Securities Mosaic® Blogwatch
July 24, 2014
Embracing Sponsor Support in Money Market Fund Reform
by Jill Fisch

Editor's Note: Jill E. Fisch is Perry Golkin Professor of Law and Co-Director of the Institute for Law & Economics at the University of Pennsylvania Law School.

Money market funds (MMFs) have, since the 2008 financial crisis, been deemed part of the nefarious shadow banking industry and targeted for regulatory reform. In my paper, The Broken Buck Stops Here: Embracing Sponsor Support in Money Market Fund Reform, I critically evaluate the logic behind current reform proposals, demonstrating that none of the proposals is likely to be effective in addressing the primary source of MMF stability—redemption demands in times of economic resources that impose pressure on MMF liquidity. In addition, inherent limitations in the mechanisms for calculating the fair value of MMF assets present a practical limitation on the utility of a floating NAV. I then offer an unprecedented alternative approach - mandatory sponsor support. My proposal would require MMF sponsors to commit to supporting their funds as a condition of offering a fund with a fixed $1 NAV.

Sponsor support of MMFs can take various forms. Sponsors can provide support by injecting cash into their funds, by purchasing distressed or illiquid assets from the fund, by providing guarantees or by purchasing insurance. A commonly overlooked form of sponsor support is the waiver of advisory fees. Since 2008, MMF sponsors have provided $24 billion in support through the use of voluntary fee waivers. Unlike some current reform proposals, this paper would not mandate a fixed type of support, recognizing that the most efficient support option will vary based on fund and sponsor attributes.

Hundreds of sponsors have supported their funds through past times of economic turmoil, and sponsor support has been a critical component of MMF stability. Yet critics denounce sponsor support as proof of MMF fragility. In this paper, I show that these criticisms are based on the flawed analogy between MMFs and banks. Unlike banks, MMF sponsors have assets and operations that are separate from the assets of the MMFs themselves. This asset partitioning serves a variety of functions, but, in a time of financial distress, offers a resource that is not available to banks.

The weakness of sponsor support is that, in the past, it has been both opaque and discretionary. This paper's straightforward solution is to move sponsor support from the shadows by making the support requirement explicit.

The modest change has several advantages. First, by obligating sponsors to provide support, the proposal would require sponsors to internalize the cost of risky investment strategies, thereby reducing moral hazard. Sponsors would also have an incentive to limit the size of their MMFs and to screen for hot-money investors, both of which would enhance stability of the funds. Second, an explicit sponsor support requirement would encourage MMF investors to look to the sponsor for support rather than relying on an implicit government guarantee. This in turn would strengthen the role of market discipline in reducing the ability of financially-limited sponsors to attract investors. Third, the proposal would allow investors to substitute monitoring the sponsor's financial viability for the difficult task of monitoring the value of fund assets directly. Finally, sponsor support would address MMF fragility while allowing MMFs to continue to meet investment demand for a safe and liquid cash management option.

The full paper is available for download here.

July 24, 2014
Simpson Thacher discusses Employee Stock Ownership Plans
by Paul Koppel

The Supreme Court recently concluded that the ERISA fiduciaries of an employee stock ownership plan (an "ESOP") are not entitled to a presumption that they acted prudently in connection with the ESOP's investment in employer stock.[1] While the Court recognized several alternative defenses to ERISA "stock drop" cases, the Court's rejection of the presumption of prudence - which had previously been adopted by a number of U.S. courts of appeals and was routinely relied upon by ESOP fiduciaries - could encourage the filing of lawsuits against public companies and their ESOP fiduciaries in the event of a decline in the company's stock price. Accordingly, public companies should carefully consider this potential litigation risk along with other risks and benefits when determining whether to offer an ERISA employee benefit pension plan that invests in company stock.

WHAT IS AN ESOP?

An ESOP is an individual account pension plan that by its terms invests primarily in employer stock and provides that distributions can be made in company stock. An ESOP can be either a standalone plan or included as a feature in a 401(k) plan in which participants otherwise direct the investment of their accounts into a menu of investment choices selected by the plan fiduciary.

