Federal Securities Law Blog : Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

Corporate clients still need to comply with the FTC’s Red Flags Rule by November 1, 2009, but it’s their lawyers who are really unhappy about the regulations.  Last week the American Bar Association sued the FTC to stop the FTC’s enforcement of the Red Flags Rule against attorneys. The FTC says the law applies to creditors, which includes lawyers who extend credit by billing for services previously rendered. The ABA counters with some compelling arguments:

1. There’s no rational connection between the practice of law and identity theft;
2. Traditionally, states regulate lawyers, not the FTC;
3. Compliance with the Rule will increase legal costs and impede the attorney-client relationship; and
4. Lawyers should not be considered “creditors” simply because ethics rules generally prohibit receiving payment in advance.

Despite the ABA’s legal fight, it should be relatively easy for most lawyers to develop written policies to ensure their clients are not using identity theft to procure legal advice.  A court may soon decide if lawyers will need to implement their own red flags policies.
 

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On Friday the Cleveland Plain Dealer reported that members of the U.S. House Financial Services Committee bought and sold financial stocks last fall, at the same time that the Committee was approving the bailout, and in the same companies that the Committee would later criticize for incompetence and greed. The article points out two potential problems:

1. The potential for conflicts of interest; and
2. The potential for trading on material, non-public information.

Some of the trades resulted in avoiding significant losses; while perhaps more troubling, some trades resulted in increased losses, which may at least be proof there was no impropriety.

In any event, such trades do not appear to violate Congressional ethics rules (although, arguably they could violate broad rules against using one’s office for “improper advantage”); however, the securities rules are more troublesome. If a member of Congress trades in securities based on material, non-public information provided by a corporate insider, the representative faces possible liability under a tipper/tippee theory assuming other elements of the offense are met. But, if the representative trades based on material, non-public information that results from the representative knowing about a new regulation or government program that will affect a company, liability depends on whether the representative has breached a duty to the source of the information, presumably Congress or some other source to which no duty is owed.

Congressional staffers are not so lucky, as they potentially owe a duty to their representative, the source of the information.

This is not a new issue. The Stop Trading on Congressional Knowledge Act aims to close this loophole but has failed to pass despite annual tries since 2006. Also interesting is the fact that two SEC lawyers got in trouble about a month ago for trading in the securities of issuers under investigation, and the Commission quickly enacted rules to stop the practice. Congress has been at least 3 years slower.
 

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On Wednesday, June 10, Secretary of the Treasury, Timothy Geithner outlined the Obama administration’s new proposals on executive compensation. The proposals focused on greater independence of corporate compensation committees and giving shareholders a nonbinding vote on executive compensation, commonly known as ‘say on pay’ provisions. Geithner outlined five guiding principals for executive compensation, namely:

1. compensation plans should properly measure and reward performance;
2. compensation should be structured to account for the time horizon of risks by aligning executive (and highly compensated individual) pay with long-term value creation;
3. compensation should be aligned with sound risk management;
4. golden parachutes and supplemental retirement packages should properly align the interests of executives with the interests of shareholders; and
5. the compensation setting process should promote transparency and accountability.

Geithner promoted the administration’s support for legislation requiring greater compensation committee independence for companies listed on the national securities exchanges. The proposed legislation would require compensation committee members to meet the stringent independence standards required of audit committee members under the Sarbanes Oxley Act. In addition, the proposed legislation would provide compensation committees with the right to (i) hire compensation consultants, (ii) hire legal counsel, and (iii) require each company to “appropriately” fund the compensation committee to allow it to execute its independent compensation oversight responsibilities.

In addition, Geithner promoted the administration’s support for legislation requiring non-binding ‘say on pay’ votes by shareholders. The legislation would require all public companies to include a proposal to allow shareholders to approve or disapprove of the compensation arrangements listed in a company’s annual proxy statement. It is unclear whether the proposed legislation would require annual non-binding shareholder votes to affirm previously approved executive compensation plans.

