Category: SEC News

Looking at the Direction of the New Securities and Exchange Commission

With Chairman Jay Clayton in place, the Securities and Exchange Commission is now controlled by Republican appointees. Former Chair White came from a litigation and prosecutor background. Chair Clayton comes from a deal-making and capital formation background. I think we can guess the direction of the SEC for the next few years.

Beyond the guessing, Chair Clayton gave a speech to the Economic Club of New York that offers some insight. He outlined eight principles that will guide his chairmanship:

  1. The SEC’s mission is our touchstone.
  2. Our analysis starts and ends with the long-term interests of the Main Street investor.
  3. The SEC’s historic approach to regulation is sound.
  4. Regulatory actions drive change, and change can have lasting effects.
  5. As markets evolve, so must the SEC.
  6. Effective rulemaking does not end with rule adoption.
  7. The costs of a rule now often include the cost of demonstrating compliance.
  8. Coordination is key.

Obviously, number 7 caught my attention.

“It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.  Vaguely worded rules can too easily lead to subpar compliance solutions or an overinvestment in control systems.  We must recognize practical costs that are sure to arise.”

He also pointed out the costs of compliance in number five on the evolution of the SEC:

As the SEC evolves alongside the markets, however, we must remember that implementing regulatory change has costs.  Companies spend significant resources building systems of compliance, hiring personnel to operate those systems, seeking legal advice concerning the design and effectiveness of those systems, and adapting the systems as regulations change.  Shareholders and customers bear these costs, which is something that should not be taken lightly, lest we lose our credibility as regulators.

The SEC uses cost-benefit analysis in its rule-making process. I expect we will see an emphasis on the compliance costs in those analyses.

I like the emphasis on “bright-line” rules in number 7. Fuzzy rules makes it hard to implement rules and hard to prove compliance with the rules, leaving you open to second-guessing by regulators.

The other news is that it is rumored that President Trump will nominate former Senate Republican aide and current Senior Research Fellow at the Mercatus Center, Hester Peirce, to fill one of the empty seats at the Securities and Exchange Commission. From her recent publications, it seems that she may have some big ideas for change at the SEC.

That leaves one empty seat that is supposed to go to a Democratic appointee. I would bet that this seat stays empty for a long time.

Sources:

SEC Releases New Form ADV Frequently Asked Questions

Earlier this month, the Securities and Exchange Commission released 23 new frequently asked questions (“FAQs”) on Form ADV to provide guidance on recent amendments to Form ADV. Those amendments become effective in October.

These new FAQs include guidance on (i) the umbrella registration approach that many private fund sponsors use to register multiple affiliates and (ii) the reporting of significant new information concerning separately managed accounts (not separate accounts).

There are four new FAQs on social media accounts. They are a bit weird. An adviser does not need to report a social media account if a third party controls the account content. So if you have a third party controlling your firm social media account under the firm name, it does not show up. On the other side, the firm does not have to report an employee’s account when the firm controls the account content.

There is an interesting FAQ on the differences between a private fund and a pooled investment vehicle in Item 5D. “[P]ooled investment vehicles include, but are not limited to, private funds.”

“Additionally, the staff believes for purposes of Item 5.D there are some facts and circumstances in which it may be appropriate for an adviser to treat a single-investor fund (also known as a “fund of one”) as a pooled investment vehicle. For example, an adviser could reasonably treat a single-investor fund as a pooled investment vehicle where the fund seeks to raise capital from multiple investors but has only a single, initial investor for a period of time, or where all but one of the investors in the fund have redeemed their interests. However, an adviser generally should not consider a single-investor fund to be a pooled investment vehicle if that entity in fact operates as a means for the adviser to provide individualized investment advice directly to the investor in the fund.”

As for distributing audited financial statements to meet the custody rule, the new FAQ in 7b makes it clear that

You may answer “Yes” if you will distribute the audited financial statements as required, but have not yet done so at the time of filing the Form ADV.