RESPONSIBILITIES OF FIDUCIARIES

Before the Supreme Court's decision in Fifth Third Bancorp v. Dudenhoeffer, many U.S. courts of appeals had recognized a presumption of prudence for ESOP fiduciaries at the litigation's pleading stage. While there were variations among courts in the presumption, the presumption generally required plaintiffs in "stock drop" cases involving ESOPs to plead facts demonstrating that the employer was in grave danger, akin to being "on the brink of collapse," as the Court phrased it. The Fifth Third decision eliminated the presumption of prudence at the pleading stage.

In light of the Fifth Third opinion, ESOP fiduciaries should give further consideration to what is required of them to comply with ERISA's duty of prudence with respect to ESOPs and other company stock funds in retirement plans, including 401(k) plans that are not structured as ESOPs but offer company stock as one investment choice. Although the Court in Fifth Third did not elaborate on the requirements of ERISA's duty of prudence, the decision leads to several observations:

Exercising the Duty of Prudence. Without a presumption that ESOP investments in company stock are prudent, it could be argued that plan fiduciaries need to develop or maintain procedures for investigating, monitoring, and evaluating investments in company stock, just as they would with regard to other ERISA plan investments. Given ERISA's duty of prudence, plan fiduciaries often have a procedure for assessing and monitoring investment choices and for adding and removing investment fund choices from a plan's fund lineup, as appropriate. ERISA fiduciaries typically evaluate the prudence of an investment in part by considering, among other factors, the availability, riskiness, and potential return of alternative investments for the plan. The Fifth Third Court made clear that ESOP fiduciaries are excused from the ERISA duty to diversify. Absent an underlying duty to diversify the investments of the plan, it is not yet clear to what degree (if at all) ESOP fiduciaries need to consider alternative investments in exercising their duty of prudence with respect to the ESOP.

Reliance on Public Information. As a general matter, when evaluating the prudence of investing a plan in company stock, fiduciaries may rely on the market price of the company's stock as an estimate of the stock's value. The Fifth Third Court held that fiduciaries are not generally expected to determine, based on publicly available information, that the stock is over- or undervalued. However, fiduciaries may need to take action where there are "special circumstances" affecting the reliability of the market price as "an unbiased assessment of the security's value in light of all public information" that could make relying on the market's valuation imprudent.[2] This is one reason, among others, why it may make sense for an ESOP not to use insiders in possession of material nonpublic information as fiduciaries making investment choice decisions for the plan.

Reliance on Nonpublic Information to Sell the Fund's Holdings. Fiduciaries are not necessarily required to sell an ESOP's holdings in reaction to nonpublic information that could imply that the market had been overvaluing the company's stock. The duty of prudence does not (and cannot) "require an ESOP fiduciary to perform an action - such as divesting the fund's holdings of the employer's stock on the basis of insider information - that would violate the securities laws."[3] Appointing as an ESOP fiduciary either an employee who is not privy to material nonpublic information or an independent fiduciary may be a good way to eliminate the risk that the fiduciary might make an investment decision on the basis of material nonpublic information.

Reliance on Nonpublic Information to Stop Making Additional Stock Purchases or Public Disclosure of Inside Information. With regard to whether fiduciaries should either stop making additional purchases based on inside information or disclose inside information to the public:

o Fiduciaries should carefully assess whether such a decision "could conflict with the complex insider trading and corporate disclosure requirements imposed by the federal securities laws or with the objectives of those laws."[4] Fiduciaries should keep in mind that ERISA's duty of prudence does not supersede federal securities laws and rules. The Fifth Third Court seems to have invited the Securities and Exchange Commission to provide its views on the relationship between insider trading and corporate disclosure requirements, on the one hand, and fiduciaries' obligations under ERISA; the SEC has not yet issued guidance on this issue.

o Fiduciaries should also determine whether a prudent fiduciary could reasonably conclude that stopping stock purchases (which could be viewed by the market as a sign that the stock is a bad investment) or publicly disclosing negative information "would do more harm than good to the fund by causing a drop in the stock price and a concomitant drop in the value of the stock already held by the fund."

ESOP fiduciaries (and the fiduciaries of plans with other company stock funds) may consider whether they should review company stock as an investment choice for the ESOP in the same way they would any other investment choice for an ERISA plan in order to satisfy ERISA's prudence requirements. Fiduciaries could use procedures commonly used for other employee benefit pension plans (which typically involve regular meetings with outside investment advisors who help analyze the investment choices and make recommendations, followed by a reasoned decision by the fiduciaries as to what investment choices remain the right ones for the plan). As with ERISA actions brought in other contexts, enhanced processes may prove critical to defending against a future claim of ERISA violations by ESOP fiduciaries.

