The Volcker Rule’s covered fund provisions have not received the attention they deserve. Like the more well-studied proprietary trading rule, the covered funds rule restricts bank investments in the name of limiting their risk-taking and mitigating their contribution to systemic risk. As with proprietary trading, legislators and regulators faced a decision with covered funds on how to define those bank activities that would be off-limits. However, unlike with prop trading, Congress, and federal regulators subsequently, chose to define the scope of the covered funds rule largely by reference to an existing statute.
In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences.
A first cut
Using Investment Company Act exemptions to set the scope of the covered funds rule has advantages. The Investment Company Act exemptions set boundaries that have already been defined by regulators and market expectations. These particular trans-statutory cross references work to circumscribe bank investments in, and sponsorships of, a wide range of entities. Congress appears to have concluded that private equity and hedge fund investments posed inordinate risks for banks and the government safety net. Since those two types of funds typically use those two Investment Company Act exemptions, the trans-statutory cross references seem to accomplish Congress’s intended purposes. A range of other entities also use these two exemptions, but the five federal regulators that promulgated the final rule ultimately carved many of those entities out. Still, many non-real-estate-related securitization vehicles would be covered by the rule.
On the other hand, prohibiting banks from investing in particular exempted funds does not necessarily mean that banks will move their money to safer locales. Many real estate securitizations, for example, are not covered by the rule. Banks could move capital to other exempted funds or even restructure existing investments to fall under other Investment Company Act exemptions not covered by Volcker. More on this in a moment.
When securities law serves banking law purposes
Stepping back from its immediate market consequences: the trans-statutory cross references at the heart of the covered funds rule highlights the ways in which the Investment Company Act, in particular, and securities regulation, more broadly, can and cannot regulate effectively the systemic risk posed by banks and other financial institutions. In other words, the tools of securities relation are in some ways aligned and in some ways mismatched with the purposes of prudential regulation. The trans-statutory cross references exacerbate Volcker’s problems of under- and over-inclusiveness in limiting the risk-taking of banks. The portions of the Investment Company Act most useful for systemic risk are its restrictions on leverage, which are somewhat unique in the pantheon of securities laws and function most similarly to banking rules.
Trans-statutory cross references can delegate power from one agency to another
Volcker’s trans-statutory cross references have not only policy but also political implications. By using a securities law to define the scope of a banking law, the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC). This has potentially profound implications given the differing statutory missions, cultures, and personnel of those agencies. Securities regulators also face different interest groups and have different institutional pressure points compared to their banking counterparts.
How the SEC will wield this power to define the scope of a banking law remains to be seen. Some commentators have doubts as to the SEC’s interest and ability to pursue systemic risk regulation alongside its traditional investor protection role. The covered funds rule will provide one test of the SEC’s resolve. Banking industry interest will likely now focus on other Investment Company Act exemptions. SEC decisions to narrow or expand other Investment Company Act exemptions – particularly Section 3(c)(5) or Rule 3-a-7 – now have cascading consequences by virtue of Volcker’s covered fund provisions. After Volcker, banks and other parties in securitization markets may seek to structure securitizations to rely on one of these other exemptions. Efforts to narrow these exemptions will likely meet strong opposition from banks and the securitization industry. In considering whether to narrow or enlarge these exemptions, the SEC must now consider not only whether investors in collective investment funds are protected. It must also consider the effects on bank risk-taking and systemic risk.
A larger lesson
The political dynamics outlined in my paper point to lessons for policymakers considering using trans-statutory cross references in the future. Trans-statutory references may take power from one regulatory body and give it to another. In the case of the covered fund rules, power over prudential rules was, perhaps unintentionally, delegated to a securities regulator. This works well if the statutory drafters trust the agency from whom power was taken less or trust the agency to whom power was given more. It works if the concern is to check potentially overzealous pursuit of policy objectives by the traditional regulator or to remedy potential shirking by a captured body. However, trans-statutory cross references may fail if the newly empowered regulator works at cross purposes to the statute it now has authority over. Trans-statutory cross references reflect a lesson that is old but one that bears repeating nonetheless: technical drafting decisions can have outsized and unintended political consequences, particularly with respect to the most important question of all – who decides policy going forward.
