Dodd-Frank Watch

Private Proxy Access Proposals on the Way?

Mark Nuccio — 2011-09-14T14:54:00Z

While the major thrust of the SEC’s proxy access was blunted by the DC Circuit’s invalidation of Rule 14a-11, a new law of unintended consequence becomes effective this week. During the pendency of the litigation over Rule 14a-11, the SEC had voluntarily stayed the effectiveness of the amendments to Rule 14a-8, adopted as a companion to Rule 14a-11, but not challenged in the litigation. When the SEC decided against pursuing an appeal of the decision involving Rule 14a-11, it decided to let the amendments to Rule 14a-8, conceived as part of the grander proxy access initiative, rise from slumber and become law anyway.

What’s this mean?
The bottom line is that eligible shareholders will now be allowed to force companies to include their proposals regarding proxy access procedures in company proxy materials. Previously, Rule 14a-8 had allowed companies to exclude such proposals. As a result of the amendments to Rule 14a-8, anyone holding stock worth $2,000 for more than one year would be eligible to file such a proposal, so the federal door for such proposals is basically is wide open. On the state level, proposals will still need to meet corporate law requirements, which, in some cases – though not in Delaware - set the bar higher.

It’s hard to argue that this development in the law was intended. The SEC originally adopted a bundle of proxy access changes, the most significant stick in which was plucked from the bundle by the Court. With the largest stick missing, reconsideration of the remaining proposals – one would think – would be warranted and some retrofitting would be required. Rather than unleashing a modified Rule 14a-8, the SEC might have hauled it back on to the shop as it begins to rebuild a Rule 14a-11 that will pass judicial muster. The ABA’s Federal Regulation of Securities Committee of the Business Law Section has formally urged the SEC to do as much.

If they have not commenced the process already, public company nominating and governance committees will want to consider the implication of the amendments. In particular, work can be commenced immediately to assess the likelihood that a proposal will be submitted, the nature, scope and impact of potential privately ordered proxy access arrangements and whether there are idiosyncratic governance issues that may raise special concern.

Thinking about the Unthinkable

Mark Nuccio — 2011-07-20T14:54:00Z

As we celebrate the one year anniversary of the enactment of the Dodd-Frank Act, the financial press is dominated by reporting on the debate over raising the debt ceiling. There’s no question that a US sovereign debt default or downgrade would send shock waves through the economy and the markets. No one really wants to think that will come to pass, but I still thought it would be interesting to put the implications of a default or downgrade under the microscope of a particular financial sector. My colleagues, Brian McCabe and Jacob Comer, stepped up to the plate and offered their insights into what a default or downgrade might mean for money market funds holding US government securities. Here’s what they had to say:

Against the backdrop of the debt ceiling debate, various credit rating organizations have threatened to review and possibly to downgrade the U.S. sovereign credit rating. In light of such threats, and given that many money market funds hold substantial amounts of U.S. Government securities in their investment portfolios, it would not be surprising that money market funds, their boards and their investment advisers would consider the implications of such a downgrade or of a default by the United States on its debt obligations and what actions those events might require. Fortunately, although consideration in the context of U.S. government securities is unusual, Rule 2a-7 under the Investment Company Act of 1940 provides a process for dealing with those events, which is summarized below. (A money market fund’s own internal policies may require additional actions or consideration.)

Potential Disposition of U.S. Government Securities
Generally, if one of the following events occurs, a money market fund must dispose of the affected portfolio security as soon as practicable consistent with an orderly disposition, unless the fund’s board finds that disposition would not be in the best interests of the fund:

• default with respect to a portfolio security (other than an immaterial default unrelated to the financial condition of the issuer),
• a portfolio security ceases to be an “eligible security” (as defined in Rule 2a-7),
• a portfolio security is determined to no longer present minimal credit risks, or
• an “event of insolvency” (as defined in Rule 2a-7) occurs with respect to the issuer of a portfolio security or the provider of a related demand feature or guarantee.