While the Fifth Third decision emphasizes that ESOP fiduciaries are subject to the duty of prudence, it is still unclear how the decision's imposition of a duty of prudence without a duty to diversify will impact the behavior of ESOP fiduciaries in practice. ESOP fiduciaries should carefully track market developments in this area over the coming months in order to inform their decisions. In the meantime, companies might consider either leaving the prudence questions to corporate personnel who are walled off from material nonpublic information or hiring independent fiduciaries for their ESOPs (and other account balance pension plans offering company stock as an investment choice) for the limited purpose of conducting the prudence analysis. Among other things, such an approach may mitigate the risk that investment decisions will be made on the basis of nonpublic information.

[1] See Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. ___, 189 L. Ed. 2d 457 (2014). For a summary of the Court's opinion, see Simpson Thacher & Bartlett LLP, The Supreme Court Clarifies Pleading Standards for ERISA Breach of Duty of Prudence Claims Against ESOP Fiduciaries (June 25, 2014).

[2] Although the Fifth Third decision did not elaborate on what constitute "special circumstances," it did find that the fact that the plaintiffs alleged "that Fifth Third engaged in lending practices that were equivalent to participation in the subprime lending market, that Defendants were aware of the risks of such investments by the start of the class period, and that such risks made Fifth Third stock an imprudent investment" did not amount to "any special circumstance rendering reliance on the market price imprudent."

[3] Fifth Third Bancorp, 189 L. Ed. 2d at 474.

[4] Id.

The full and original memo was published by Simpson Thacher & Bartlett LLP on July 21, 2014, and is available here.

July 24, 2014
SEC Charges Penny Stock Company CEO and Purported Business Partner for Defrauding Investors With False Press Releases
by Alexa Astarita

The SEC charged a serial con artist and a penny stock company CEO with misleading investors in a supposed vaccine development company by issuing false press releases portraying it as a successful venture when it was in fact a failing enterprise.


The SEC alleges that this individual teamed up with another CEO to defraud investors with extravagant claims about the microcap company's revenue and other benefits flowing from a "shared revenue agreement" with an electricity provider supposedly operated by the individual.  However, his entity was a complete sham.

"[These men] misled investors by widely mischaracterizing a worthless thinly-traded microcap issuer as a growing success with lucrative new business opportunities," said Andrew M. Calamari, director of the SEC's New York Regional Office.  "Crooked penny stock promoters like [them] and their unscrupulous sidekicks, often company CEOs, must be held accountable to the investing public for the misinformation they so freely disseminated into the marketplace."

According to the SEC's complaint filed against these individuals and their companies in federal district court in Manhattan, one of them also spearheaded a separate scheme around the same time in 2010 involving another microcap company that similarly issued a rapid-fire series of press releases with bogus information.  Those press releases touted a purported partnership with his phony power company to own and operate solar energy farms across the country.  In reality, the microcap issuer was in dire financial straits and lacked the financial or logistical capability to commercially produce a product of any kind let alone break ground on energy farms.  The company continues to have no operations, customers, or revenues. 

For more information, visit: SEC Charges Penny Stock Company CEO and Purported Business Partner for Defrauding Investors With False Press Releases

July 24, 2014
Charts: Intrastate Crowdfunding Exemptions
by Broc Romanek

As the result of a collaborative effort between Ginsberg Jacobs' Anthony Zeoli, Crowdcheck and Seyfarth Shaw's Georgia Quinn, here is a comparative summary chart where you can go to compare all of the enacted instrastate crowdfunding exemptions side-by-side - and here's a chart with the proposed intrastate crowdfunding exemptions...

More on "New Intrastate Offering Exemptions: Not Useful"

Back in April when Corp Fin issued 3 CDIs about the intrastate offerings exemption, I ran a blog noting that they weren't useful. Now Joe Wallin explains more about why that's the case in his blog...

Please take a moment to participate in this "Quick Survey on CEO Succession Planning" - and this "Quick Survey on Ending Blackout Periods."

Checklist: Board Minutes - Conversion to Digital

I've been posting a slew of new checklists recently. This checklist is about whether it's worth the hassle of converting old board minutes from paper to digital - and if so, how to best do it...

