Securities Legislation

Two years ago, the United States Supreme Court stated in an opinion that the five-year statute of limitations for the SEC to seek civil monetary sanctions began from the date of the fraudulent act, as opposed to when the SEC discovered the fraudulent act. In doing so, the Court rejected the discovery rule.

The discovery rule extends the statute of limitations because it provides that the statute does not begin to run until the party brining the claim discovers the wrongdoing. For example, if the fraud happened 10 years ago, but was discovered yesterday, the SEC would have had five years from yesterday to bring a claim against the fraudster. Applying the Supreme Court’s rule noted above, the SEC would be out of luck to bring a claim for civil and calculator

This week, Senator Reed of Rhode Island introduced a bill that would extend the SEC’s statute of limitations from five to 10 years. Applying this new limitations period, the above-referenced scenario would fall within the time in which the SEC could act.

The logic behind extending the limitations can be seen as a way to insulate the impact of the Court’s decision and the absence of the discovery rule. In other words, it extends greater protection to investors who are the victim of a fraud.

Under the new proposed limitations period, the SEC would have twice as long to uncover a fraud to seek civil monetary penalties. The moral of the story; if you are committing securities fraud be prepared for the SEC to have more time to come after you. Better yet; don’t engage in fraud.

A reverse triangular merger was not an assignment by operation of law.  See Meso Scale Diagnostics LLC v. Roche Diagostics GMBH, Del. Ch., C.A. No. 5589-VCP, 2/22/13, 

The court explained that a company entered into a series of contemporaneously executed agreements that granted it a new non-exclusive license. However, before the transaction was complete the licensor, transferred all of its intellectual property assets, subject to outstanding licensee rights, to a newly created corporation.  These were then acquired in a reverse triangular merger where the new company was the surviving entity.

The plaintiffs sued claiming that the company and various affiliates breached provisions in two agreements.  However, the court granted summary judgment on the first count since the reverse triangular merger was not an assignment by operation of law or otherwise requiring consent.  The court said mergers do not result in an assignment by operation of law of assets that began as property of the surviving entity and continued to be after the merger.  

Thus, the court dismissed the complaint.

The SEC recently completed the Dodd-Frank mandated study on financial literacy for retail investors and it revealed, not shockingly, an absence of basic financial literacy.  The study also found that it was important for retail customers to have a better appreciation of the costs associated with their investments, as well as conflicts of interest related to transactions. 

All those years of hearing customers testify of not knowing the difference between a stock and a bond may not have been a lie.  Without basic financial literacy, how can you know your customer to make investment recommendations with a reasonable basis and satisfy the applicable rules.

These issues should not come as a surprise to you because they are fundamental things that both your clients must know and you need to certain that they know. The absence of financial literacy will lead to two bad results.  First, you do not know your customer as required.  Second, if you do not know your customer, you could not have had a reasonable basis for making your investment recommendations.  As such, you will have liability exposure if sued by this client.

So what do you do.  For one, make sure that you do what you can to make your clients financially literate.  Once you have level of comfort that your client possesses some basic understanding of investing, you are then able to make suitable investment recommendations.  Take your time with this analysis; it may be the best way to protect yourself from customer complaints.

Despite the fact people are still unemployed, the drought rages and farmers suffer, and the deficit continues to grow, Congress seems to float absurd legislation across the partisan divide to regulate the regulators and the market.

In particular, the House passed a bill that would tighten the cost-benefit analysis for both the SEC and CFTC rule process.  This proposed legistlation would require the consideration of certain mandatory factors in these agencies’ cost-benefit analysis of promulgated rules.  This legislation merely generates sadness from my perspective.  Why, you ask?  Well, it shows a glaring failure of those representatives in Congress to understand the regulation process in the securities industry.  You think after almost 80 years, someone in Congress would get it!!

