Securities Mosaic® Blogwatch
August 29, 2014
The SEC and Administrative Proceedings (Part 3)
by J Robert Brown Jr.

We are discussing some of the issues raised by Peter Henning in his DealBook column, The S.E.C.'s Use of the 'Rocket Docket' Is Challenged. The article examines concerns that have been raised about the use of administrative proceedings ("AP") by the SEC.  

The decision in Gupta v. SEC held out the possibility that challenges to the SEC's choice of forum could be successfully maintained. It wasn't long after the decision came down that Egan-Jones, the rating agency, likewise lodged a challenge to the SEC's decision to bring an AP. The Company challenged the absence of safeguards in the administrative process and also viewed the choice of forum as unfair and unsupported by a rational basis. As the complaint stated:   

  • This Enforcement Action, if allowed to proceed in an administrative forum, would deprive both Egan-Jones and Mr. Egan of their right to a jury trial and other critical procedural safeguards available in our judicial system, including, but not limited to, the ability to mount defenses and obtain evidence in support thereof relating to the unfair and disparate treatment of Egan-Jones by the SEC, with no rational basis, and evidence relating to the motive for the SEC to do so; the SEC's improper motive in bringing this action including the denial or marginalization of Egan-Jones' content and voice in the marketplace; and the maintenance and continuation of the status quo conflicted issuer-paid ratings model in contravention of Congressional direction.

Egan-Jones viewed itself as singled out but the case involved a different set of facts than those at issue in Gupta. Gupta could point to other similar cases that raised concerns over disparate treatement. As the court stated in that case: 

  • A funny thing happened on the way to this forum. On March 11, 2011, the Securities and Exchange Commission (the "SECI" or "Commission")--having previously filed all of its Galleon related insider trading actions in this federal district--decided it preferred its home turf. It therefore issued an internal Order Instituting Public Administrative and Cease-and-Desist Proceedings (the "OIP") against Rajat K. Gupta. 

Egan-Jones also alleged disparate treatment. The disparate treatment, however, was that it was the only rating agency singled out for administrative action in the described circumstances. See Egan-Jones Complaint ("While the SEC targets Egan-Jones for alleged infractions which have not affected a single rating or investor, the SEC has not suggested that it will ever take any real, proportional action against the large issuer-paid firms for issuing profitable inflated ABS and CDO ratings which brought about America's economic crises.").   

The SEC sought dismissal, primarily by arguing that the district court lacked jurisdiction (the appropriate forum was the court of appeals) and that there was no final agency action under the APA. Egan-Jones contested the motion (to which the SEC replied), but there was never a resolution of the issue. The plaintiffs voluntarily dismissed the action.  

August 29, 2014
Are the Reports of the Cupcake Craze Death Greatly Exagerated?
by Lisa Fairfax

Last month when Crumbs, America's first public cupcake company, announced it was closing most of its stores after its stock was delisted by Nasdaq, and it had defaluted on some $14.3 million in financing, many viewed the annoucement as a sign that the cupcake industry bubble had finally burst.

In the past decade, cupcakes appeared as if they were taking over with businesses sprouting up everywhere. Not only had cupcakes come to replace traditional cakes at weddings and birthday parties, but people were willing to stand in ridiculously long lines and pay sometimes as much as $5 for a single cupcake or between $30 and $50 for a dozen. A 2012 story on Georgetown Cupcakes in DC suggested that sometimes the lines could take up to an hour to get through.

Some view the apparent demise of Crumbs as a sign that the cupcake craze was a trend that had finally run its course. Or put differently, an unsustainable business model. In addition to concerns about potential market saturation and over exposure, some indicated that pricing was a problem. Indeed, while cupcakes were touted as an "affordable luxury," some note that at $3.50-$6 each, cupcakes seemed more like an overpriced snack. As this article suggests, these cupcakes were not something middle America could afford. Another problem was low cost of entry--potentially reflected in the many people who thought they could give the cupcake business a try. Still another was diversity--could an industry based on a single food really survive with competitors that offered more than just cupcakes? And then there was the problem of potentially swimming against the health trend. Cupcakes seem like a healthier option than your large slice of cake or pie, but alas as a Forbes article points out "your typical large frosted premium cupcake can have as much as 500 calories," and lots of people eat more than just one.