- Broc Romanek

July 24, 2014
Market Structure Reform and the SEC (Part 1)
by J Robert Brown Jr.

John Coffee has an interesting piece on the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term.  

The article highlights two cases, one brought by (but yet to be resolved) N.Y. Attorney General Schneiderman against the dark pool operated by Barclays (the press release is here and the complaint is here) and a private action (also yet to be resolved) against a number of stock exchanges alleging that customers received from exchanges the proprietary data feeds before the information reached the SIP. See Lanier v. BATS Exchange, Inc. (alleging that "[o]n average, the data is received by the Processor approximately 1,499 microseconds after the Preferred Data Customers receive it.").  

The two actions are united in that they both involve practices that affect high frequency traders. Other than that, however, they are quite different in what they indicate about market structure.  

In the Barclays case, the complaint mostly alleges misrepresentations by Barclays with respect to its dark pool (partly by understating the presence of HFT in the dark pool). See Barclays Complaint ("Barclays falsely marketed the percentage of aggressive high frequency trading activity in its dark pool, asserting to clients and to the investing public that less than 10% of the trading activity in the pool was 'aggressive,' while at the same time secretly indicating to at least one high frequency trading firm that the level of such trading activity was at least 25%"). 

The Lanier case (and by the way, the case is against a number of exchanges, not just BATS), which is a contract action, involves allegations that the proprietary data feeds provided by exchanges reached customers (such as high frequency traders) before reaching the SIP. The distribution of proprietary data feeds is regulated under Regulation NMS. See In re NYSE, Exchange Act Release No. 67857 (admin proc 2012) ("This rule prohibits an exchange from releasing data relating to quotes and trades to its customers through proprietary feeds before it sends its quotes and trade reports for inclusion in the consolidated feeds."). The SEC has sanctioned exchanges for violating this rule. See Id. (sanctioning NYSE for vioaltions of Rule 603 of Regulation NMS by failing to distribute market data information to market participants on terms that were "fair and reasonable" and "not unreasonably discriminatory.").

Barclays is mostly interesting because it sheds potential light on practices in dark pools. But in the end it is a claim of misrepresentation. Nothing in the existing structure of the market needs to be changed to prohibit materially false statements to investors. Of course, the alleged misrepresentation was in part facilitated by the lack of transparency in dark pools. The SEC has recognized this. See Speech by Chair White, June 5, 2014 ("Dark venues lack transparency in other important respects. Although the trades of dark venues are reported in real time, the identity of participants in the dark venue is not disclosed to the public. And dark venues generally only provide limited information about how they operate. ATSs, for example, file a form with the SEC on some aspects of their operations, but the forms are not publicly available under current rules."). As a result, increased transparency for dark pools is on the regulatory agenda.

Lanier raises more intriguing issues. The case involves allegations that do not turn on the release time but the arrival time of the data feed. This is a consequence, at least in part, of technology. According to the complaint: 

  • The Exchange Defendants sell advance access to market data to the Preferred Data Customers that is transmitted using Private Feeds faster than the data is transmitted to the Processor. The Exchange Defendants use transmission lines for the Private Feeds that carry the data to the Preferred Data Customers in a fraction of the time it takes for the slower transmission lines to deliver the same market data to the Processor.

As a result of the differences in transmission lines, according to the allegations in the complaint, the information reached preferred customers first.  

  • While it may take less than two thousand microseconds for the market data to initially arrive at the Processor through which the Subscribers receive the data, the Preferred Data Customers receive the data directly in as fast as one microsecond.

Similarly, the complaint alleges that co-location services provided to preferred customers with "valuable additional microseconds because the data travels a shorter distance than the data travels from the exchanges to the Processors."  

Rule 603(a) of Regulation NMS requires the distribution of market data on terms that are "fair and reasonable" and "not unreasonably discriminatory." Lanier at least raises the question as to whether it is fair and non-discriminatory to release data that is made available to the customer before it is available to the SIP. Moreover, the SEC in the adopting release for Regulation NMS spoke not in terms of "release" but in terms of availability. See Exchange Act Release No. 51808 (June 9, 2005) ("These requirements prohibit, for example, a market from making its 'core data' (i.e., data that it is required to provide to a Network processor) available to vendors on a more timely basis than it makes available the core data to a Network processor.").  