The SEC revised its FAQ on Item 1.O and points out question that many people trip over in Item 1.O. The question is whether the adviser has over $1 billion in assets. It’s not whether the adviser as more than $1 billion in AUM. “Non-proprietary assets, such as client assets under management, should be excluded when responding to Item 1.O, regardless of whether they appear on an investment adviser’s balance sheet.”

Sources:

Supreme Court Limits One of the SEC’s Remedies

The Securities and Exchange Commission has essentially been claiming that its remedy of disgorgement is not subject to a statute of limitations. To the SEC, disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.

Charles Kokesh decided to fight back against this position. In the SEC’s case against him, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”. If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

Yesterday, the Supreme Court agreed with Mr. Kokesh and set a limit on the SEC’s powers.

Disgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462. Accordingly, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.

In addition to limiting the period susceptible to disgorgement, the Supreme Court indicated that a facial attack on the disgorgement remedy in footnote 3:

Nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to §2462’s limitations period.

The Supreme Court noted that the SEC specifically has the powers of injunction and civil penalties. Perhaps the disgorgement could be tested. In the decision, the Supreme Court noted that the “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and, ” as demonstrated by this case, SEC disgorgement sometimes is ordered without consideration of a defendant’s expenses that reduced the amount of illegal profit.”

Sources:

The SEC Reaching Back Far In The Past With Its Powers of Disgorgement

We have become used to the Securities and Exchange Commission extracting disgorgement of ill-gotten gains from those violating the securities laws. However, the enabling laws do not explicitly grant the SEC the right to disgorgement. We seem to accept that power, but how far back can the SEC go to grab cash from defendants?

In the SEC’s case against Charles Kokesh, the SEC wants to go back ten years. Between 1995 and 2006, Kokesh pilfered $34.9 million from the business-development companies for which his firm was acting as investment adviser. Some of that ill-gotten cash was overcharging to pay expenses of the investment advisory firm, but some went into his pocket and that of his stable of polo ponies. The SEC brought charges in 2009. The court ordered disgorgement of all of the pilfered funds.

Mr. Kokesh argues that 28 U.S.C. §2462 limits the disgorgement to five years by stating that “an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued”.

If the five-year limit is imposed, Mr. Korkesh’s penalty would be reduced to $5 million.

The briefs and arguments are a delight for legal scholars. The parties are battling over legal history and dictionary definitions to determine what Congress meant in 1839 when it passed that five year limit and used the word “forfeiture.”

The arguments are compounded by the creation of the SEC’s power of disgorgement, not by Congressional action, but by case law. The SEC only legitimized disgorgement in 1970 in the case of  SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970).

The Kokesh case was argued in front of the Supreme Court last month, so we should be looking ahead to decision shortly that may have a profound impact on SEC enforcement actions.

Sources:

The Jay Clayton Era at the SEC Has Begun

Jay Clayton was sworn in last week as the new Chairman of the Securities and Exchange Commission. That makes him the first permanent head of a financial regulator during the Trump administration.

Yesterday, Chairman Clayton gave his first public speech by making the opening remarks at the SEC Advisory Committee on Small and Emerging Companies.

Facilitating capital formation is one of the central tenets of the SEC’s mission and it is a focus that this committee and I share. One of my priorities is for the Commission to focus on facilitating capital-raising opportunities for all companies, including, and importantly, small- and medium-sized businesses. Doing so will not only help those companies, but it also will provide expanded opportunities for investors, help our economy grow, facilitate innovation, and further job creation.

Nothing dramatic. We expected Chairman Clayton to have more of a focus on capital formation than enforcement actions. He comes from a capital formation background. Former Chair White came from a prosecutorial background.

It’s not too early to look to the rest of the Commission. There are still two vacancies. The candidates put worth by President Obama are back working at their old jobs. I think there is little expectation that they will end up in those vacant seats.

Commissioner Stein’s term expires next month. That will give President Trump three seats to fill.