Securities regulation is not simply a dollars and sense proposal, any ability to place such a cap as passed by the House misses the point.  In fact, if you follow through on this ridiculous proposition, no regulation would ever be imposed and the market would be allowed to freely do whatever it wants, including, among other things, allowing fraudulent practices to occur continuously.  Please keep in mind that all regulations require costs, and it is not a simple business proposition.  For example, if you follow the House’s proposal and applied it to the SEC’s work, the SEC may propose a rule to stop certain fraudulent activity, requiring market participants to implement certain controls and procedures.  Of course, the preparation and implementation of these procedures would cost market participants money.  However, given that the activity may only effect part of the market, the House legislation would require the SEC to drop the rule because it would “cost” too much money for the market participants to implement.  As a result, investors could lose money (that could have been avoided if the proposed rule had been implemented), but, according to the House legislation, those individuals and their potential losses are not important enough to require the enactment of the rule given the House’s proposed cost-benefit analysis.  Essentially, under the House legislation, one could argue that Exchange Act Rule 10b-5– the lynchpin of criminal and civil securities fraud enforcement– would not have been enacted today because it would cost the industry too much money!!!  Truly, the silly season is upon us!!   

Equally silly is the bill introduced in the Senate that would significantly enhance the penalties that the SEC may seek.  In typical legislative fashion, it is believed that the more you raise fines or prison sentences, it will somehow deter people’s conduct.  Unfortunately, time and time again, such approaches have failed.  Despite the fact that criminal penalties and civil sanctions have been increased exponentially over time, people continue to commit securities fraud.  If this legislation were to pass, it would only engender more unpaid fines that the government already does not collect.  Interestingly, this piece of legislation, unlike the House legislation, actually has bipartisan support and has a chance of passage.  I suppose everyone wants to pile on, and make themselves look tough on fraud.  However, such actions are merely an act of rushing to the bottom.

In short, neither position espoused by either party seems to make much sense or have the ability to improve our securities and capital markets.

As a result of conclusions from a recent study by Woodbine Associates, Senator Charles Schumer wrote to SEC Chairman Schapiro requesting that the SEC take action to ensure that brokerages disclose rebates and incentive payments they receive from national exchanges and other trading venues that they receive for routing securities transactions to those entities.  According to Schumer, the current disclosures do not go far enough to ensure customers are fully informed; he wants the SEC to take action.  Moreover, Schumer raised the spectre of conflicts of interest if routing decisions are based upon the economics for the brokerage.

The study found that most brokers are routing their trading orders to exchanges not based upon “best execution”, but rather on pricing incentives.  In other words, decisions are being made to route trades based upon the remuneration that the brokerage will receive from the exchange.  This system, the study says, has a direct impact on investment returns.  To combat this system, Schumer has called for more robust disclosures to ensure transparency for customers.

Although there are currently rules requiring the disclosure of information at the customer’s request, Schumer’s letter seeks to have the SEC put more of the onus on the brokerage to provide this information without a request.  If the SEC revisits this issue, the focus will surely be on transparency in the market.  Customer’s should know that they are obtaining best execution at the best price, not possibly best execution but the brokerage received an economic incentive.  It seems to me that with more transparency, there will be better competition and a more disciplined trading system based more on best execution than something else.

Recently, an investor advocacy group petitioned the SEC to prohibit brokerage firms, who offer wraparound accounts, to also provide investment advice through both a duly registered BD and investment adviser. 

This group claims that terminating this practice would resolve a very troubling regulatory issue.  The group also petitioned the SEC to ban mandatory arbitration accounts for individual retirement accounts and allow for a private right of action by investors in a court.  In any event, this group claims that its petition and potential subsequent SEC action were necessary because FINRA has refused to take any action to resolve this problem.

The groupl claims that FINRA refuse to enforce any fiduciary standard for investment advice relating to wrap accounts.  This group believes that such a “non-practice” violates the U.S. Court of Appeals for the District of Columbia Circuit’s decision in 2007 in a case entitled Financial Planning Association v. SEC.  The group believes that the D.C. Circuit stated that the SEC exceeded its authority in promulgating a rule exempting from regulation broker-dealers who also provided investment advice to client fee based accounts. 

As a result of FINRA’s inaction, these dully registered wrap accounts are creating conflicts that are not being disclosed.  Further, this group claims that confusion exists in the industry, leaving retail retirement investors without any appropriate legal process for claims of breach of fiduciary duty under the Investment Advisers Act of 1940.

Although it is unlikely this petition will ever be acted upon, it is important to keep in mind that, in an election year, anything is possible, and, who knows, the SEC may consider appropriate action at some time in the future.

In its never ending quest to find suitable ways to address capital formation issues in the United States, the SEC’s Division of Corporation Finance is looking to see if foreign jurisdictions handle some of these issues better and if it could be applied in the United States. 