To the extent that the appropriate focus should be on the arrival of the information (that is, information cannot be provided to customers until it arrives at the SIP) there will be a serious oversight issue. Given the short time periods involved (milliseconds and, invariably, microseconds), the need to have information arrive simultaneously is likely to pose a technological challenge. Moreover, monitoring a system that operates at these speeds is also likely to pose a challenge, particularly for regulators.

Of course, if exchanges could not distribute proprietary data feeds prior to disclosure in the CTS, the problem would essentially go away.

July 23, 2014
IR Executive Settles SEC Insider Trading Charges
by Tom Gorman

The SEC filed a settled insider trading case against a partner in an investor relations firm who traded securities based on information he obtained from draft press releases he worked on for firm clients. The settled action alleges that the executive was a "temporary" insider and breached a duty to his firm. It was resolved with a conduct based injunction and monetary payments. SEC v. McGrath, Civil Action No. 14 CV 5483 (S.D.N.Y. Filed July 22, 2014).

Kevin McGrath has been with Cameron Associates since 1996 and a partner since 2003. Previously, he worked for an investment advisory firm and had been a registered representative.

Cameron is an investor relations firm whose clients are primarily small, publicly traded companies. Two of its clients are Misonix, Inc. and Clean Diesel Technologies, Inc. Misonix, a developer and manufacturer of medical devices and laboratory equipment, became a firm client in 2008. Clean Diesel, a global manufacturer of emissions and control systems and products, became a firm client at the end of 2010.

Mr. McGrath worked on a number of press releases for Misonix. In April 2009 he purchased 10,000 shares of Misonix stock. Later that same month he began communicating with the company on an Earnings Release.

On May 6, 2009 Mr. McGrath sent an e-mail to a Misonix employee regarding the date the Release would be issued. He was told that it would be issued in May. The next morning he received a draft of the Release. The drafts stated that the company had significant declines in revenue from the prior nine-month period. A comment by the CEO stated that difficult times were ahead. Later that afternoon a Misonix employee confirmed in an e-mail to the executive that the Release would be finalized on Friday, the next day. About forty minutes later Mr. McGrath sold all of his Misonix shares.

On Monday Mr. McGrath submitted the Release to the PR Newswire for issuance. By the time of the market close the stock price had dropped 36%. By selling his shares the prior week Mr. McGrath avoided losses of $5,400.

Mr. McGrath began providing investor relations services to Clean Diesel in January 2011. He frequently received non-public information from the firm.

In May 2011 Mr. McGrath was involved in drafting a May 25 release in which the company announced it had received a significant amount of orders in connection with a recently announced program by the State of California. On May 24, 2011 a Clean Diesel employee sent Mr. McGrath an e-mail stating that the release would be issued the next day. Fourteen minutes later the account executive purchased 1,000 shares of Clean Diesel.

The next day the release was issued after the close of the market. By the close of the market on the following day the share price had increased about 95%. Mr. McGrath sold his shares, realizing profits of $6,376.

The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. McGrath resolved the matter, consenting to the entry of a "conduct-based injunction" which prohibits future violations of the Sections cited in the complaint. It also permanently requires Mr. McGrath to abstain from trading in the stock of any issuer for which he or his firm has performed any investor relations services within a one year period. His employer is also required to provide written notice to a client upon any intent to sell shares received as compensation for services performed and must receive written authorization for the sale from the company management. In addition, he agreed to pay disgorgement of $11,776, prejudgment interest and a penalty equal to the amount of the disgorgement. See Lit. Rel. No. 23049 (July 22, 2014).

7/24/2014 posts

HLS Forum on Corporate Governance and Financial Regulation: Embracing Sponsor Support in Money Market Fund Reform
CLS Blue Sky Blog: Simpson Thacher discusses Employee Stock Ownership Plans
The Securities Law Blog: SEC Charges Penny Stock Company CEO and Purported Business Partner for Defrauding Investors With False Press Releases
CorporateCounsel.net Blog: Charts: Intrastate Crowdfunding Exemptions
Race to the Bottom: Market Structure Reform and the SEC (Part 1)
SEC Actions Blog: IR Executive Settles SEC Insider Trading Charges

Blog posts are subject to copyrights held by the authors and are republished here with permission. Views expressed are those of the authors alone. Infringement Notification.
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