The law is that no more three commissioners may belong to the same political party (Section 4 of the Exchange Act). Chairman Clayton and Commissioner Piwowar are both Republicans. Would it surprise anyone if President Trump nominated another Republican to fill the vacant seat of Commissioner Stein and leave the other two seats vacant?

Sources:

Real Estate Fund Information from the SEC

The Securities and Exchange Commission has been acquiring troves of data about private funds through the Form PF filing requirement. Some, including myself, have been skeptical that the SEC will figure out what to do with the data as a tool to protect investors. But, the SEC has been able to compile statistics and published a suite of new data and analyses of private fund statistics and trends. The SEC released the third quarter private fund statistics.

The number of real estate funds reporting on Form PF has increased.
The number of real estate funds reporting on Form PF has increased.

period 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Q3
Funds 1,802 1,800 1,801 1,806 2,056 2,093 2,091 2,108
Advisers 262 263 264 265 288 290 288 290
Net NAV ($billions) 280 280 281 319 323 323 323 323

The rise from 1802 to 2108 in advisers is a big increase. There is only a small rise of 52 from the end of 2015 to the end of the third quarter in 2016. It’s the larger multi-platform Form PF filers who file quarterly.

Pure real estate fund advisers are only filing quarterly. Given that, I didn’t expect to see much change intra-year, and that held true.

There is a wealth of information in the SEC’s report. I’m still looking for some trends.
Sources:

The SEC Is Making Room For A New Regulation

Although is questionable whether the Securities and Exchange Commission is subject to President Trump’s executive order calling for a reduction in the number of regulations, the SEC seems to be taking it to heart.

Last week, Congress started the push to roll back the Extraction Disclosure Rule. This week, the SEC is looking to roll back the pay ratio disclosure rule.

The SEC is short-handed. Acting SEC Chair Michael Piwowar asked SEC staff to reconsider implementation of the rule. The pay-ratio rule mandates companies to disclose median worker pay and compare it with CEO compensation. This product of Dodd-Frank is supposed to put pressure on corporate boards to slow pay increases for CEOs.

The argument against is that is a costly to implement and not valuable to shareholders.

Unlike the Extraction Disclosure Rule, the Pay Ratio Rule was not implemented in the window subject to the Congressional Review Act. The SEC cannot rely on Congress to repeal the rule for them.

For the SEC to make changes, it has to create a new rule-making process and open to comments on changing the rule. Repealing the rule would put the SEC at odds with the Congressional mandate in Dodd-Frank to create the rule. That seems an untenable position to take.

Since the SEC is currently subject to three vacancies, it’s unlikely that anything will happen until Jay Clayton is approved by the Senate as the new Chair. That would likely mean two votes in favor of killing or maiming the rule, to one likely opposed.

According to the President’s executive order, the SEC has identified two rules to be repealed. That means it can now roll out a new regulation. Wonder what it will be?

Sources:

The New Supreme Court Pick and Private Funds

Justice Scalia died last year and replacing his position has been held up by partisan politics ever since. President Trump has made his pick, federal appeals court judge Neil Gorsuch from the 10th Circuit, and the confirmation battle has begun.

Being very liberal on social issues, I’m disappointed that the Senate chose not consider President Obama’s pick for the vacancy. We’re now faced with a justice who is likely to cause an erosion of some of the liberal gains we have seen on social issues.

But Compliance Building is about compliance so I quickly looked for some of judge Gorsuch’s opinions involving the Securities and Exchange Commission or private funds. I didn’t find much.

In ACAP Financial v. US SEC (2015), Judge Gorsuch wrote the opinion upholding an SEC penalty levied against the appellants for failing to take sufficient steps to guard against the firm’s involvement in the unlawful trading of unregistered shares. I found the writing to be very clear and easy to read. It lacks the ponderous rhetoric of many court opinion.