Noticeably absent from the newly announced proposals were the threatened executive compensation caps similar to those that the Treasury Department imposed on the largest recipients of TARP funds in February. According to Geithner, the proposed legislation seeks to avoid compensation caps or precise prescriptions for how companies should set compensation.

Less than a day after Geithner announced the administration’s executive compensation proposals, however, Rep. Barney Frank, Chairman of the House Financial Services Committee, and other committee Democrats indicated that they were less interested in merely reforming the independence of the compensation committee and requiring non-binding resolutions. Rep. Frank stated that he would prefer a bill that altered the structure of executive pay. Rep. Frank flatly rejected the administration’s “hope” that compensation committee independence would lead to greater oversight and curtail excessive risk taking. In addition, Rep. Brad Sherman voiced his support for binding ‘say on pay’ shareholder votes.

To its credit, the administration’s proposals have the full support of both FED Chairman Ben Bernanke and SEC Chairman Mary Schapiro. In addition, many commentators have voiced relief and support for the seemingly modest executive compensation proposals. It is clear, however, that some of the Congressional Democrats will require more convincing before they can sign-off on the executive compensation proposals.
 

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The FTC has extended the enforcement deadline of its Red Flag Rule to August 1, 2009, for most “creditors” under the Rule that are not already subject to enforcement as financial institutions.

The American Medical Association vows to use this extra time to lobby that doctors are not “creditors” under the Rule. The FTC disagrees for now, and even posts information specifically for health care providers on its red flag website.

The FTC promises to release a “template” to help companies with a low-risk of enabling identity theft to develop programs to identify red flags that signal potential identity theft. The AMA calls their own version of a template a “sample policy.”

Despite the AMA’s protesting, the health care industry may have an easier time complying than others given they already have to comply with the Health Insurance Portability and Accountability Act (HIPAA). Telecom, Utilities, car dealers, and retailers are starting from zero.
 

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The SEC announced yesterday charges against a former Citigroup investment banker who allegedly tipped his friends and family about upcoming mergers involving Citigroup’s healthcare industry clients, resulting in more than $5,000,000 in illegal insider-trading profits.

The case highlights a common insider-trading scenario: an employees uses inside information not to trade stock in his or her employer, but rather to trade stock in the employer’s clients.

In particular, privately-owned companies tend to think of illegal insider trading as a public-company problem, but often private companies and their employees are privy to information about public-company clients that can lead to insider trading concerns.

For example, the healthcare industry has a strong support industry of researchers, policy analysts, consultants, lobbyists, etc., all of whom potentially have access to material non-public information from their public healthcare clients that can be used to engage in illegal insider trading.

This raises a host of issues for private companies that service public companies, including:

• Should we have a company policy regarding employees owning stock in our clients?
• Should we accept stock as payment for services?
• If an employee who knows a lot about the industry makes great stock picks in client stock, will it seem like illegal insider trading even if technically it is not?
• If an employee pieces together a series of seemingly inconsequential non-public information and trades stock based on that information, what are the chances he or she will be accused of illegal insider trading?
• Is there a difference between having a hunch something good will happen to the client’s stock and knowing something good will happen?
• May an employee trade stock based on information that is technically publicly available (or would be provided by the client upon request) but was never actually in a press release?

These issues become more important as the SEC continues to step up enforcement.
 

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The Federal Reserve and the U.S. Department of Treasury have recently begun new lending to encourage investors to buy securities backed by consumer and small business loans. The lending program, known as TALF for Term Asset-Backed Securities Loan Facility, could be a favorable investment opportunity for large investors at the same time that it provides up to $1 trillion in new lending to encourage the issuance of securities backed by consumer credit.

Under TALF, the Federal Reserve Bank of New York (FRBNY) lends a minimum of $10 million to each eligible borrower to buy securities backed by auto loans, credit card loans, student loans, and certain small business loans. The TALF Borrower must pledge these asset-backed securities as collateral for the non-recourse TALF loan. If the investment is unsuccessful and the TALF borrower cannot repay the loan, it must surrender the collateral, but it is generally not subject to additional recourse.