For example, the SEC is looking to see if other jurisdictions handle solicitations and advertising of private offerings differently.  Coupled with this item, Corporation Finance is also reviewing the regulation of private issuers as well.  In particular, Corporation Finance is looking at private placements and general solicitation bans in light of the new age of social media, and 24 hour news coverage.  One consideration is if the current regulatory scheme of a registered offering regime is relevant when one considers the way information is received in this type of market and the attempts to encourage investors through these communications.

The SEC is intrigued at the way foreign private issuers handle these matters overseas and if its current system should remain in place.  Historically, foreign private issuers in the United States ahd been the traditional large cap companies.  However, this model is changing, and it is unclear if the SEC’s current regulatory framework has adapted.

Finally, the SEC should be applauded for its efforts in realizing not all regulation needs to be addressed from an American standpoint, but that certain goals could be achieved by following an overseas model.

Congressman Bachus (R-Ala.) introduced a bill that would shift the oversight of registered investment advisers from the SEC to a self-regulatory organization that would report to the SEC.  This development represents the crystallization of one of the fears emanating out of Dodd-Frank, which mandated that the SEC study how to tighten oversight over RIAs.

Advisers fear that an SRO will be more expensive than the SEC and would lack the experience to address the fiduciary duty standard that governs RIAs.  Conversely, FINRA has long lobbied for it to become the SRO for RIAs, noting its long-standing oversight of broker-dealers.  FINRA’s track-record with broker-dealers suggests that it is well-positioned to become the SRO for RIAs.  From the public’s perspective, something has to be done because, under the current system, RIAs are examined less than once every 11 years, a point on which Bachus has focused.  The SEC has at least tacitly endorsed the role of an SRO over RIAs because of the SEC’ budget limitations to do the job itself.

The timing of this bill does not endear it to short term success.  In an election year, many may not want to rock the boat to push this bill along.  In other words, the bill just may not have the political juice to become reality.  Nevertheless, at some point there will surely be an SRO for RIAs, either FINRA, a better funded SEC, or, less likely, a brand new agency.  Time will tell, but we are probably looking at another year of this debate before there is an SRO for RIAs.


According to an internal SEC guidance report, the SEC is taking to heart the criticism that it does not employ enough of an economic analysis in its rule-making process.  The guidance directed the SEC to take a cost-benefit approach to all rule-making, regardless if the rules are discretionary or mandated by Congress.

This guidance report is in direct response to an earlier report that sharply criticized the SEC for not conducting the cost-benefit analysis for rules mandated by Dodd-Frank.  As part of its response, Chairman Schapiro has noted that the SEC has hired 20 economists and is asking Congress form the funding to hire an additional 20 economists.

Although the SEC should be praised for taking criticism to heart, it also reflects a bit of self-preservation.  If the SEC did not take this action, then it faced the risk of legislation that would require the cost-benefit analysis in rule-making.  Some in Congress still want to press for such a statutory mandate.  That way, there would be no room for confusion as to what is expected from the SEC. 

Regardless of why the SEC is employing a cost-benefit analysis in its rule-making, it should only be seen as a positive development.  In the absence of such an analysis, we could be faced with, for example, a uniform fiduciary duty for anyone providing investment advice regardless of its costs.  Such a result would be problematic to say the least.

The Department of Labor has a rule pending that would impose a fiduciary duty standard for investment advice pertaining to retirement plans.  Like the resistance faced by the SEC in its attempt to create a uniform fiduciary duty for retail investment advice, the DOL has faced similar resistance, with calls for a cost-benefit analysis before imposition of such a standard.

Opponents to the rule say that the cost will not outweigh the benefits of this heightened standard of care.  Skeptics of the pending rule suggest that it will drive brokers out of the IRA market so that they can avoid being confronted by a fiduciary duty standard.  Some critics believe that the DOL is targeting a non-existent problem.  Others claim that the rule would deprive small investors from obtaining IRA advice as brokers leave the business. Advocates of the fiduciary duty assert that such a rule will require brokers to provide unbiased advice.

Wherever the DOL lands on this issue, I believe that it should, like the SEC, conduct a cost-benefit analysis to really determine if (1) such a rule is needed and (2) do the benefits of the rule outweigh the costs incurred to impose such a rule.  Only after the completion of this analysis could we objectively say it is a good thing and will be deployed in a cost effective manner.