If the United States defaulted on a debt obligation held by a money market fund, the fund’s board would have to consider whether disposition of that obligation is in the fund’s best interests. The board cannot delegate that determination to the fund’s investment adviser, but the determination can be informed by the adviser’s views about prevailing market conditions that could affect the fund’s orderly disposition of the obligation. If a default were occasioned by a failure to raise the U.S. debt ceiling, the board might also wish to consider statements made by various participants in the negotiations, and the board’s assessment of the likelihood and timing of an agreement. Additionally, if the debt obligation accounted for 0.5% or more of the fund’s total assets immediately prior to the default, the fund would have to provide notice to the SEC of the default and the actions the fund intends to take in response to the default.

Even if there is no actual default, one or more credit rating organizations might downgrade the U.S. sovereign short-term credit rating from its current AAA rating. As a technical matter, a downgrade would not cause a U.S. government security held by a money market fund to be reclassified from a “first tier security” to a “second tier security” because any U.S. government security that is an eligible security is, by definition, a first tier security. However, if enough credit rating organizations downgrade the U.S. sovereign short-term credit rating to A or lower that the fund could no longer identify two “NRSROs” that rate U.S. short-term sovereign debt A-2/P-2 or higher, then U.S. government securities held by the fund would cease to be “eligible securities,” and the fund would be required to dispose of them unless its board found that disposition would not be in the best interests of the fund. Unlike with a default, however, such a downgrade would not require notice to the SEC.

Considerations Relating to Net Asset Value
A U.S. government default or rating downgrade could potentially affect adversely the market prices of U.S. government securities, which in turn could affect adversely the fund’s net asset value calculated using market quotations. If the fund’s net asset value declined so much that its net asset value per share deviated from its amortized cost price per share by more than 0.5%, the fund’s board would have to consider promptly what action, if any, it should initiate. If the fund’s board were to determine that the deviation may result in material dilution or other unfair results to fund investors, then it would have to cause the fund to take appropriate actions to reduce or eliminate such dilution or unfair results to the extent reasonably practicable.

New Investments
A default or downgrade could prevent a money market fund from buying new U.S. government securities if the securities no longer qualified as eligible securities, or if a default or other U.S. actions prevented the fund’s board from determining that U.S. government securities present minimal credit risks. In that case, the fund’s portfolio managers would need to identify other eligible investments that comport with the fund’s investment objectives and strategies, or hold uninvested cash until U.S. government securities again became eligible securities. This issue could be more significant for money market funds that, by virtue of their names (“U.S. government,” “U.S. Treasury,” etc.), have policies normally to invest at least 80% of their assets in U.S. government securities, though one could argue that a U.S. government default or a substantial U.S. government rating downgrade would be an abnormal circumstance in which the policy would not apply.

In addition, it is possible that the SEC or its staff would provide guidance to money market funds in the event of a U.S. government default or material rating downgrade, particularly if relief is necessary on an interim basis for a brief period following resolution of the debt ceiling debate. It is impossible to predict how such guidance might differ from the Rule 2a-7 process.

Derivative Action

Mark Nuccio — 2011-06-21T14:54:00Z

The financial press has churned out stories covering the continuing controversy about the Dodd-Frank Act derivatives reforms. When the law was passed on July 21, 2010, the reforms were slated to take effect on July 16, 2011, and rule-making putting some meat on the new legal bones was supposed to be completed. The spirited derivatives debate that raged during the legislative process has continued unabated into the regulatory phase. The rule-making process for the derivatives reforms, like many other Dodd-Frank Act reforms, has bogged down. The CFTC and the SEC have recently, in effect, delayed the date by which the reforms will take hold. The delays will hopefully permit the regulators enough time to produce sensible rules to govern the new world derivatives order.

For purposes of this blog, I wanted someone to address the Dodd Frank derivatives subject and distill it into something that directors of non-financial companies could digest without too much heartburn. I asked my partner, Leigh Fraser, who is one of our resident derivative experts, to cut through the hundreds of pages of legislation and thousand plus pages of rules and proposed rules and give us a summary of how most non-financial companies will be affected by the derivatives reforms. Among other things, Leigh says to watch for the manner by which each public company complies with a new requirement that a board committee review and approve “uncleared” swaps.