Of course others note that the demise of Crumbs may reflect issues unique to Crumbs. Indeed, there are some cupcake businesses that continue to thrive.

And even the Crumbs story is not over. Just this week it was announced that Crumbs would begin reopening its stores because, as the Wall Street Journal notes, a court signed off on a sale of Crumbs to "self-styled turnaround guru Marcus Lemonis and Dippin Dots owner Fischer Enterprises." Apparently, part of the turnaround strategy will be moving away from reliance on just cupcakes and incorporating other desserts.

So while the cupcake bubble has certainly gotten smaller, it may be too soon to tell if we can really call the cupcake craze a bust.

August 29, 2014
Alston & Bird discusses Tax Allocation Agreements
by Clifford S. Stanford

On June 13, 2014, the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System, and the Office of the Comptroller of the Currency (collectively, the "agencies") issued a final version of an addendum to the Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure (the "policy statement") to address certain questions pertaining to an insured bank's entitlement to a tax refund owed to it when filing federal and state tax returns as a group with its parent holding company.

Importantly, the addendum requires that banks ensure that tax allocation agreements include certain language regarding the principal-agent relationship of a bank and its holding company by October 31, 2014, in order to avoid potential implications under Section 23A of the Federal Reserve Act.

The original policy statement was issued in 1998 and established regulatory expectations for tax allocation agreements. Specifically, the agencies required that such agreements be no less favorable to the bank than if it were a nonaffiliated, independent taxpayer such that the bank should receive any tax benefit it would have received had it filed as a stand-alone entity.

Recent controversy in this area centers on the nature of the relationship between a holding company and a bank when filing consolidated tax returns. Under the policy statement, the agencies indicated that this should be a principal-agent relationship, meaning that the holding company has no actual claim to the refund and simply holds the refund as an agent for its bank subsidiary. Further, tax refunds should not be described as property of the holding company in either the tax allocation agreement or in the holding company's corporate documents. Some recent court decisions, however, have instead classified this relationship as that of a debtor and its creditor. As a result, banks (and the FDIC, as receiver of many failed banks) have been treated as unsecured creditors for the refund, virtually eliminating their ability to recover the amount of the refund from the holding company during bankruptcy.

The addendum is an attempt by the agencies to address this issue. First, the addendum makes clear that tax allocation agreements must explicitly state that a principal-agent relationship exists between the bank and its holding company and that the agreements must not contain any language to the contrary. Further, the addendum requires that such agreements should expressly disclaim any right of the holding company to retain a tax refund. Second, the agencies have made it clear that the failure to include such language, or the inclusion of any language creating a debtor-creditor relationship, may cause the tax allocation agreement to constitute a loan to the holding company subject to Section 23A of the Federal Reserve Act.

The agencies have provided sample "safe harbor" language that reinforces the agency relationship, disclaims the holding company ownership interest in a tax refund and avoids the collateral and other requirements of Section 23A. Banks may use other language in place of the recommended "safe harbor" so long as it is substantially similar and reflects the intent of the addendum.

The agencies further emphasize the application of Section 23B of the Federal Reserve Act, which generally requires that transactions between a bank and its holding company be "arm's length." In this context, the agencies expect that tax allocation agreements between banks and their holding companies include terms requiring the prompt transfer of any refunds to the bank. Any agreements containing provisions entitling the holding company to hold on to the refund for any length of time will not be compliant with Section 23B.

The full and original memorandum was published by Alston & Bird LLP on August 22, 2014, and is available here.

August 29, 2014
SEC: New Disclosure Rules for Asset-Backed Securities
by Broc Romanek

A few days ago, the SEC adopted new rules for asset-backed issuers governing the disclosure, reporting, and offering process. This is the 1st part of the new rules relating to Regulation AB II. The adopting release is sorta not out yet (it's out in draft form while pending OMB review). And here are notes from the open meeting from Alston & Bird and MoFo.

In addition, the SEC adopted rules to reform credit rating agencies. The adopting release is not out yet (except in draft form).

Rebuttal to "Shareholder Proposals: 10 Things About NY Times' 'Gadflies' Column"

After my blog last week that parsed this DealBook column, Professor Bainbridge went through my "10 Things" in this blog and gave his 10 cents on each. He embraces the "gadfly" term for openers...