TALF Terms and Conditions:

• Eligible Borrowers: U.S. businesses and investment funds with U.S. investment managers such as hedge funds, private equity funds, and mutual funds.
• Eligible Collateral: AAA-rated securities issued mostly in 2009 backed by auto loans, student loans, credit card loans, and small business loans guaranteed by the Small Business Administration. Securities backed by commercial mortgages, certain vehicle fleets, equipment, and private-label residential mortgages may be included in the future.
• Loan Terms: Minimum $10 million loan (no maximum) with a three-year term, a fixed or floating interest rate depending on the collateral, and an administrative fee of 0.05% of the loan amount on each settlement date. The principal amount of each loan depends on the value of the pledged collateral with borrowers expected to contribute 5% to 16% of the total investment depending on the collateral.
• Restrictions: TALF loans cannot be secured by loans originated or securitized by the TALF borrower or an affiliate. Each borrower must be approved by the FBRNY in its sole discretion, and the FBRNY may inspect and audit each borrower. TALF loans are not subject to mark-to-market or re-margining requirements, and substitution of collateral is not permitted unless the collateral is found ineligible after the loan is made.

Treasury and the Fed hope that TALF, along with recently announced Public-Private Investment Program, will encourage consumer credit transactions because lenders will be able to once again pool loans and sell asset-backed securities, a market that has largely collapsed. TALF may have the added benefit of being a favorable investment opportunity for eligible borrowers. It is unclear which borrowers will take advantage of TALF, but hedge funds, private equity funds, and similar investment vehicles are likely participants.

The largest perceived advantage of TALF is the opportunity for significant returns with a limited risk to the investor. As credit protection, Treasury will use Troubled Asset Relief Program funds to buy and manage TALF loan collateral that is foreclosed upon by the FRBNY.

The Federal Reserve Bank of New York began accepting subscriptions for TALF loans on March 17, 2009, and will continue to accept subscriptions on the first Tuesday of each month until December 31, 2009 (unless the Fed extends the program). Updates to TALF are forthcoming and can be found at the TALF website, www.ny.frb.org/markets/talf.html.
 

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Earlier this week the U.S. Senate began consideration of a bill that would require States to obtain the identity of a corporation’s beneficial owners as part of the incorporation process.  Most states allow the formation of a variety of business entities without asking for the names of owners. Numerous law enforcement agencies claim criminals use corporations to hide money laundering and tax fraud.

The bill is called the Incorporation Transparency and Law Enforcement Assistance Act, sponsored by Sen. Carl Levin and Sen. Chuck Grassley (the same Senators who recently introduced the Hedge Fund Transparency Act), along with Sen. Claire McCaskill.  President Obama was also a sponsor when it was introduced last year.  The Senate’s Permanent Subcommittee on Investigations has been pursuing this issue since 2000.

The Government Accountability Office and the Senate Subcommittee cite numerous examples of criminals using business entities to break the law and avoid individual identification.  It seems that criminal activity would be easier to combat if law enforcement could readily obtain names of business owners, but the costs of implementation of this program are difficult to measure at this point.

Implementation will clearly have costs for every state, but the costs may be outweighed by the benefits to law enforcement.  The current regulatory climate of Washington is on the rise, but this bill could prompt an interesting alliance between privacy advocates and business supporters.  It is not hard to imagine privacy advocates not liking a bill that could subject individuals to scrutiny for forming a business entity that for whatever reason is disliked by government.  Nor is it hard to imagine business advocates not liking a bill that impedes what are sometimes competitive reasons for forming a business in secret.  Although, to be fair, the bill indicates the names of owners would only be available if requested by law enforcement or required by subpoena.
 

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Senators Grassley and Levin have introduced a bill that would require certain hedge funds to register under the Investment Company Act and the give the SEC the long-desired power it needs to examine them. The SEC tried to regulate hedge funds under the Investment Advisers Act a few years ago, but the D.C. Circuit ruled the SEC had exceeded its power. The Hedge Fund Transparency Act of 2009 is a proposed congressional response to the D.C. Circuit opinion.

