SEC Whistleblower Banks $400K+ Award

[This story previously appeared in Securities Regulation Daily.]

By Amy Leisinger, J.D.

The SEC today announced an award of more than $400,000 for a whistleblower who reported a fraud to the SEC after the company failed to address the issue. According to the Commission, the whistleblower provided the Commission with specific and credible information and gave the agency the opportunity to complete its investigation quickly following the company’s failure to internally address the whistleblower’s numerous attempts to rectify the matter (Release No. 34-72727, July 31, 2014).

In a press release, Sean McKessy, chief of the SEC’s Office of the Whistleblower, said: “The whistleblower did everything feasible to correct the issue internally. When it became apparent that the company would not address the issue, the whistleblower came to the SEC in a final effort to correct the fraud and prevent investors from being harmed.”  

Whistleblower award. Last year, the SEC’s Claims Review Staff preliminarily determined that the whistleblower’s award claim should be denied because the information did not appear to have been “voluntarily” provided as required by the whistleblower rules. According to the determination, the information was imparted as a result of a prior inquiry by a self-regulatory organization. However, following a detailed response by the claimant describing the order of events and the individual’s long-term, diligent efforts to correct the underlying misconduct, the SEC decided to waive the “voluntary” requirement of Rule 21F-4(a) based on extenuating circumstances. The award recognizes the claimant’s efforts both to protect investors and to report the violation internally, the Commission explained.

House Leader Asks NY Fed for FSOC SIFI Designation Data

Rep. Scott Garrett (R-NJ), Chair of the House Capital Markets Subcommittee, has asked the Federal Reserve Bank of New York to share information that it has provided to the Financial Stability Oversight Council (FSOC) related to the process of designating financial firms as systemically important financial institutions (SIFIs). In a letter to the NY Fed, Chairman Garrett said that designating a financial firm as a SIFI could have wide ranging and unpredictable consequences in terms of a company’s competitive position, cost-of-capital, regulatory treatment, and the expectation of government support in the event of its failure. The Chair views it as essential that Congress have sufficient information on this process to perform its legislative and oversight responsibilities.

The request comes against the backdrop of legislation proposed by Chairman Garrett to make FSOC more transparent by, amongm other things, allowing all members of the Commissions and Boards that make up FSOC to attend FSOC. It would also subject FSOC to government in the sunshine mandates.

Bi-Partisan House Bill Would Enhance Cybersecurity at Office of Financial Research

Rep. Ed Royce (R-CA) and Rep. Patrick Murphy (D-FL) have introduced legislation to improve transparency and increase accountability at the Office of Financial Research created by the Dodd-Frank Act. The Office of Financial Research Accountability Act, H.R. 5037, would also bolster cybersecurity protections at the OFR since, in the view of Rep. Royce, the OFR holds a great deal of sensitive information and must be protected from bad actors. The legislation would require the OFR to develop and implement a cybersecurity plan that will be annually reviewed by the GAO; and require the OFR to release an annual work plan outlining its priorities. The measure would also require the OFR, when preparing a report on a specific entity or a financial product or service, to consult the federal regulatory agencies with expertise in regulating that entity or product or service.

After a devastating financial crisis., noted Rep. Murphy, the OFR was created to function like the National Transportation Safety Board and find out what went wrong and how to prevent it in the future. Instead, the OFR has come under heavy criticism after the quality of reporting and quantity of research was found lacking. The legislation is designed to restore confidence in the OFR so that Congress and the Financial Stability Oversight Council will have access to an improved quality of financial data. The Financial Institutions Subcommittee of the House Financial Services Committee has set a hearing on H.R. 5037 for July 15, 2014.

House Hearing Reveals Consensus for Bankruptcy Code Reform to Conform to Dodd-Frank Title II

A hearing of the House Subcommittee on Regulatory Reform revealed a strong bi-partisan consensus for amending the Bankruptcy Code to provide a first alternative to putting failed and failing financial firms into the orderly liquidation authority of Title II of the Dodd-Frank Act. Subcommittee Chair Spencer Bachus (R-AL) noted that two points of consensus emerged after careful expert consideration of why the Bankruptcy Code was not used to resolve failing firms during the financial crisis. The first point is that a single point of entry is the best way to resolve a failing firm; and the second point is that the current Bankruptcy Code cannot accommodate single point of entry. Hence, the need for the legislation.

Amplifying the deep bi-partisan support for the bill, the Ranking Member of the full Committee, John Conyers (D-MI), noted that the goal of the legislation is to position the Bankruptcy Code so that it can better facilitate the resolution of failing financial firms. Dodd-Frank posits the Bankruptcy Code as the first alternative for resolving a failed financial firm.