Here’s how Leigh sees the derivatives reform in the Dodd-Frank Act affecting non-financial companies:

The Dodd-Frank Act will transform how many derivatives work. Some of the types of derivatives that are likely to be most greatly affected by Dodd-Frank are those that many non-financial companies use—such as plain vanilla interest rate swaps and currency swaps.

The Current Regime. Currently, over-the-counter derivatives such as swaps are individually negotiated, bilateral agreements between two parties, such as a company and a broker-dealer or bank. Each party agrees to make certain payments to the other. For example, a company that is required to pay a floating interest rate under its credit facility (for example, LIBOR plus a spread) might enter into an interest rate swap to hedge its interest rate exposure by fixing its interest rate. To do so, the company could enter into a swap with a broker-dealer, under which the broker-dealer would agree to make payments to the company equal to LIBOR plus a spread on a “notional amount” (the principal amount of the credit facility) and the company would agree to make payments to the dealer equal to a fixed interest rate on the same notional amount. The company’s interest rate exposure would be hedged, because the company would owe fixed amounts under the swap, and would receive floating amounts from the broker-dealer under the swap sufficient to cover its risk of having to make larger interest rate payments under its credit facility due to increases in LIBOR.

Since the swap is just an agreement between two parties, it gives rise to credit risk. In fact, the entire value of the swap is tied to the ability of the other party to make its payments. It is entirely up to the parties to agree whether collateral will be provided to secure these obligations. Also, the details of the terms of the swaps are not typically public, which can make derivatives hard to value and also makes it difficult to determine the amount of a particular institution’s derivatives exposure.

Regulation Under Dodd-Frank. In general, the Dodd-Frank Act addresses the credit risk and lack of transparency under the current regime by imposing four kinds of requirements on over-the-counter derivatives trading:

• Clearing Requirement. Some over-the-counter derivatives will be required to be cleared. These are likely to include the most common types of derivatives, such as plain vanilla interest rate swaps. If a swap is cleared, after the two parties enter into a swap, the parties give up their rights and obligations under the swap to a clearinghouse (through a futures commission merchant appointed as their clearing member). Going forward, each party has credit risk with respect to the clearinghouse (and its clearing member), but not to the other party to the swap.
• “Swap Execution Facility” Requirement. All swaps that are required to be cleared will also be required to be entered into on a swap execution facility or on an exchange. Many swaps now are just entered into over the telephone. The details of what will qualify as a swap execution facility are still to be determined by CFTC and SEC rules, but may require companies to offer several dealers the ability to bid on swaps.
• Margin Requirements. In addition to margin requirements to be imposed by the clearinghouses on cleared swaps, the regulators will impose minimum margin requirements on uncleared swaps. In many cases these requirements are likely to be higher than those now typically negotiated by swap parties.
• Reporting Requirements. All swaps (whether cleared or uncleared) will be required to be reported to a new type of entity called a “swap data repository” or to the CFTC or SEC. Information regarding the terms of the swap will then be made available to the regulators and the public, although the identity of the parties to the swap will not be made publicly available.

Treatment of Non-Financial Companies. Some of this sounds quite good for non-financial companies; for example, the use of clearinghouses may reduce credit risk to broker-dealers and banks, and publicly available information regarding the terms of derivatives will likely make them easier to value and may also increase price competition. However, these changes will likely make derivatives more expensive, both because of higher margin requirements and because the Dodd-Frank Act will impose substantial additional regulatory requirements on swap dealers which will be expensive to comply with, and the dealers are likely to pass through those costs by charging more for swaps. As a result, there has been a substantial lobbying effort by certain non-financial companies to exempt certain derivatives entered into by such companies from the Dodd-Frank requirements.

To some extent, this effort has been successful. Rules proposed by the banking regulators and the CFTC under the Dodd-Frank Act do not specify a minimum amount of margin to be posted to swap dealers by companies that are not “financial entities.” Instead, it is generally left up to the swap dealer to determine how much margin will be required. This may mean that non-financial entities will have to post less margin than “financial entities” for uncleared swaps.