Cross-posted at Columbia's Blue Sky Blog.
I think they're doomed, but opponents of the 25 year old tradition of SEC administrative proceedings have had a good couple of days. Distressed Debt Diva (or whatever the right sobriquet is) Lynn Tilton has convinced the Second Circuit to hear her claim that appearing before an ALJ would be unconstitutional, which, if the court ruled in her favor, would create a circuit split with the 7th Circuit.
Also, the Wall Street Journal made much of a colloquy before Judge Richard Berman, who is one of the few judges who has ruled that ALJ proceedings are unconstitutional. He wanted to know more about the farcical decision by the SEC to send one of its ALJs a letter inviting him to tell them whether he was biased against defendants. He quite properly refused to answer, and they promptly reassigned him to another case. "You'll want to come up with a good explanation why," Judge Berman approximately told the agency.
I can't claim to understand what the SEC was doing with that missive to its ALJ, though it's always worth observing that ALJs work for the commissioners (much to their displeasure, ordinarily), and it isn't totally obvious that it is wrong to send a missive to an employee asking him to explain himself. But, oddly, adjudicative subordinates have a great deal of independence, to the point where I think we could consider them to be comparable to those most independent of regulators, bank supervisors. We wouldn't expect Janet Yellin to bother filing an affadavit explaining her thinking on interest rates if President Obama instructed her to do so, and there's no question that he is her boss.
The Wall Street Journal reports that the White House is considering our colleague for the SEC. Bainbridge thinks she'd be an excellent choice, and so do we. I won't gush, but Lisa has it all - she would be perfect for the agency.
I wrote in DealBook about SEC ALJs. Here's a taste:
I read every decision issued by the S.E.C.’s administrative law judges from the enactment of Dodd-Frank in 2010 to March of this year. Graded toughly – on whether the S.E.C. received everything it wanted from the case – the agency’s rate of success is high, but not unblemished.
In those decisions where at least one of the defendants was represented by counsel, the agency received everything it asked for only 70 percent of the time; that is not too different from the “rule of thumb” rate for victories by any federal agency in a federal court.
Of course, there is not getting everything the agency asks for, and there is losing the case. It is true that S.E.C. administrative law judges are willing to reduce the penalties sought by the agency’s enforcement division, either by reducing the amount of money that the defendant must pay to the S.E.C. or by reducing the length of their bar from practicing in their industry.
But in my sample, the agency rarely lost cases that it pursued to the point at which an administrative law judge would issue a decision. I identified only six of the first 359 decisions issued since Dodd-Frank was enacted that rejected the arguments of the enforcement division wholesale.
I wrote a paper on the SEC's ALJs, which I think are plenty independent and not at all unconstitutional. They cite federal judges and write sentences with the same degree of difficulty, and though the SEC usually wins before them, there are plenty of reasons for that.
It's forthcoming in the Texas Law Review, and here's the abstract. Do give it a look and let me know if you have any thoughts.
The Dodd-Frank Wall Street Reform Act allowed the Securities & Exchange Commission to bring almost any claim that it can file in federal court to its own Administrative Law Judges. The agency has since taken up this power against a panoply of alleged insider traders and other perpetrators of securities fraud. Many targets of SEC ALJ enforcement actions have sued on equal protection, due process, and separation of powers grounds, seeking to require the agency to sue them in court, if at all.
This article evaluates the SEC’s new ALJ policy both qualitatively and quantitatively, offering an in-depth perspective on how formal adjudication – the term for the sort of adjudication over which ALJs preside – works today. It argues that the suits challenging the SEC’s ALJ routing are without merit; agencies have almost absolute discretion as to who and how they prosecute, and administrative proceedings, which have a long history, do not threaten the Constitution. The controversy illuminates instead dueling traditions in the increasingly intertwined doctrines of corporate and administrative law; the corporate bar expects its judges to do equity, agencies, and their adjudicators, are more inclined to privilege procedural regularity.