Professor Thomas Jackson of University of Rochester business school, and a member of the Federal Deposit Insurance Corporation’s (FDIC) Systemic Resolution Advisory Committee, testified that in two key places, the Dodd-Frank Act envisions bankruptcy as the preferred mechanism for the resolution of SIFIs. The effectiveness of bankruptcy law in being able to resolve SIFIs in ways that do not unnecessarily destroy value (such as by liquidating a viable going concern) is critically important to the development of approvable resolution plans under Title I of Dodd-Frank. In his view, the important question for bankruptcy law is the effectiveness of the current Bankruptcy Code as a credible resolution mechanism for a SIFI in financial difficulty, measured today against the FDIC’s single point of entry proposal for how it would use Title II of the Dodd-Frank Act.

Donald S. Bernstein, co-chair of the Insolvency and Restructuring Group at Davis Polk & Wardwell LLP, testified that the single-point-of-entry approach to resolution involves commencing resolution proceedings only with respect to the financial firm’s top-level parent holding company, with all losses of the distressed financial firm being borne by shareholders and creditors of that entity and not the taxpayers. Operating entities like the firm’s brokerage subsidiary would not be placed into resolution but would be recapitalized using assets of the holding company. Fortunately, he continued, in the United States (unlike some other countries), large financial firms already utilize a holding company structure, and significant amounts of equity and long-term unsecured debt are issued by these holding companies and are structurally subordinated to deposits and other operating liabilities of financial subsidiaries.

In addition, he noted that, because of initiatives by regulators at the multinational level, including those of the Financial Stability Board and crisis management groups organized among key regulators of individual firms, there is increasing alignment among national regulatory authorities regarding the benefits of the recapitalization and bail-in approaches to dealing with distressed financial firms. A single-point-of-entry recapitalization, for example, protects host-country interests by making resolution proceedings for host country operations unnecessary.

Rep. Sherman Pressing to End FASB Lease Accounting Initiative

At a recent hearing of the House Financial Services Committee, Rep. Brad Sherman (D-CA) pressed Fed Chair Janet Yellen to help him kill the FASB initiative to change the lease accounting standard, which he said is an effort to fix something that is not broken. While he is aware that the Fed does not have direct oversight of FASB, he hopes that the Fed will use its tration powers of persuasion to get FASB to drop the project. Chair Yellen said that she would look into the issue. Similarly, at a recent Capital Markets Subcommittee hearing, Rep. Sherman pressed SEC Corp Fin Director Keith Higgins to help end FASB’s lease accounting initiative. While the Corp Fin Director has no direct authority over FASB, the SEC does as it recently reiterated in the release adopting the money market fund reforms. In giving its position on cash equivalents and US GAAP, the Commission said that a more formal pronouncement to confirm this position was not required because the federal securities laws provide the Commission with plenary authority to set accounting standards.

Noting that FASB is funded by the SEC with a mandatory tax through a convoluted process designed to claim that it is not a government agency, Rep. Sherman filed an amendment to the SEC spending bill, H.R. 5016, that would deprive FASB of the funds to implement and enforce a new lease accounting standard. While he ultimately withdrew the amendment, Rep. Sherman said on the House floor that FASB wants to list on every balance sheet the future amount that will be paid in all lease payments as a liability, which would increase the liabilities shown on the balance sheets of U.S. businesses by $2 trillion. For 100 years, the U.S. has had a good standard on how to account for leases, he pointed out, under which the tenant pays rent, the owner of the building owns the building, and the financial statements disclose in the footnotes all the details any financial analyst would want to see. (Cong. Record, July 15, 2014, H6268).

Rep. Sherman said that an additional disadvantage of this accounting proposal is that it will cause tens of thousands of businesses to be in violation of their loan covenants, which means that they will have to immediately pay off their liabilities or renegotiate with their bankers, who will insist upon higher personal guaranties and higher interest rates. Moreover, thousands and thousands of long term bonds that have been sold in the public market will be held to be in violation of their loan covenants and will become immediately due because the accounting standards changed.

President Issues Veto Message on SEC Spending Bill

The President issued a veto message on the FY 2015 Financial Services and General Government Appropriations Act (H.R. 5016), which the House approved on a vote of 228-195 to provide annual funding for the SEC, the Treasury Department, the Judiciary, the Small Business Administration, and several other agencies. The legislation sets the SEC budget for FY 2015 at $1.4 billion, which is $50 million above the FY 2014 enacted level and $300 million below the president’s budget request. The increase in funds is targeted specifically toward critical information technology initiatives. The legislation also includes a prohibition on the SEC spending any money out of its reserve fund.