Also, the Dodd-Frank Act includes a provision often referred to as the “end user clearing exemption.” Under this exemption, a swap is not required to be cleared or traded on a swap execution facility if it meets four requirements:
• At least one of the parties to the swap must be a “non-financial entity.” If a company is not engaged predominantly in financial activities, it should be a non-financial entity.
• The swap must be entered into to hedge or mitigate commercial risk. Many swaps typically entered into by non-financial companies are likely to meet this requirement.
• The non-financial entity must notify the CFTC or SEC how it generally meets its financial obligations with respect to uncleared swaps. Based on proposed rulemaking, it looks like this will be accomplished through certain boxes being checked on the form reporting each swap to the swap data repository. For example, the form might indicate that the company has provided collateral for the swap or has provided a guaranty.
• If the non-financial entity is a public reporting company, the “appropriate” committee of its board of directors must have reviewed and approved the company’s decision to enter into uncleared swaps. The purpose of this requirement seems to be for the directors specifically to approve the company deciding to enter into uncleared swaps rather than cleared swaps, due to the perceived higher credit risk of uncleared swaps. Proposed rulemaking contemplates that the committee would review this decision on a periodic basis; it seems unlikely this would require an approval every time the company entered into an uncleared swap, but it might for example require approval on an annual basis.

A committee is “appropriate” if it is specifically authorized to review and approve the company’s decisions to enter into swaps. A committee could be given this authority through a vote of the full board or through a provision in the committee’s charter, for example.

There are no exemptions for non-financial companies from the swap reporting obligations imposed by Dodd-Frank.

Look for the derivatives provisions of the Dodd-Frank Act to start becoming effective later this year. They are likely to be phased in, with certain requirements becoming effective sooner and others not becoming effective until 2012 (or possibly later). Board members will want to keep informed on the final rules as they develop to understand the requirements and what exemptions may be available for derivatives entered into by their companies.

Whistleblowing Lessons

Mark Nuccio — 2011-06-16T14:54:00Z

While the Dodd-Frank Act added a new whistleblower law as Section 21F of the Exchange Act and the SEC recently published its final rule implementing the new law, whistleblower laws are not at all new. Companies and courts have decades of experience contending with whistleblower claims under the False Claims Act. It stands to reason that the sturm und drang of future whistleblower claims under Section 21F may end up resembling the woof and warp of whistleblower claims made under the False Claims Act. So I asked my colleagues, Doug Hallward-Driemeier and Kirsten Mayer, what insights the False Claim Act experience provides for public companies about whistleblower claims made under the SEC’s new rule.

Doug developed many of his insights from inside the Justice Department and Solicitor General’s office where he argued False Claim Act and securities law cases, so he possesses both good technical expertise and practical knowledge about how to be ready for life with the new SEC whistleblower rule. Kirsten has been counseling clients on FCA matters for over ten years, and recently spoke on an ABA panel regarding recent amendments to the FCA, including the amendments to its anti-retaliation provisions. Here’s what they think are the biggest lessons.

There’s no question that the whistleblower and anti-retaliation provisions mandated under Section 922 of the Dodd-Frank Act, and implemented by Regulation 21F, are a game-changer that significantly expand the SEC’s largely non-functional bounty program and the anti-retaliation provisions of Sarbanes-Oxley § 806. And it’s no accident that new Section 21F of the Exchange Act resembles the FCA’s whistleblower provisions. Under criticism from the SEC’s Office of the Inspector General, the agency consulted with the DOJ to identify the types of “best practices” that were successfully utilized to recover $3 billion in 2010 and more than $27 billion since 1986.

You already know the bad news: Like the FCA, the SEC’s whistleblower provisions offer whistleblowers substantial financial incentives for providing information about fraud to the government, which translates to increased compliance costs and a threat of follow-on civil litigation for public companies.

