an affiliate relationship with the listed company, a subsidiary of the listed company or an affiliate of a subsidiary of the listed company.

The proposing release specifically provides that the NYSE does not believe that board compensation should be considered as part of the independence determination.  Further, commentary to the proposed NYSE rules provides that “the board should consider whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company’s executive compensation. Similarly, when considering any affiliate relationship a director has with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company, in determining his independence for purposes of compensation committee service,. . . the board should consider whether the affiliate relationship places the director under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his ability to make independent judgments about the listed company’s executive compensation.”

 Compensation Committee Adviser Independence

The NYSE proposed rules related to compensation committee advisers provide that prior to hiring a compensation adviser, the compensation committee must consider the six factors set forth in Rule 10C-1(b)(4).  The NYSE proposed rules do not add any factors for a compensation committee to consider prior to hiring an adviser, as the “Exchange believes that the list included in Rule 10C-1(b)(4) is very comprehensive and the proposed listing standard would also require the compensation committee to consider any other factors that would be relevant to the adviser’s independence from management.”

The NYSE’s proposed new rules are subject to SEC review and comment.  We believe it is unlikely that the SEC will have many objections to the proposed rules, as they essentially mirror the SEC’s rules.  In light of the NYSE proposed rules, NYSE listed companies should be reviewing their compensation committee charters, the composition of the compensation committee and their relationships with the compensation advisers in order to identify whether any modifications or changes may be in order to comply with the coming NYSE standards.