In a Statement of Policy, the Administration strongly objected to the funding level of $1.4 billion for the SEC, which is $300 million below the FY 2015 Budget request. The bill also prohibits authorized spending from the agency's mandatory Reserve Fund, which would reduce the resources available to the SEC in FY 2015 by an additional $50 million. At this funding level, noted the Administration, the SEC would be unable to add critical positions in market oversight, compliance, and enforcement to carry out its financial oversight responsibilities under the Dodd-Frank Act and other authorities. The SEC is fee-funded and its funding level has no impact on the deficit, the Statement pointed out.

Levin Senate Panel Finds Basket Options Abused by Banks and Hedge Funds

Two global banks and more than a dozen hedge funds misused a complex financial structure to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt, a Senate panel has found. The improper use of this structured financial product, known as basket options, is the subject of a 93-page report released by the Chair and Ranking Member of the Senate Permanent Subcommittee on Investigations, Senator Carl Levin, D-Mich., and Senator John McCain, R-Ariz., and was the focus of a  hearing at which bank and hedge fund officials and tax experts  testified.

Over the years, the Subcommittee has focused significant time and attention on two important issues: tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system, said Senator Levin. The investigation brings those two themes together, he noted. The banks and hedge funds used dubious structured financial products in a giant game of let’s pretend, he said, costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation.

The banks and hedge funds involved used the basket options structure to change the tax treatment of their short-term stock trades.

The report outlines how Deutsche Bank AG and Barclays Bank PLC, over the course of more than a decade, sold financial products known as basket options to more than a dozen hedge funds. From 1998 to 2013, the banks sold 199 basket options to hedge funds which used them to conduct more than $100 billion in trades. The Subcommittee focused on options involving two of the largest basket option users, Renaissance Technology Corp. LLC (“RenTec”) and George Weiss Associates.

The banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks and create the fiction that the banks owned the account assets, when in fact the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits.

The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year. RenTec claimed it could treat the trading profits as long term gains, even though it executed an average of 26 to 39 million trades per year and held many positions for mere seconds.

In 2010, the IRS issued an opinion prohibiting the use of basket options to claim long-term capital gains. Based on information examined by the Subcommittee, tax avoidance from the use of these basket option structures from 2000 to 2013 likely exceeded $6 billion. 

In addition to avoiding taxes, the structure was used by the banks and hedge funds to evade federal leverage limits designed to protect against the risk of trading securities with borrowed money. Leverage limits were enacted into law after the stock market crash of 1929, when stock losses led to the collapse of not only the stock speculators, but also the banks that lent them money and were unable to collect.

Had the hedge funds made their trades in a normal brokerage account, noted the report, they would have been subject to a 2-to-1 leverage limit, that is, for every $2 in total holdings in the account, $1 could be borrowed from the broker. But because the option accounts were in the name of the bank, the option structure created the fiction that the bank was transferring its own money into its own proprietary trading accounts instead of lending to its hedge-fund clients.

Using this structure, hedge funds piled on exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1. The banks pretended that the money placed into the accounts were not loans to its customers, even though the hedge funds paid financing fees for use of the money. While the two banks have stopped selling basket options as a way for clients to claim long-term capital gains, they continue to use the structures to avoid federal leverage limits.

The Levin-McCain report includes four recommendations to end the option abuse. First, the IRS should audit the hedge funds that used Deutsche Bank or Barclays basket option products, disallow any characterization of profits from trades lasting less than 12 months as long-term capital gains, and collect from those hedge funds any unpaid taxes. Second, to end bank involvement with abusive tax structures, federal financial regulators, as well as Treasury and the IRS, should intensify their warnings against, scrutiny of, and legal actions to penalize bank participation in tax-motivated transactions.

Third, Treasury and the IRS should revamp the Tax Equity and Fiscal Responsibility Act regulations to reduce impediments to audits of large partnerships, and Congress should amend TEFRA to facilitate those audits. Fourth, the Financial Stability Oversight Council (FSOC), working with other agencies, should establish new reporting and data collection mechanisms to enable financial regulators to analyze the use of derivative and structured financial products to circumvent federal leverage limits on purchasing securities with borrowed funds, gauge the systemic risks, and develop preventative measures.

 

House Capital Markets Panel Grills Corp Fin Director on SEC Disclosure Initiative

A House oversight panel grilled SEC Corporation Finance Director Keith Higgins on the SEC’s new initiative to completely review the mandated disclosure regime. Members of the Capital Markets Subcommittee, chaired by Rep. Scott Garrett, are intensely interested in the disclosure companies provide in financial statements and in the SEC’s study of disclosure regulation. Chairman Garrett praised the Commission for refocusing on the mandatory disclosure regime, adding that current disclosure is almost useless to many retail investors. He said that the SEC disclosure regime must be designed to provide material information to investors that is formatted to make it easier to read.