But there is also some good news (or, at least, not-as-bad-as-it-could-have-been news). In certain key aspects, Section 21F may avoid some of the worst abuses that have plagued the FCA’s whistleblower provisions:

1. Unlike the FCA, the SEC whistleblower provisions do not offer whistleblowers a private right to sue in court. Of course, there are already private suits for securities fraud, but these are limited to investors who have suffered a personal loss. One of the major frustrations and inefficiencies under the FCA is that qui tam whistleblowers who have no personal stake in the litigation aside from a hope to collect part of the government’s take are empowered to pursue lawsuits for alleged wrongs to the government. A qui tam whistleblower can press ahead with his suit even when the government decides to forego intervention. The suit is filed, and can proceed, without any exercise of enforcement discretion by the government. Self-appointed government representatives frequently pursue accusations of supposed fraud against the government, even though the agency may not agree with the whistleblower’s view of the regulatory scheme at issue. Though DOJ can, in theory, move to dismiss a case with which the government disagrees, in practice it does not do so because it does not want to bite the hand that feeds it.

Under Section 21F, by contrast, only the SEC can pursue securities fraud litigation based on the whistleblower’s information. Whistleblowers must follow an administrative process to furnish original information voluntarily, and awards are dependent upon success of the action. But enforcement power rests finally and completely with the SEC. Since enforcement must be financed by the government, we can hope to see significantly greater control and oversight than currently exists in the FCA enforcement space.

2. More whistleblowers will be excluded under the terms of Section 21F than the FCA. The SEC rules require, in order to be eligible for any reward, whistleblowers must “voluntarily” provide the SEC with “original information” about “a violation of the securities laws that leads to the successful enforcement of an action” brought by the SEC “that results in monetary sanctions exceeding $1,000,000.”

The most significant of these restrictions is likely to be the requirement that the whistleblower’s tip be based on “original information.” Section 21F’s requirement that “original information” must derive from “independent knowledge” or “independent analysis” should help to limit the proliferation of whistleblower allegations based entirely on second-hand information or on information already known to the government – a longstanding threat under the FCA’s imprecise public disclosure bar. Under the FCA, a qui tam whistleblower is free to file a parasitic suit relying on others’ inside information, even information in the government’s possession, as long as that information has not previously been released through one of a few limited means such as federal government reports or the news media. Only if the information was publicly disclosed must the qui tam whistleblower prove he was an “original source.” Under Section 21F, by contrast, every would-be whistleblower recovery will depend on providing “original information” that is not already known to the SEC, or exclusively derived from an allegation in a judicial or administrative hearing, a governmental report, hearing, audit, or investigation, or from news media.

Another significant difference is the incentive the SEC has to enforce the “original information” requirement. Under Section 21F, whistleblowers will only recover if the SEC has brought a successful enforcement action. Section 21F defines information that “leads to” a successful enforcement action as information that is “sufficiently specific, credible and timely” to cause the SEC to launch a new investigation, or that “significantly contributes” to an existing investigation. If the SEC feels the action was based on its own labors, and the whistleblower’s whistle did not contribute to the recovery, we can expect the SEC to apply the “original information” requirement rigorously, limiting recovery to truly worthy whistleblowers. By contrast, the incentives under the FCA are for DOJ to take a broad view of when a whistleblower is an original source. Because the FCA permits whistleblowers to sue without DOJ’s intervention, the government stands to collect the majority of any recovery without doing much heavy lifting. When defendants try to knock a qui tam suit out of court on the ground that the allegations of fraud were already publicly disclosed, DOJ has an incentive to support the qui tam whistleblower’s argument that he is an “original source” and, thus, able to proceed with the case without DOJ’s involvement. In addition, courts have allowed qui tam whistleblowers to receive a share of recovery – over the government’s objection – even when they provided no new information concerning preexisting investigations.

3. A related feature of Section 21F that may reduce financial incentives for whistleblowers is that the SEC is afforded broad discretion to make award determinations. While allocation of awards to both SEC and FCA whistleblowers are predicated on similar factors, including the significance of the information and the degree of assistance provided by the whistleblower, allocations under Section 21F will occur absent district court approval. SEC whistleblower awards will be granted, in the first instance, subject to the SEC’s complete discretion, and any appeals of award amounts will be reviewed by the circuit courts, presumably under established deferential standards of administrative review. Under the FCA, by contrast, district courts have broad authority to approve FCA settlements and whistleblower rewards from settlements or judgments. The SEC’s greater authority, coupled with the fact that whistleblower awards will be paid from the same fund that finances the SEC OIG’s activities, has significant potential to temper the Commission’s generosity, and, in turn, the volume of meritless whistleblower accusations.