Something Cool to Talk About at Labor Day BBQs? Cinemagraphs

You gotta check out these animated photos called "cinemagraphs"...

- Broc Romanek

August 28, 2014
Foreign Corrupt Practices Act and Implications for Institutional Investors
by Susan Mangiero

For those who don't know, I am the lead contributor to an investment compliance blog known as Good Risk Governance Pays. I created this second blog as a way to showcase investment issues that had a wider reach than just the pension fund community. While I strive to publish different education-focused analyses on each blog, sometimes there are topics that I believe would be of interest to both sets of readers. A recent article that I co-wrote is one example. Entitled "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel" (The Corporate Counselor, September 2014), Mr. H. David Kotz and Dr. Susan Mangiero explain the basics of the Foreign Corrupt Practice Act. Examples and links to reference materials are included, along with a discussion as to why this topic should be of critical importance to pension funds and other types of institutional investors. Click to download a text version of "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel."

August 28, 2014
Intellectual Property, Innovation and Economic Growth: Mercatus Gets it Wrong
by Adam Mossoff

[Cross posted at the CPIP Blog.]

By Mark Schultz & Adam Mossoff

A handful of increasingly noisy critics of intellectual property (IP) have emerged within free market organizations. Both the emergence and vehemence of this group has surprised most observers, since free market advocates generally support property rights. It's true that there has long been a strain of IP skepticism among some libertarian intellectuals. However, the surprised observer would be correct to think that the latest critique is something new. In our experience, most free market advocates see the benefit and importance of protecting the property rights of all who perform productive labor - whether the results are tangible or intangible.

How do the claims of this emerging critique stand up? We have had occasion to examine the arguments of free market IP skeptics before. (For example, see here, here, here.) So far, we have largely found their claims wanting.

We have yet another occasion to examine their arguments, and once again we are underwhelmed and disappointed. We recently posted an essay at AEI's Tech Policy Daily prompted by an odd report recently released by the Mercatus Center, a free-market think tank. The Mercatus report attacks recent research that supposedly asserts, in the words of the authors of the Mercatus report, that "the existence of intellectual property in an industry creates the jobs in that industry." They contend that this research "provide[s] no theoretical or empirical evidence to support" its claims of the importance of intellectual property to the U.S. economy.

Our AEI essay responds to these claims by explaining how these IP skeptics both mischaracterize the studies that they are attacking and fail to acknowledge the actual historical and economic evidence on the connections between IP, innovation, and economic prosperity. We recommend that anyone who may be confused by the assertions of any IP skeptics waving the banner of property rights and the free market read our essay at AEI, as well as our previous essays in which we have called out similarly odd statements from Mercatus about IP rights.

The Mercatus report, though, exemplifies many of the concerns we raise about these IP skeptics, and so it deserves to be considered at greater length.

For instance, something we touched on briefly in our AEI essay is the fact that the authors of this Mercatus report offer no empirical evidence of their own within their lengthy critique of several empirical studies, and at best they invoke thin theoretical support for their contentions.

This is odd if only because they are critiquing several empirical studies that develop careful, balanced and rigorous models for testing one of the biggest economic questions in innovation policy: What is the relationship between intellectual property and jobs and economic growth?

Apparently, the authors of the Mercatus report presume that the burden of proof is entirely on the proponents of IP, and that a bit of hand waving using abstract economic concepts and generalized theory is enough to defeat arguments supported by empirical data and plausible methodology.

This move raises a foundational question that frames all debates about IP rights today: On whom should the burden rest? On those who claim that IP has beneficial economic effects? Or on those who claim otherwise, such as the authors of the Mercatus report?

The burden of proof here is an important issue. Too often, recent debates about IP rights have started from an assumption that the entire burden of proof rests on those investigating or defending IP rights. Quite often, IP skeptics appear to believe that their criticism of IP rights needs little empirical or theoretical validation, beyond talismanic invocations of "monopoly" and anachronistic assertions that the Framers of the US Constitution were utilitarians.

As we detail in our AEI essay, though, the problem with arguments like those made in the Mercatus report is that they contradict history and empirics. For the evidence that supports this claim, including citations to the many studies that are ignored by the IP skeptics at Mercatus and elsewhere, check out the essay.