Robert Hurt (R-VA), the Subcommittee’s Vice Chair, emphasized that the SEC’s mission to facilitate capital formation must inform all aspects of the review of the disclosure regime. In that spirit, the Vice Chair urged the Commission to keep the needs and concerns of emerging growth companies in mind when examining financial statement disclosures. He specifically asked that emerging growth companies be exempted from having to use XBRL formatting, adding that XBRL is not ready for prime team. XBRL is part of the SEC disclosure regime, he reminded. He asked the Director the timeline and goal of the disclosure review.

Mr. Higgins replied that the Division has been tasked by SEC Chair Mary Jo White with preparing disclosure recommendations; and he expects that after that a release will be exposed to the public. The goal is to provide material and useful information to investors in order to properly inform their investment decisions, while at the same time being aware of the burdens on companies. At the end of the day, it is a balancing act in an effort to provide effective disclosure.

Both Rep. Hurt and Rep. Steve Stivers (R-OH) feared disclosure overload that can actually harm investors. Director Higgins affirmed that shareholders sometimes find more information useful and that some large financial institutions have asked for additional disclosure. He reaffirmed that it is a balancing act between more mandated disclosure and burdening companies.

Rep. David Scott (D-GA) strongly emphasized the need to coordinate cross-border Dodd-Frank derivatives disclosure rules with the CFTC and with global counterparts. In his view, the key to the cross-border harmonization of derivatives regulations is to ensure that the top 8 foreign jurisdictions in derivatives markets have robust disclosure regimes equal to the U.S, The SEC and CFTC must facilitate that, he said. He wants a report to Congress within 30 days when and if it is determined that one of these foreign derivatives regimes does not have an equivalently robust regime.

On the issue of proxy advisory firms, Chairman Garrett said that the SEC’s guidance is useful and, appropriately, in his view, effectively reduces the power of proxy advisors. He also noted that the guidance requires disclosure of conflicts of interest and the creation of a system to address conflicts of interest. Noting that it is important to get oversight of these firms, the Chair asked how the SEC intends to oversee the guidance. The Director replied that, while no formal monitoring process is in place, the Commission will monitor the market and will be receiving feedback from market participants, adding that there is currently a lull in the proxy season. Chairman Garrett asked if the Commission will issue a report on compliance with the guidance after the next proxy season. There are no current plans for such a report, said the Director, but the SEC will give it consideration.

The Chair asked if the SEC would consider amending the shareholder proposal rules to curtail abuse of the process by activist shareholders. The Director acknowledged that there is a lot of angst on the shareholder proposal process and that no one is totally happy with it. But the staff does not currently have a view on what or should be done. Any proposal to change the shareholder proposal process must have a consensus, he stressed.

Rep. Gary Peters (D-MI) mentioned his legislation, the Outsourcing Accountability Act, H.R. 790. which would require companies to annually disclose the total number of employees physically working in and domiciled in any country other than the United States. On a question from Rep. Peters, the Director said that the SEC would have the authority to implement the Act without further congressional action.

Representatives Bill Foster (D-IL) and Bill Huizenga (R-MI) are concerned about private companies in a supply chain to a public company being caught up in the Dodd-Frank mandated conflict minerals disclosure regime. While the regulations pertain to public companies, private companies in the supply chain could be forced to disclose the use of conflict minerals, Rep. Foster is concerned about what would constitute due diligence for private companies, for example, can they just take a supplier’s word for it. He requested that this be made part of the SEC’s disclosure review. The Director allowed that feedback during the disclosure review will help achieve better guidance on what constitutes due diligence.

Rep. Huizenga noted that the recent DC Circuit ruling added fog to the conflict minerals disclosure mandate. He emphasized that issuers need clarification, adding that reports are mixed on whether this well-intended statute is having its intended effect.

Senator Vitter Urges SEC to appeal DC Circuit Stanford Ruling to Supreme Court

In the wake of the DC Circiuit panel's ruling that investors in the Stanford Ponzi scheme were not customers of the broker-dealer within the meaning of the Securities Investor Protection Act and that the SEC could not compel SIPC liquidation, Senator David Vitter urged the SEC to appeal the ruling to the U.S. Supreme Court. But it is very unlikely that the SEC will appeal this ruling to the Supreme Court. The SEC rarely if ever has appealed a ruling by a three-judge panel of the DC Circuit to the en banc DC Circuit let alone to the Supreme Court. From the Business Roundtable v. SEC case years ago to the recent ruling on the resource extraction disclosure regulation implementing Section 1504 of the Dodd-Frank Act, tha panel ruling is almost always the last word.

Also, this was a bi-partisan unanimous ruling by Judge Srinivasan (Obama appointee), Chief Judge Garland (Clinton appointee) and Senior Circuit Judge Sentelle (Reagan appointee).