Despite the potential advantages of certain features of the SEC’s whistleblower provisions when compared to the FCA, the SEC rules nevertheless create enormous incentives for employees to report potential knowledge about federal securities law violations to the SEC. And because the SEC will fund the investigations and litigation, it will be virtually cost-free for lawyers to represent SEC whistleblowers. We can expect that there will be a sizeable cast of attorneys offering to prepare whistleblower submissions, wait to see what sticks, and then come in to fight for the bounty if SEC recovers anything.

It is more important now than ever that public companies invest in robust internal compliance and audit procedures to remediate wrongdoing, investigate allegations, and, when appropriate, report violations to the SEC. Our experience with the FCA suggests that many whistleblowers are employees who initially sought to address a perceived problem internally. When their intra-mural efforts were unsuccessful, the feeling of disappointment with the company’s response helped to justify and overcome feelings of guilt and discomfort at reporting the company for personal gain.
Active compliance programs, remedial measures, and self-reporting, can also significantly reduce the company’s ultimate exposure. DOJ has long-incentivized self-policing with non-prosecution agreements or reduced penalties for companies. When evaluating global settlements that implicate both civil liability under the FCA and criminal liability under related criminal statutes, prosecutors are specifically instructed to consider “the corporation’s timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation” and “the corporation’s remedial actions, including any efforts to implement an effective corporate compliance program, or to improve an existing one, to replace responsible management, to discipline or terminate wrongdoers, to pay restitution, and to cooperate with the relevant government agencies.” References to such compliance, remediation, and cooperation have become a veritable fixture in plea agreements.

Similarly, the SEC has indicated that companies will benefit by proactively addressing problems, or will be punished more severely for failure to do so. The SEC’s Seaboard Report, for example, outlines criteria that the agency will evaluate, including: “What steps did the company take upon learning of the misconduct? Did the company immediately stop the misconduct? Are persons responsible for the misconduct still with the company? If so, are they still in the same positions?” In addition, the new SEC rules encourage use of internal compliance programs. Section 21F’s 120-day relation-back provision, the expanded scope of information attributable to whistleblowers who utilize internal compliance, and the explicit financial incentive offered to whistleblowers for not hindering or bypassing internal compliance speak to the SEC’s desire to avoid displacing internal compliance programs.

The American experience with whistleblower laws has come a long way since, upon the passage of the FCA in 1863, President Lincoln derided as “worse than traitors in arms, the men who pretend loyalty to the flag, feast and fatten on the misfortunes of the nation.” While the new SEC scheme may avoid some of the worst pitfalls of the FCA, it is essential that board members draw upon the lessons of FCA enforcement to position their companies for the new enforcement environment.

August 12, 2011 is just around the corner.

What's That Sound I Hear - Rapture or SEC?

Mark Nuccio — 2011-05-31T14:54:00Z

Turns out it was not exactly the Rapture that caused some shrieking last week. But the Securities and Exchange Commission did adopt, by a 3-2 vote, a rule creating a whistleblower program that was mandated by Section 922 of the Dodd-Frank Act, which added Exchange Act, new Section 21F. The whistleblower program is primarily intended to reward individuals who expose violations and who provide significant evidence that helps the SEC bring successful cases. Leaving aside fears of actual whistleblower claims, the existence of such a program will, in and of itself, justify dialing up focus on securities-related compliance efforts. The details of the new rule and policy behind it are contained in a 300-page release. So the new rule is hell for some, and heaven for others.

To be considered for an award, the SEC’s rules require that a whistleblower must voluntarily provide the SEC with original information that leads to the successful enforcement by the SEC of a federal court or administrative action in which the SEC obtains monetary sanctions totaling more than $1 million. The meaning of the word “voluntary” is important. No financial bonanza awaits those who labor under a duty to report already. (And you know who you are!)