Regulation of hedge funds was opposed by several members of Congress, President Bush, and many hedge fund managers when regulation was first attempted, but the current financial crisis has changed the debate. Hedge funds are traditionally small groups of private investors with significant net worth. Many argue these are not the type of investors who need the help of SEC oversight. However, given the power of institutional investors like hedge funds to move markets and affect prices for securities, a general feeling is growing that small investors want to know what hedge funds are doing.

The proposed bill would require hedge funds to register but would not subject them to the same requirements of an average public mutual fund (a traditional registered investment company). The newly registered funds would have to maintain books and records for inspection by the SEC and would need to disclose the names of all owners and explain the structure of ownership interests.

The big concern is how broad will the registration requirements be? The proposed bill eliminates the exemptions from Investment Company Act registration for investment companies with less than 100 beneficial owners and investment companies held solely by qualified purchasers. Any entity relying on those exemptions would have to register, regardless of whether it is a hedge fund.
 

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The collapse of the market for auction rate securities (“ARS”) left investors who thought they had a safe, liquid investment with illiquid securities. While there have been a number of government settlements with sellers of ARS, the agreements have focused on providing a recovery for small investors, leaving corporate and institutional purchasers of these securities to pursue their own remedies. Nevertheless, there are meaningful opportunities for corporate purchasers of these securities to recover their investments. Prompt action is required, as described further in this Porter Wright Law Alert.

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Porter Wright attorney Thomas Gorman discusses the Bernard Madoff $50 billion Ponzi Scheme on CNBC:

www.cnbc.com/id/15840232

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The FTC has granted a six-month delay for enforcement of its Red Flag Rules, previously discussed here. Note that the other agencies responsible for the rules, including the National Credit Union Administration, the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision did not issue a similar extension. Therefore, financial institutions must still comply by November 1, 2008.

The extension highlights that several entities potentially affected by the Red Flag Rules are not ready to comply. Affected entities include car dealers, mortgage brokers, utilities companies, and any entity that regularly extends credit for accounts used mostly for personal, family, or household purposes.

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Financial institutions and businesses that extend credit to consumers will soon need to comply with new rules effective November 1, 2008 designed to protect against identity theft. The Federal Trade Commission, Federal Reserve, and other financial regulators have developed the Red Flag Rules under the Fair and Accurate Credit Transactions Act of 2003.

The Red Flag Rules apply to “financial institutions” and “creditors” with “covered accounts.” A financial institution is essentially a bank or credit union that holds a deposit or other type of account on behalf of consumers. “Creditor” has a much broader definition that includes any entity that regularly extends credit or is an assignee of an original creditor and is involved in the decision to extend credit. A “covered account” is an account used for personal, family, or household purposes that involves multiple payments or any account for which there is a reasonable foreseeable risk of identity theft.

The Rules are designed to make sure creditors are investigating the identity of the individuals to whom they extend credit. The broad definition of “creditor” includes finance companies, car dealers, mortgage brokers, utility companies, telecommunications companies, and non-profit and government entities that defer payment for goods and services.

The Rules are flexible depending on the size and nature of the financial institution or creditor and include 26 possible “red flags” to be identified in a written identity theft prevention program, including:

• Forged applications
• Suspicious documents, personal identifying information, or addresses
• Change of address followed by a request for a new credit card
• Consumer reporting agency alerts or warnings
• Identical social security numbers supplied by different customers
• Customers not receiving account statements; and
• Inactive accounts

Financial institutions and creditors must have a written program that detects red flags in connection with a covered account by November 1, 2008. Failure to comply could result in monetary fines and enforcement actions. Furthermore, companies that unwittingly facilitate identity theft are often subject to significant negative media attention. Some commentators suspect that the Red Flag Rules will eventually become the standard of care for determining whether a company has negligently contributed to identity theft.
 

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