European Central Bank Chief Wants Swift Implementation of Accounting Standard for Valuing Financial Instruments

The President of the European Central Bank, Mario Draghi, called for the speedy implementation of IFRS 9 on the valuation of financial instruments. It is very important to have IFRS 9 as part of global accounting standards as swiftly as possible, he emphasized in recent remarks. More than 100 countries speak the same accounting language today, he noted in recent remarks, whereas a decade ago, no major economy used the International Financial Reporting Standards (IFRS). This momentum must be kept going and built upon, he said. The financial crisis would not have been as severe if there had been more integration, not less integration in Europe, he averred, and the future lies with more integration. The European Union has required the use of IFRS since 2005.

IFRS 9, to issue in July, completes the IASB’s response to the financial crisis by providing a comprehensive package of improvements to financial instruments accounting. IFRS 9 introduces a new, expected-loss impairment model that limits the ability of banks and others to defer the timely recognition of loan losses and provides a logical single classification approach driven by cash flow characteristics and how cash flow is managed.

It solves the so-called own credit issue, whereby banks and others are able to book large gains through their P&Ls as a result of the value of their own debt falling due to a decrease in credit worthiness. It allows companies, both within and outside of the financial sector, to better reflect their risk management activities in their financial statements. It also significantly reduces the complexity associated with the accounting for financial instruments.

E.U. Securities Commissioner to Propose Equivalency Decision on Derivatives Central Counterparties upon Successful Conclusion of Talks with CFTC

E.U. Commissioner for the Internal Market Michel Barnier said that he will soon propose that the European Commission adopt equivalence decisions on decisions on derivatives counterparties with a number of jurisdictions including the United States, but the U.S. will not be in the first round. In a statement, the Commissioner said that he intends to propose shortly that the European Commission adopt equivalence decisions that will allow derivatives central counterparties from five countries outside the EU, Japan, Singapore, Australia, Hong Kong and India, to clear E.U. derivatives trades. Equivalence decisions for other countries should follow shortly afterwards, said the Commissioner, including the U.S., whose central counterparties he described as truly global market infrastructures. He emphasized that the equivalence decisions will be done in full deference to the rules and regulatory regimes of those countries.

Commissioner Barnier also noted that technical talks with the CFTC are progressing well and he is confident that the E.U and the CFTC will be able to agree on outcomes-based assessments of their respective derivatives regulations and on aligning key aspects of margin requirements to avoid arbitrage opportunities. If the CFTC also gives effective equivalence to third country central counterparties, deferring to strong and rigorous rules in jurisdictions such as the E.U., the European Commission will be able to adopt equivalence decisions very soon, he predicted.

Chair Hensarling Says FSC Will Move Legislation Ending FSOC SIFI Designation

In remarks at the Cato Institute forum on the Dodd-Frank Act, Rep. Jeb Hensarling (R-TX), Chair of the House Financial Services Committee, said that the Committee, in its last major legislative initiative for the 113th Congress, will soon take up a too-big-to-fail legislative package that posits that Dodd-Frank did not end TBTF but actually codified it. One part of the legislative effort would be to repeal the ability of the Financial Stability Oversight Council (FSOC) to designate financial firms as systemically important financial institutions (SIFIs). The Chair said that FSOC can damage the economy with SIFI designations. In addition, designating asset managers as SIFIs could damage investors. The legislative package will also take up the reform of Title II of Dodd-Frank, which provides for an orderly liquidation authority for failed financial firms. The Chair also noted that the Committee will soon mark up legislation on Fed oversight that would bring more transparency and accountability to the Federal Reserve Board.

More broadly, Chairman Hensarling said that the Committee will continue to report out pieces of legislation on regulatory reform and correcting the unintended consequences of Dodd-Frank. He noted that the Committee has already reported out around 20 pieces of legislation to the House floor, many of which have been passed, some with overwhelming bi-partisan majorities.

Senator Dodd Says Don't Do Dodd-Frank Act Corrections Bill Until Regulatory Implementation Completed

While supporting targeted changes to the Dodd-Frank Act, former  Senator Chris Dodd (D-CT) cautioned that the premature  opening up of Dodd-Frank  could cause more harm than good and open up a Pandora’s box since there are some who wish to weaken the legislation.  Senator Dodd recommended that any legislative changes to Dodd-Frank await the full regulatory implementation  of the Act by the SEC and other federal financial regulators. He added that federal agencies like the SEC still have many rules to adopt to fully implement the Act. Only after the entire law is implemented by regulations  will we  know what has to be done, he noted.  In addition, in remarks at the Bipartisan Policy Center,  Senator Dodd decried what he called the ``purposeful underfunding’’ of the SEC and CFTC  after Dodd-Frank gave them significant new duties. This agency underfunding  places the economy  at risk, he warned.