Dan Katz (Michigan State), Michael James Bommarito, Tyler Soellinger (Michigan State), and Jim Chen (Michigan State) have posted a new paper that studies empirically the impact of SCOTUS opinions on the share prices of the winning and losing corporate parties. WSJ Blog blurb here. As corporate law professors know, the SCOTUS docket is not mainly corporate law cases or cases in which one corporation's prospects might be substantially changed (employment case, etc.), but the study did find 79 cases in the relevant period that seem to match changes in stock price equal to $140 billion.
Why do the authors think that's important? Obviously, in cases in which corporations get large securities fraud lawsuits dismissed or on the other hand, get a ruling that opens the door to a class action or multiple lawsuits, the share price could react. But what the authors are really interested is predicting that movement and exploiting it. Here is there information market website: https://fantasyscotus.lexpredict.com/. Here is their algorithm: http://arxiv.org/abs/1407.6333.
From a securities law standpoint, I can't help but wonder when predictive trading on court decisions begins to cross the "outside trading" line. No, the information isn't nonpublic -- the information is public, but only accessible through an enormous amount of computing power. Bud Fox following a corporate raider around all day and making very informed guesses as to his next target is one thing, but following every CEO around with invisible drones is another. At some point, does technology make information gathering cross the line? I don't have an answer for this, but I know that Larry Ribstein and Bruce Kobayashi hinted at the positive aspects of this in "Outsider Trading as Incentive Device," which responded to Ian Ayres and Steven Choi's "Internalizing Outsider Trading" and the concern that the ability to trade in similar ways would lead to excessive search costs. (None of the authors contemplated a scenario in which technology makes information that for all practical purposes was nonpublic and uses it for trading purposes.) I look forward to hearing more.
In what I think is the first appellate decision on the issue, the Seventh Circuit held that timing problems prevented courts from entertaining collateral attacks on SEC administrative proceedings. It means that defendants have to raise their constitutional claims before the ALJs, and then the SEC itself on appeal, before they can get into court on appeal from that.
These timing issues have always looked really problematic for the plaintiffs. Essentially, they have been arguing that they think the SEC is about to open an administrative case against them, and that a court should tell the SEC that it can't do that, because administrative cases are unconstitutional. Usually, claiming that you think the government is about to do something isn't a very good reason to sue the government. Why not wait and see? You'll save the court's time and keep it from issuing an advisory opinion.
Put that way, it's not surprising that a CEO anticipating administrative proceedings against her was told to make her constitutional arguments to the agency, if the agency does, in fact, file papers against her, before trying to get the courts involved.
On the other hand, the case that has ginned up these suits, Free Enterprise Fund v. PCAOB, let a couple of accountants make their constitutional claims against PCAOB before it had lifted a finger against them. So the Seventh Circuit basically said "we don't think the Court meant to get rid of the doctrines of standing, finality, and exhaustion in that case," which is sort of hand waving, but probably true.
Anyway, it increases the likelihood that we will soon get an initial decision from an SEC ALJ ruling whether SEC ALJs are unconstitutional. I'm very much looking forward to that. You can find a gloss on the opinion here, and a link to the actual opinion at the end of the gloss.
There's not too much new in the indictment for insider trading of the former partner of Philly firm Fox Rothchild. The partner didn't work on the deal, but he overheard a conversation between one who was working on the deal and the legal assistant they shared. And then he traded so unbelievably transparently you can barely believe that he was a lawyer. He bought shares in his wife's IRA account, and then he bought shares in his own IRA account. The next day, the merger was announced, the shares went up 80ish percent, and he instantly sold, making $75 grand. Which doesn't do his wife any favors, in the end.