The decision is an easy one to find in favor of the SEC, so it does not offer much insight. The appellants did not argue their liability, but merely disputed the remedy imposed. The remedy was one proscribed for “egregious” behavior and they argued that their behavior was not “egregious.” The judge goes on for ten pages shooting down the appellants’ arguments, none of which even come close.

Gorsuch’s 10th Circuit is responsible for the Bandimere decision that recently struck down the SEC’s current system of administrative law judges. That put the 10th Circuit in opposition to other appeals courts, setting up a potential clash at the Supreme Court. However, Judge Gorsuch was not one of the appellate judges on the Bandimere case.

Let me know if you find any other cases from Judge Gorsuch that are relevant to private funds, compliance or the SEC.

Sources:

Add One, Take Two Away

Prior to his inauguration, President Trump promised a 75% reduction in regulations. I was left scratching my head about what he meant. Did he want the Code of Federal Regulation to be 75% shorter? How do you decide where one regulation begins and another starts? What about statutes enacted by Congress that specifically mandate the promulgation of new regulations? Isn’t repealing a regulation itself a new rule-making?

President Trump followed up on the promise and issued a new executive order. Whenever an agency publicly proposes a new regulation, it must identify at least two existing regulations to be repealed.

Additionally, the order requires the net incremental cost for fiscal 2017 to “be no greater than zero.” The cost of new regulations should be offset by existing rules that will be rescinded. I assume this add one, take away two is being put in place to achieve his 75% promise.

It looks like Dodd-Frank is the biggest target. I’m not sure the executive order will do it. Dodd-Frank mandated many new regulations. Repealing those regulations would seem to require an act of Congress.

I focus on the Securities and Exchange Commission, so I decided to take a closer look at the executive order. First up is what was meant by regulation.

“For purposes of this order the term “regulation” or “rule” means an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or to describe
the procedure or practice requirements of an agency…”

Wow.

I think this executive order could affect not only the promulgation of new rules, but could also affect staff guidance. I think a rule-making is general applicability and guidance is particular applicability. That could affect information updates and staff guidance. Could it even affect no-action letters? I think you can read it that way. Ultimately, it will be the SEC commissioners interpretation of the executive order that matters.

Of course, there is the argument that the SEC is an independent agency and not subject to the executive order. The order itself states that it applies to each “executive department or agency.”

Regardless of whether the order applies, President Trump has lesser power to fire the commissioners on the SEC so they may chose to ignore the executive order. Or they may embrace the concept and begin de-regulating.

Sources:

The New Administration’s Pick for the Chair of the SEC

Wall Street lawyer Jay Clayton is slotted to head the U.S. Securities and Exchange Commission in the Trump administration.

This is a big change from Chair White whose background was in prosecution. Chair White had a long list of prosecutions from serving a decade as the U.S. Attorney for the Southern District of New York. (She is the only woman to have held that position.) Then served another decade as a litigator in private practice.

Mr. Clayton has a wide-ranging corporate practice spanning mergers and acquisitions, IPOs, corporate governance, and investment advice. He is respected lawyer and will likely do a great job with the SEC.

But he is a very different kind of lawyer than Ms. White. He is a deal lawyer, largely working on corporate transactions and governance.

Perhaps that marks a change in the SEC from one of enforcement to one of enhancing the capital markets. Chair White was saddled with the rule-making imperatives from Dodd-Frank. With most of those in place, the SEC will have more bandwidth to focus its agenda. The appointment of Mr. Clayton seems to be an indication that the SEC may focus more on the other prongs of its mission: maintain fair, orderly, and efficient markets, and facilitate capital formation.

The front page of the Wall Street Journal laments the loss of public companies: America’s Roster of Public Companies Is Shrinking Before Our Eyes. I think most people are guessing that Mr. Clayton will try to fix that issue.

With the appointment of Mr. Clayton, that still leaves two open slots to be filled. No word on whether the stalled nominations of Lisa Fairfax and and Hester Peirce will proceed or whether there will be new candidates.