The Dodd-Frank Act is not biblical, he said, and there are good amendments being proposed.  For example, one change he supports is legislation to codify the exemption from margin requirements for non-financial derivatives end users.

The Senator reminded that the financial crisis that caused stunning carnage to the financial system  was caused by an outdated financial regulatory system.  The Dodd-Frank Act  created a financial regulatory infrastructure designed to prevent a future financial crisis. The Act, which  was the result of an open and accessible process,  created a framework for a 21^st century financial regulatory system.  While Senator Dodd wanted a single prudential regulator, he could not get 60 votes for that.

He said that the Financial Stability Oversight Council is doing a remarkable job in making regulators work together and spot initial financial stability problems that could trigger another crisis. He also strongly emphasized that Dodd-Frank unmistakably  eliminated too big to fail.

Senate Panel Hears Testimony on Revising SEC Regulation NMS

A hearing before the Senate Banking Committee on the SEC’s regulation of the equity markets revealed a growing consensus that Regulation NMS, while it has served nobly over the past years, is in need of comprehensive reform to reflect dynamically changing markets. The testimony demonstrated that many of the concerns raised by market participants and investors are the outgrowth of SEC Regulation NMS, noted the Committee’s Ranking Member Mike Crapo (R-ID), and the overall patchwork approach to market trading infrastructure and stability taken by the SEC in the past. Senator Crapo sounded a word of caution as the SEC engages in a comprehensive review of market regulation. While it is important and prudent for regulators to periodically review existing regulations to ensure that they are still appropriate in today’s automated world, said the Ranking Member, any such holistic review of regulation should be based on empirical analysis, data-driven, and incorporate the input of market participants, industry and the investors who make the investments. In other words, Senator Crapo believes that everyone should have a seat at the table in this important discussion and everyone must be willing to roll up their sleeves to find the right solutions.

While much has been made recently of the potential dangers of automated trading, noted Senator Crapo, what is often forgotten is that technology and innovation have benefitted investors by leading to tighter spreads, lower costs and more efficient markets. Today, he noted, an individual retail investor has an easier time participating in the equity markets than at any time in the history of those markets. With fees under $10 a trade, the spreads between bid and ask prices for most stocks are as narrow as they have ever been, and with trading being done in a matter of sub-seconds rather than minutes, retail investors have been able to enjoy greater involvement in, and access to, the markets. To continue this level of investor participation, he emphasized that Congress and the SEC must ensure that the markets have the resiliency and capabilities to handle the evolving speed and complexity of today’s trading world.

Senator Richard Shelby (R-AL), a former Chair of the Banking Committee, expressed concern about investor confidence in the equity markets, particularly with retail investors. This is an overall concern of Senator Shelby as high frequency trading and dark pools become more pervasive in the equity markets. The very term ``dark pool’’ can impact investor confidence in the markets, again, particularly with retail investors.

Jeffrey Sprecher, ICE CEO, ( and in November of last year, ICE completed its acquisition of NYSE Euronext), testified that, while Regulation NMS sought to increase competition among markets and consequently increased fragmentation, the costs associated with maintaining access to each venue, retaining technologists and regulatory staff, and developing increasingly sophisticated risk controls are passed on to investors and result in unnecessary systemic risk. The fragmentation also decreases competition among orders, he noted. Orders routed to and executed in dark trading centers do not interact or compete with other orders, which detracts from the price discovery function that participants in lit markets provide. The lack of order competition in a fragmented market negatively impacts markets in the form of less liquidity, information leakage and wider spreads.

While Regulation NMS achieved its goal of increasing competition among markets, said the ICE CEO, the pendulum has swung too far at the cost of less competition among orders. Action must be taken to correct these trends and rebalance the trade-offs of yesterday, and consequently build the confidence of individual investors and companies seeking to access the public markets and to bring back the balance set out in the Securities Exchange Act of 1934.

The ICE CEO detailed a number of measures that should be taken. For example, he said that order competition should be enhanced by giving deference to regulated, transparent trading centers where orders compete and contribute to public price discovery information. Limited exceptions could apply for those with unique circumstances. He also called for a ban on maker-taker pricing schemes at trading venues. Rebates that were used to encourage participants to quote on regulated, transparent markets add to complexity and the appearance of conflicts of interest.

Mr. Sprecher urged a lowering of the statutory maximum cap on exchange fees. Regulation NMS set a cap of what regulated transparent markets can charge to access a quote. In combination with giving deference to regulated, transparent markets and eliminating maker-taker rebates, the SEC should require lowered exchange access fees.