The SEC’s complaint filed in federal court in Philadelphia names Sudfeld’s wife, Mary Jo Sudfeld, as a relief defendant for the purpose of recovering insider trading profits in her brokerage account through trades conducted by Sudfeld. The complaint charges Sudfeld with violating antifraud provisions of the federal securities laws and an SEC antifraud rule. The SEC seeks a permanent injunction and financial penalties against Sudfeld and return of allegedly ill-gotten gains and prejudgment interest from Sudfeld and Mary Jo Sudfeld.
That is insider trading of the most "please, catch me!" variety. But maybe this guy hasn't head of the duties of quasi-insiders, and thought he was an accidental tippee.
Over at DealBook, I have a piece up on the state of cost-benefit analysis at the SEC. Inadequacies in the CBA were how the SEC used to lose all its rulemakings in the D.C. Circuit; its latest rulemaking on clawbacks sets the stage for how seriously the agency takes cost-benefit analysis now, and how much it believes that analysis should be quantified. A taste:
Throughout the cost-benefit analysis, the agency warns that it is “often difficult to separate the costs and benefits,” and that various effects of the rule are “difficult to predict.”
I suspect the agency thinks it doesn’t need to blow the court of appeals away with some numbers to survive, though of course the S.E.C. can do more cost-benefit analysis in the final rule. It does, however, believe that a lengthy consideration of the costs and benefits of a rule should be part and parcel of any proposal.
For those who think that cost-benefit analysis slows the pace of regulation, this may not be good news. Economists might wish that numbers were being appended to the discussion.
But I am happy enough to see rules without numbers. Justifying rules only with regard to their costs and benefits is pretty routine. As routines develop, it may become difficult for regulators and judges to consider new sorts of costs, and unforeseen benefits contained, for example, by the simple expression of what the rule favors and what it discourages.
Go give it a look!
The front page of today's WSJ featured a story about Mylan NV's failure to disclose a potential conflict of interest transaction with Rodney Piatt, its vice chairman, lead independent director, and compensation-committee chief. On the surface it looks like a classic conflict, and corporate law students and professors alike know that's a big no-no. As a director, Piatt has a fiduciary duty to look out for the best interests of Mylan--i.e., to pay the least possible amount. Of course, if he's on the other side of the transaction, human nature is to try to get the most money possible. Ergo, conflict.
The WSJ article suggests that failure to disclose the transaction violates a securities law that requires disclosure of related party transactions. The company says there was no related party transaction because "The day before Mylan announced plans to build the new headquarters, a company managed and partly owned by Mr. Piatt sold a 7-acre site for $1 to an entity owned by a business partner in Southpointe II, according to property records reviewed by The Wall Street Journal. The partner’s firm sold the same land to Mylan for $2.9 million later the same day."
Yeah, it sounds fishy to me, too. But according to Mylan, "Mr. Piatt was not a party to either transaction” and “had no direct or indirect material interest in the transactions.” Clearly they're arguing it doesn't count as a related party transaction because Piatt is not a party.
OK, maybe. Maybe. But Mylan might have another securities law problem: its code of ethics, which specifically covers directors (p. 3). Codes of ethics tend to be broader in scope than related party transactions. Nobody (but me) ever thinks about them, but Sarbanes-Oxley required that ethics codes be disclosed--along with any waivers the board of directors grants directors and senior officers (For you history buffs, this provision was the result of Andy Fastow's related-party transactions with Enron, all blessed by the board via ethics waivers).
Mylan's has a lengthy section on conflicts of interest. From the introduction:
We must avoid personal interests that conflict with the interests of Mylan, or that might influence or appear to influence our judgment or actions in performing our duties. The word “appear” is most important. Even where there is no actual conflict of interest, the appearance of such a conflict is damaging because it can undermine trust among personnel and jeopardize the company’s standing with our customers, regulators, shareholders and others.
It's not clear what Piatt's relationship is to the business partner in Southpointe II to whom he sold the land for a dollar. But
Neither you nor any family member(s) may directly or indirectly participate in any business relationship with Mylan, other than your relationship as a director, officer, employee of Mylan, contractor or agent, unless such an arrangement has been approved by the OGC. Executive officers and directors must also obtain approval from the committee regarding such ar- rangements. Any such arrangement that has not been approved by the OGC or the Committee, as applicable, is a violation of the code and is prohibited.