The question whether whistleblowers must work through internal compliance programs in order to qualify for a bounty generated substantial comment, but calls for requiring whistleblowers to work through such programs were ultimately unheeded.

In a nod to the importance of maintaining sound internal compliance programs, the final rule does seek to encourage, in a modest fashion, their use. The final rules make a whistleblower eligible for an award if the whistleblower reports internally and the company informs the SEC about the violations. Under the SEC program, a person becomes a whistleblower as of the date that employee reports the information internally – as long as the employee provides the same information to the SEC within 120 days. The rule also provides that a whistleblower’s voluntary participation in an entity’s internal compliance and reporting systems is a factor that can increase the amount of an award, and that a whistleblower’s interference with internal compliance and reporting is a factor that can decrease the amount of an award. It’s probably fair to conclude that the changes made in the final rule bow slightly in the direction of making it somewhat more attractive for a whistleblower to work through the internal system, but it is an overstatement to say they provide any real incentive to do so. Rather than dismissing the efficacy of internal compliance in the face of the opportunity to do an end around, it’s time to re-think how internal programs work and how they may be made to work better with the new Dodd-Frank whistleblower program in place.

Another area of the proposed rule that engendered comment was the definition of whistleblower. The rule, as proposed, termed as a “whistleblower” anyone who provides information to the SEC relating to a “potential violation” of the securities laws. The SEC sided with those who suggested that the term “potential violation” was imprecise, and changed the final rule to say “possible violation” that “has occurred, is ongoing, or is about to occur.” The final rule also clarifies that the violation must involve federal securities laws, rule or regulations – state or foreign violations do not qualify, and that, in order to be granted an award and qualify for heightened confidentiality treatment, a whistleblower must submit information to the SEC by following the procedures set forth in the new rules.

The new rule contains anti-retaliation provisions designed to protect whistleblowers. The rule is clear that, while you must have a “reasonable belief” that the information you provide relates to a possible violation, you do not need to be right in order to be covered by the protections. Unsurprisingly, such protections give rise to fears that those seeking protection from termination will find it convenient to allege wrong-doing by their employers.

The new whistleblower rules will need to be immediately factored into the design and implementation of internal compliance programs as well as employee manuals. In designing strategies that may further encourage use of existing internal processes, companies will want to consider the impact of the new rule’s prohibition on impeding an individual from communicating directly with the SEC staff about a possible securities law violation, including enforcing or threatening to enforce a confidentiality agreement or the like. The new rule also authorizes the SEC staff to communicate directly with anyone who has initiated communication with the SEC relating to a possible securities law violation, and who works for an entity that has counsel, without obtaining the consent of such counsel. The provision does not say that the SEC may do so if the individual has his or her own counsel. Amen to that.

The SEC’s rules will be effective 60 days after they are submitted to Congress or published in the Federal Register.

Regulatory Cherry Blossoms

Mark Nuccio — 2011-05-09T14:54:00Z

With financial reform legislation barely nine months old, federal policymakers have been busily spinning the threads of the Dodd-Frank Act into new regulatory fabric, trying to ignore the distraction of initiatives to shred certain aspects of the law. This blog will provide perspectives on some of the developments that are most noteworthy to board members.

All financial institutions and public companies will be touched by the Dodd-Frank Act in a number of important ways. Now that the regulatory flood gates are opening, boards will want to make sure they are prepared to react or adjust to developments. If readiness for the Dodd-Frank reforms is not a regular board meeting agenda item, it should be. Efforts to prepare for the implementation of the Dodd-Frank reforms call for many judgments, and a nuanced approach, that make the preparation for the Year 2000 look like a walk in the park by comparison. The cross-currents of political maneuvers in Washington are tempting distractions from the matters at hand, but the federal financial bureaucracy is on the march.