He also called for a revamp of the current market data delivery system. ICE supports the SEC taking a closer look at the current Securities Information Processors and proprietary data feeds to adopt policies that promote fairness. More broadly, in order to increase transparency in the way that markets operate, the SEC should demand that all trading centers report trade executions in real time, and all routing practices should be disclosed by those trading centers and brokers who touch customer orders.

Kenneth Griffin, CEO of Citadel, a global asset management firm, testified that as the SEC considers various reform ideas and assertions about problems with the current equity market structure, the Commission needs a rich set of data to analyze methodically, which will ensure that the SEC has the best information available when making these critical decisions.

He said that Regulation NMS and the foundational regulations that preceded it, along with technological advances, have helped unleash an enormous degree of competition among market centers. But in recent years, the costs that each new market center imposes on the market in terms of additional complexity and operational risk have started to outweigh the marginal benefits of a new competing market center.

Mr. Griffin said that specific regulatory action is needed to restrike this balance by requiring that market centers have sufficient resources and make sufficient investments in operational excellence. Over time this will reduce fragmentation by eliminating marginal market centers that rely on the low cost of market entry and operation.

More granularly, the Citadel CEO called for a reduction in access fees to reflect declining transaction costs and the broadening of caps on access fees. Under Regulation NMS, he explained, the charge to liquidity takers in today’s maker-taker system is called an access fee. The current NMS maximum access fee of 30 cents per 100 shares is now significantly greater than the cost of providing matching services by the exchanges, he noted, and should be reduced to reflect the current competitive reality. Exchanges are permitted to share the access fees they charge with liquidity providers in the form of exchange rebates. A meaningful reduction in the maximum access fee would materially reduce such rebates.

In general, exchange rebates encourage exchanges and liquidity providers to be more competitive. Exchange rebates also reward and encourage displayed liquidity, which greatly benefits the price discovery process. Banning exchange rebates would dampen competition between exchanges and would result in less posted liquidity and could result in wider quoted spreads. Mr. Griffin noted that the SEC has wisely focused on disclosure and other mechanisms to manage any potential conflicts of interest that may arise as a result of these fee structures.

Citadel believes that a reduction in the minimum tick size for the most liquid low priced securities combined with a reduction in the maximum permitted access fee would serve the best interests of all market participants. More importantly, he urged the SEC to close gaps by adopting an access fee cap in important segments of the market that have no access fee cap. Specifically, he asked the SEC to expand the access fee cap to include quotes that are not protected by Regulation NMS. He also urged the Commission to implement a parallel and proportionate access fee cap for sub-dollar stocks. The SEC should also move forward with its proposed rulemaking to cap access fees in the options markets.

BATS Global Markets CEO Joe Ratterman applauded the SEC’s plan for a continuous and comprehensive review of the state of the national market structure under Banking Committee oversight. Such a review is timely, he testified, because changes after the implementation of Regulation NMS reflect a relatively recent and dramatic evolution in the manner in which securities trade.

Specifically, Mr. Ratterman supports the review of current SEC rules designed to provide transparency into execution quality and broker order routing practices. In particular, Rules 605 and 606 of Regulation NMS require execution venues to periodically publish certain aggregate data about execution quality and require brokers to publish periodic reports of the top ten trading venues to which customer orders were routed for execution over the period, including a discussion of any material relationships the broker has with each venue. In his view, the publication of this data has helped better inform investors about how their orders are handled.

Nonetheless, he continued, these rules were adopted nearly 15 years ago and the market has evolved significantly enough to warrant re-examining whether additional transparency could be provided that would benefit investors. For example, advances in technology now permit significant market events to occur in millisecond time frames, and audit trails are granular enough to capture that activity.

However, the current requirements of Rule 605 effectively allow a trading venue to measure the quality of a particular execution by reference to any national best bid or offer in effect within the one-second period that such order was executed. Given the frequency of quote updates in actively traded securities within any single second, compliance with this requirement may not in all cases provide adequate transparency into a particular venue’s true execution quality. In addition, the scope of Rule 605 could be extended to cover broker-dealers, and not just market centers. Transparency could further be improved by amending Rule 606 to require disclosure about the routing of institutional orders, as well as a separate disclosure regarding the routing of marketable and non-marketable orders.

The BATS CEO also noted that all exchanges are given a significant competitive advantage regardless of their size by virtue of the order protection rule under Regulation NMS. While this was necessary in an era where legacy exchanges routinely ignored their competitors, he noted, current practices have reduced the need for regulatory protections of smaller venues. Recent events provide evidence that market forces ultimately can correct for venues that add only marginal value. The existing concentration of exchanges among scale providers means that in some cases the marginal operating cost for a new exchange is near zero.