Except as provided in this code, you are prohibited from acquiring any interest in a company that competes with Mylan or does business with Mylan, such as a vendor, supplier or customer, without the prior written consent of the OGC. Executive officers and members of the board must also obtain approval of the Committee before acquiring any such interest.
What's supposed to happen if there is the appearance of a conflict?
If a situation arises in which there is an actual, apparent or potential conflict of interest, you must disclose the matter to the OGC. If required, the OGC will escalate the matter to the Senior Executive Compliance Committee (committee).
If the committee finds that such conflict is not material and does not appear to be of a nature that it would influence the business decisions of those involved, the committee may grant a waiver in its sole discretion.
At Piatt's level, any such waiver should be disclosed as an 8-K, about which I know a little something. I didn't see one in December of 2013.
It's hard to find cases of where companies don't disclose waivers when they should have--you have to ferret out the nondisclosure first. It looks like the WSJ might have here.
Update: I forgot, Section 406 covers only the CEO, CFO, and CAO, so Piatt's waiver wouldn't have needed to be disclosed. He would still need to get one, arguably. And since the corporation has adopted a code of ethics that purports to apply to its board, if it is not following the required procedures that information would arguably be material.
The thing that gets me about codes of ethics is that they seem largely like empty corporatespeak. But they all address conflicts of interest. Conflicts of interest are the one thing that shareholders really might care about--because they're a sign that corporate insiders are really just out to line their pockets at the company's expense. But nobody seems to take the codes seriously, and so conflicts often get ignored. Or that's my hunch--I don't know, because aside form the top three financial officers, waivers don't have to be disclosed!
The rule, authorized by Dodd-Frank, would permit companies to claw back compensation from executives if things go south. Or, more specifically, the rule will "require national securities exchanges and national securities associations to establish listing standards that would require each issuer to implement and disclose a policy providing for the recovery of erroneously paid incentive-based compensation." Clawbacks would happen when, well: "the trigger for the recovery of excess incentive-based compensation would be when the issuer is required to prepare an accounting restatement as the result of a material error that affects a financial reporting measure based on which executive officers received incentive-based compensation."
The rule had the usual two dissenters, independent statements by each of the commissioners. The SEC is a divided agency. But I'm interested in how the staff hope to close the deal, assuming that the rule will be litigated.
First, even though this is a proposed rule, the agency is already responding to plenty of comments from prior concept releases, &c. Second, 50 of the 198 pages of the rule are devoted to the cost benefit analysis that so stymied the SEC when the DC Circuit had a majority of Republican judges. But the analysis isn't heavy on quantitative cost-benefit, but rather an assessment of the implications on a variety of affected components in the agency. I think the agency thinks it doesn't need to blow the court of appeals away with some numbers to survive, though of course the agency can do more cost-benefit analysis in the final rule.
While reading this article I was pleased to find quotes from my good friend and colleague, Kent Barnett. I asked him to share with the Glom readers further insights on Judge May's recent ruling that the SEC's use of an ALJ in an insider trading case may be unconstitutional. Here's Kent with more:
Today's WSJ brings a page one headline: Tech Startups Play Numbers Game. The gravamen of the charge is that still-private companies are using unusual revenue-like/revenue-lite metrics like "billings" or "bookings" to paint a rosier picture than their finances warrant for would-be investors. Rob Beardon, entrepreneur-in-residence at UGA's Terry business school, was the article's lead example: His company Hortonworks forecast a "strong $100 million run rate" in 2014, but at Hortonworks' 2015 IPO the application of traditional accounting methods led to only $46 million of reported revenue.
The WSJ's tone is one of revelation and shock, but is this really surprising? Consider (with occasional color quotes from the WSJ article)
- Venture capitalists funds take rich people's money and invest it in private companies that are not subject to the 1933 and 1934 Act disclosure rules. These investments are by definition risky; associate with that risk is the prospect of a greater return than the public markets can provide.