Despite these historical and economic facts, one may still believe that the US would enjoy even greater prosperity without IP. But IP skeptics who believe in this counterfactual world face a challenge. As a preliminary matter, they ought to acknowledge that they are the ones swimming against the tide of history and prevailing belief. More important, the burden of proof is on them - the IP skeptics - to explain why the U.S. has long prospered under an IP system they find so odious and destructive of property rights and economic progress, while countries that largely eschew IP have languished. This obligation is especially heavy for one who seeks to undermine empirical work such as the USPTO Report and other studies.

In sum, you can't beat something with nothing. For IP skeptics to contest this evidence, they should offer more than polemical and theoretical broadsides. They ought to stop making faux originalist arguments that misstate basic legal facts about property and IP, and instead offer their own empirical evidence. The Mercatus report, however, is content to confine its empirics to critiques of others' methodology - including claims their targets did not make.

For example, in addition to the several strawman attacks identified in our AEI essay, the Mercatus report constructs another strawman in its discussion of studies of copyright piracy done by Stephen Siwek for the Institute for Policy Innovation (IPI). Mercatus inaccurately and unfairly implies that Siwek's studies on the impact of piracy in film and music assumed that every copy pirated was a sale lost - this is known as "the substitution rate problem." In fact, Siwek's methodology tackled that exact problem.

IPI and Siwek never seem to get credit for this, but Siwek was careful to avoid the one-to-one substitution rate estimate that Mercatus and others foist on him and then critique as empirically unsound. If one actually reads his report, it is clear that Siwek assumes that bootleg physical copies resulted in a 65.7% substitution rate, while illegal downloads resulted in a 20% substitution rate. Siwek's methodology anticipates and renders moot the critique that Mercatus makes anyway.

After mischaracterizing these studies and their claims, the Mercatus report goes further in attacking them as supporting advocacy on behalf of IP rights. Yes, the empirical results have been used by think tanks, trade associations and others to support advocacy on behalf of IP rights. But does that advocacy make the questions asked and resulting research invalid? IP skeptics would have trumpeted results showing that IP-intensive industries had a minimal economic impact, just as Mercatus policy analysts have done with alleged empirical claims about IP in other contexts. In fact, IP skeptics at free-market institutions repeatedly invoke studies in policy advocacy that allegedly show harm from patent litigation, despite these studies suffering from far worse problems than anything alleged in their critiques of the USPTO and other studies.

Finally, we noted in our AEI essay how it was odd to hear a well-known libertarian think tank like Mercatus advocate for more government-funded programs, such as direct grants or prizes, as viable alternatives to individual property rights secured to inventors and creators. There is even more economic work being done beyond the empirical studies we cited in our AEI essay on the critical role that property rights in innovation serve in a flourishing free market, as well as work on the economic benefits of IP rights over other governmental programs like prizes.

Today, we are in the midst of a full-blown moral panic about the alleged evils of IP. It's alarming that libertarians - the very people who should be defending all property rights - have jumped on this populist bandwagon. Imagine if free market advocates at the turn of the Twentieth Century had asserted that there was no evidence that property rights had contributed to the Industrial Revolution. Imagine them joining in common cause with the populist Progressives to suppress the enforcement of private rights and the enjoyment of economic liberty. It's a bizarre image, but we are seeing its modern-day equivalent, as these libertarians join the chorus of voices arguing against property and private ordering in markets for innovation and creativity.

It's also disconcerting that Mercatus appears to abandon its exceptionally high standards for scholarly work-product when it comes to IP rights. Its economic analyses and policy briefs on such subjects as telecommunications regulation, financial and healthcare markets, and the regulatory state have rightly made Mercatus a respected free-market institution. It's unfortunate that it has lent this justly earned prestige and legitimacy to stale and derivative arguments against property and private ordering in the innovation and creative industries. It's time to embrace the sound evidence and back off the rhetoric.

View today's posts

8/29/2014 posts

Race to the Bottom: The SEC and Administrative Proceedings (Part 3)
Conglomerate: Are the Reports of the Cupcake Craze Death Greatly Exagerated?
CLS Blue Sky Blog: Alston & Bird discusses Tax Allocation Agreements Blog: SEC: New Disclosure Rules for Asset-Backed Securities
Pension Risk Matters: Foreign Corrupt Practices Act and Implications for Institutional Investors
Truth on the Market: Intellectual Property, Innovation and Economic Growth: Mercatus Gets it Wrong

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