Waiting for the political fog to lift along the Potomac, here are four Dodd-Frank regulatory cherry blossoms that are worthy of attention right now:

1. SIFI Companies. Should you be losing sleep wondering whether your company is an important enough financial player to be regulated by the Federal Reserve Board as a systemically important financial institution? Under Section 113 of the Dodd-Frank reform, a nonbank financial company may be designated by FSOC as a SIFI and become subject to regulation by the Federal Reserve Board, including heightened prudential standards and other restrictions, if FSOC determines that material financial distress, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the company’s activities could pose a threat to the financial stability of the US. It would be an odd outcome to the process if none of the largest non-bank financial companies enters this brave new world of regulation.

The Federal Reserve Board issued a Notice of Proposed Rulemaking that brings into focus the difficulty of determining which nonbank financial companies will become subject to Federal Reserve Board regulation. The proposal sought comments on a definition of the term “predominately engaged in financial activities” that is of particular interest to large investment managers and large companies heavily engaged in nonbank financial activities. The proposal established $50 billion or more in total consolidated assets as an asset threshold for nonbank financial companies and FSOC staff members are looking at four industries: asset managers, insurance companies, specialty lenders and broker/dealers and futures commission investments. The Managed Funds Association, understandably focused on the question whether client assets would be included in the total consolidated assets has commented that it would be inappropriate to include client assets in measuring the size of an asset management firm. The Federal Reserve Board’s elastic notion of controlling influence, applied by the Board staff in the context of evaluating proposed investments in banking entities, provides sufficient cause to keep a close eye on how this proposal is finalized. By drawing upon its own historic precedents as a starting point, the Federal Reserve Board also confirmed to many how the Federal Reserve Board would frame out the scope of financial activity that requires measurement.

2. Compensation issues. Among a number of Dodd-Frank compensation–related reforms, the SEC has released for comment proposals to implement Dodd-Frank Section 952 reform provisions relating to compensation committees and the use of compensation consultants. The regulatory bite is applied in the form of new exchange listing standards: if companies fail to meet the new standards, they cannot be listed. Compensation committee members will need to be independent as defined by exchanges and based on considerations set forth in the regulation. The Committee is empowered to be advised by consultants and legal advisers (of course!), that need not be independent, but whose independence (based upon guidance in the regulation) must be taken into account. The effective date for these changes is still more than a year away because the exchanges need to adopt standards and have them approved by the SEC. The SEC also proposed new proxy statement disclosure requirements to address whether the Compensation Committee has retained or obtained the advice of a compensation consultant; and whether the work of any Compensation Committee consultant has raised any conflict of interest, and if so, the nature of the conflict and how the conflict is being addressed.

3. The Volcker Rule. With regulations adopted that set forth the timetable for its implementation, the Volcker Rule continues to be the subject of much analysis and debate. Contrary to wishful thinking on the part of many who will be subject to the new rule, the Volcker Rule will become effective long before the return of Halley’s Comet. With the handwriting on the wall, some financial holding companies, have already taken measures to separate themselves from proprietary trading activity in its purest form. The existing and proposed relationships between banking entities and hedge funds and private equity funds will remain particularly complicated until regulations are in place that implement the substantive provisions of the Volcker Rule. In spite of the uncertainty that remains about the scope of potential exceptions, some organizations, like Bank of America, have concluded that private equity investment is decidedly non-core to their business and have made plans to spin them off. Proposed rules are expected in the next two months.

4. Derivatives. If your company participates in the derivatives market, it is watching developments at CFTC and SEC very carefully, and bankers have their eyes on the FDIC and other banking regulators. The Dodd-Frank derivatives reform sought to introduce a higher degree of transparency, accountability and risk management into the derivatives markets. The level of proposed regulation will likely result in much greater availability of data, but it is an open question who will be in a position to take advantage of it and how the cost of compliance will impact the efficiency of the new market dynamic. The CFTC, in particular, has unleashed a torrent of proposals designed to regulate, in a thorough manner, the over-the-counter swaps market. The SEC is trying hard to keep up with its proposals to regulate the security-based swaps market. Board members should be kept apprised of the possible impact of these regulatory developments.

Regulatory Cherry Blossoms

Mark Nuccio — 2011-05-09T14:54:00Z