- A bubble currently exists in the valuation of private tech companies.
- In a bubble, rational people become less rational: (From Benchmark partner Bill Gurley's blog, quoted in the WSJ "Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis.")
- If private investors aren't doing their own diligence, they'll pay the price eventually.
- Entrepreneurs are always optimistic. That's why they're entrepreneurs. Of course they're going to paint a rosy picture ("Many tech-company executives say nontraditional numbers often are a better barometer of a firm’s progress at luring customers, outrunning competitors and pushing the company’s value higher.")
- Accountants don't want a barometer. They want the facts. (“Everyone loves [the non-traditional bookings metric] except the SEC,” [accounting consultant Barrett Daniels] says, adding that it is “easily inflated, and the auditors won’t review it.”)
So will this "numbers game" be the scandal du jour? The SEC doesn't generally concern itself ex-ante with fraud in private firms, but is "increasing its scrutiny of non-GAAP terms at young companies."
I don't this the SEC should concern itself much with this. The private markets are private for a reason--supposedly these investors can fend for themselves. If ever the future crowdfunded companies, in which Joe Public can invest, start touting their "bookings,"then the SEC should act.
Still, private venture-backed companies would do well to remember that puffery may be ok, but Rule 10b-5 makes it a federal securities violation to lie when you sell securities-- even if you're private.
We rarely get to point to a story in the New York Post, but I've always enjoyed its business coverage. Anyway, last week Gotham's finest tabloid took a quick look at the fate of those convicted under the pre-Newman standard, using Michael Kimmelman, a part of the Galleon conspiracy, as part of the network, as a case study. The government is uninterested in reopening these cases just because Newman didn't go its way:
the government doesn’t think it matters, in large part because Kimelman never brought up the issue on appeal. His claim has been “procedurally defaulted,” the government said in court papers earlier this month.
During the trial, Judge Richard Sullivan did not tell jurors the government had to show that Kimelman knew the tippers received a substantial benefit.
The same instructions in the trial of Todd Newman and Anthony Chiasson led the appeals court to overturn their case — setting the new standard.
“The procedural default is irrelevant because under Newman, Kimelman is actually innocent,” said Kimelman lawyer Alexandra Shapiro in a recent filing.
Really, this is something that your average death penalty lawyer could answer pretty quickly. If the law changes, does that make you "actually innocent"? You get the idea - but the distance between finality and precision (or legal accuracy, at least) is always something that lawyers can fight about. Kimmelman's judge, by the way, is the tough on white collar crime judge who gave the jury the government's preferred instructions in Newman.
The SEC announced an indictment against a financial advisor that got a bunch of public Georgia pension funds to invest in its own affiliated product. Which I guess sounds kind of dodgy - you're obligated to offer advice in the best interests of your client, and yet you're pushing your own investment vehicle. The strange thing about the case, however, is that it isn't about that sort of breach of fiduciary duty. Instead, the SEC, a federal agency, is going after Gray and its principals because they failed to comply with Georgia law. From the SEC's release:
The SEC’s Enforcement Division alleges the investments violated Georgia law in the following ways:
- A Georgia public pension fund’s investment is limited to no more than 20 percent of the capital in an alternative fund. Two of the pension funds’ investments surpassed that limit.
- The law requires at least four other investors in an alternative fund at the time of a Georgia public pension fund’s investment. There were fewer than four other investors in GrayCo Alternative Partners II L.P. at the time of these investments.
- There must be at least $100 million in assets in an alternative fund at the time a Georgia public pension fund invests. GrayCo Alternative Partners II LP has never reached that amount.
Gray knew this was coming, and knew that the SEC wouldn't be taking them to court, but rather before one of its own judges. It had already filed suit alleging that the ALJ program is unconstitutional - and among the many problems with these types of suits, imagine the timing and ripeness challenges presented by litigation premised on "we think the SEC may be bringing administrative proceedings against us in the future."
Still, I think this case is interesting. Shouldn't Georgia be bringing it instead of the SEC?