The cost and complexity of connectivity to a small venue for market participants, however, can be substantial. Thus, he urged the SEC to revise Regulation NMS so that, until an exchange achieves greater than a de minimis level of market share, perhaps 1 percent, in any rolling three-month period, they should no longer be protected under the order protection rule; and they should not share in any NMS plan market data revenue.

Senate and House Companion Bills Would Provide Tax Credit for Angel Investors

Senator Chris Murphy (D-CT) introduced legislation that would provide incentives to angel investors to invest significant capital in startups. The Angel Tax Credit Act, S. 2497, would allow them to claim a tax credit equal to 25 percent of their aggregate qualifying equity investments of $25,000 or more to U.S.-based high-tech startups. Establishing this incentive, said Senator Murphy, would help create a funding pipeline to grow startups and target job growth in the science, technology, and engineering fields so the United States can continue its leadership in these fields. A companion bill, H.R. 4931, has been introduced in the House by Rep. Steve Chabot (R-OH).

SEC Amicus Urges Supreme Court to Give 1933 Act Section 11 the Broad Reach Congress Intended

In a Supreme Court case involving the contours of liability under Section 11 of the Securities Act, the SEC filed an amicus brief  contending that a  statement of opinion is actionable under Section  11  if it lacked a basis that was reasonable under the circumstances, even if it was sincerely held. The Commission rejected the assertion that  a statement of opinion is actionable under Section 11 only if it is not sincerely held, on the theory that the only fact expressly stated by the opinion is that the speaker holds that opinion.  The SEC said that this view overlooks that Section 11 applies to both misstatements and omissions. Section 11 creates an express cause of action for a registration statement that contained an untrue statement of material fact or omitted to state a material fact necessary to make the statements not misleading.  Omnicare, Inc. v. Laborers District Council Construction Industry Pension  Fund, Dkt. No. 13-435.

The Court took the case on appeal from the Sixth Circuit to answer the question of whether in a Section 11 action a plaintiff who seeks to impose liability for a statement of opinion in a registration statement  and who alleges that the opinion lacks a reasonable basis must also allege that the maker of the statement did not subjectively hold that opinion. The SEC said that, since an opinion can be misleading either because it is insincere or because it lacks foundation, the Sixth Circuit correctly held that a Section 11 plaintiff need not allege that the defendant disbelieved the opinion. But, continued the SEC, the appeals court erred in suggesting that a statement of opinion is actionable whenever it is ultimately proved incorrect.  Section 11 liability should be determined based on the facts at the time  the statement was made, said the Commission, not at a later time.

The SEC asserted that imposing Section 11 liability for statements of opinion that are not genuinely held or lack a reasonable basis furthers Congressional intent and fulfills the purposes of the Securities Act, which focuses on disclosure to investors.  The registration statement plays a foundational role, continued amicus, it must be filed before any security can be sold and, if it contains any material misrepresentations or omissions, the SEC may prevent the sale of the security and a purchaser of the security may sue for damages.

In enacting Section 11, Congress built on common law principles to create a far-reaching cause of action under which liability could be imposed for misstatements and omissions. Congress dispensed with  proof of scienter,  reliance,  and causation and allowed only limited affirmative defenses once it was established that a registration included a material misstatement or omission.  In the SEC’s view, the imposition of liability for a statement of opinion that is not genuine  or that lacks a reasonable basis is consistent with this scheme because it ensures that registration statements are both literally true and do not omit information that would matter to a reasonable investor. The Commission has consistently recognized  that a genuinely held statement of opinion may be materially misleading when it lacks a reasonable basis.

E.U. Securities Commissioner Leaves Legacy of Financial Reform and Regulatory Congruence

The tenure of E.U. Commissioner for the Internal Market Michel Barnier has been historic and his legacy will be farreaching. In the aftermath of the global financial crisis, Commissioner Barnier ushered in a series of financial reform measures involving derivatives, credit rating agencies, hedge funds and private equity fiunds,  mutual funds, and financial instruments. On his watch, the E.U. also set up a Recovery and Resolution regime similar to the orderly resolution authority established by the Dodd-Frank Act. While the U.S. enacted the omnibus Dodd-Frank Act to deal with many areas of financial reform, the E.U. took the path of many disctrete pieces of legislation.

Commissioner Barnier has always recognized that the financial crisis was global in nature and that the regulatory solution must be globally consistent, congruent and harmonized. In that spirit, he recenly called on U.S. and E.U. trade negotiators to include the harmionizaiton of derivatives regulation in their talks so that regulatory convergence and the avoidance of arbitrage can elevated to a Treaty level since it does not apprear that voluntary harmonization is working in this area. Commissioner Barnier said that global derivatives markets need worldwide standards and national rules that work together seamlessly.