Securities Mosaic® Blogwatch
December 17, 2014
Sullivan & Cromwell discusses FDIC Final Rule Issued to Align the Deposit Insurance Assessment System with Basel III Capital Rules
by H. Rodgin Cohen

On November 18, 2014, the Federal Deposit Insurance Corporation (the "FDIC") published a final rule (the "Final Rule") modifying certain elements of its deposit insurance assessment system for insured depository institutions ("IDIs").[1] The Final Rule amends the FDIC's 2011 revised methodology for determining insurance assessment rates both for large institutions and for highly complex institutions (the "2011 Assessments Rule")[2]—the so-called "scorecard" method that is currently used to calculate assessment rates for these institutions. The Final Rule indicates that it is intended to align the deposit insurance assessment system for all IDIs - including advanced approaches banking organizations - with the standardized approach (the "Standardized Approach") under the new U.S. Basel III-based revised capital rules (the "U.S. Basel III Capital Rules"),[3] which were adopted by the Federal banking agencies in 2013.[4]

The scorecards for both large and highly complex institutions introduced in the 2011 Assessments Rule use quantitative measures in attempting to predict a large institution's long-term performance. The scorecard for highly complex institutions, however, includes additional measures, such as (i) the ratio of top 20 counterparty exposures to Tier 1 capital and reserves and (ii) the ratio of the largest counterparty exposure to Tier 1 capital and reserves. The methodology used to calculate exposure is the sum of exposure at default associated with derivatives trading and securities financing transactions ("SFTs") and the gross lending exposure for each counterparty or borrower.

Although the Final Rule largely adopts the FDIC's rule as originally proposed (the "Proposed Rule"),[5] the Final Rule includes the following modifications in response to comments received by the FDIC:[6]

  • Allows highly complex institutions to reduce their scorecard counterparty exposure amount associated with derivative transactions by the amount of cash collateral that is all or part of variation margin that satisfies the same conditions that would allow such collateral to be excluded
    from the institution's total leverage exposure for purposes of the U.S. supplementary leverage ratio.[7] This calculation, however, differs from the applicable methodology in the Standardized Approach, which permits other types of collateral to reduce an institution's derivative counterparty exposure.
  • Provides that any changes to the conversion of the counterparty exposure measures to scores (that is, recalibration of the minimum and maximum cut-off values) will be done through a future notice-and-comment rulemaking. The minimum and maximum cut-off values are used to scale the exposure measures across highly complex institutions so that an institution's score is determined relative to other highly complex institutions. The FDIC adjusts the minimum and maximum cut-off values as it collects additional data that affect what the cut-off values should be. For example, as exposures to central counterparties ("CCPs") increase, the existing cut-off values, which were established before clearing mandates came into effect, may need to be adjusted. The FDIC continues to reserve the general right to update the minimum and maximum cut-off values for all other measures in the scorecards without additional notice-and-comment rulemaking.
  • Allows custodial banks to continue to deduct from their assessment base certain securitization exposures that have a risk weight of 20% under the Standardized Approach. The Proposed Rule would not have permitted custodial banks to deduct any assets that qualify as securitization exposures from the assessment base.

The Final Rule largely rejects the comments received, in particular with respect to better aligning the proposal with actual economic risk, and thereby continues to shift the burden of deposit premium assessments to the largest banks. In particular, the Final Rule continues to require exposures to non-U.S. sovereigns, affiliates and CCPs, including default fund contributions to CCPs, to be included as counterparty exposures. In addition, the Final Rule, consistent with the Proposed Rule, eliminates the internal model method ("IMM") option for measuring counterparty exposure. The rejection of the previously adopted more risk sensitive IMM for these purposes, even when the models involved would require regulatory approvals, underscores the growing skepticism of some in the regulatory community of models-based approaches.

Except as noted above, the Final Rule is consistent with the Proposed Rule. Specifically, the Final Rule revises the ratios and ratio thresholds for "well-capitalized," "adequately capitalized," and "undercapitalized" evaluation categories used in the FDIC's risk-based deposit insurance assessment system to conform to the prompt corrective action ("PCA")[8] capital ratio thresholds adopted by the Federal banking agencies as part of the U.S. Basel III Capital Rules. Additionally, the Final Rule expands the category of liquid assets that a custodial bank may deduct from its total average consolidated assets at 50% to include those assets with a Standardized Approach risk weight greater than 0% and up to and including 20%, in order to include cleared transactions with Qualified Central Counterparties, which carry 2% or 4% risk weights.[9] Custodial banks may continue to deduct 100% of liquid assets with a Standardized Approach risk weight of 0%.

The Final Rules will be effective on January 1, 2015, except with respect to the supplementary leverage ratio equivalent PCA requirement, which does not become effective until January 1, 2018, the effective date under the U.S. Basel III Capital Rules.



[1] FDIC, Assessments (Nov. 18, 2014), available at

[2] 76 Fed. Reg. 10,672 (February 25, 2011). The FDIC amended Part 327 in a subsequent final rule by revising some of the definitions used to determine assessment rates for large and highly complex insured depository institutions. 77 Fed. Reg. 66,000 (Oct. 31, 2012). The term "2011 Assessments Final Rule" includes the October 2012 final rule. Under the 2011 Assessments Final Rule, a "large institution" generally is an IDI with assets of $10 billion or more and a "highly complex institution" generally is an IDI (i) with assets of $50 billion or more that is controlled by a holding company with assets of $500 billion or more or (ii) that is a processing bank or trust company with assets of $10 billion or more and fiduciary assets of $500 billion or more. The Final Rule does not change those definitions.

[3] The "U.S. Basel III Capital Rules" refer to those rules issued by the Federal banking agencies that replace the agencies' Basel I-based generally applicable risk-based capital rules. Among other things, the U.S. Basel III Capital Rules create the Standardized Approach for non-advanced approaches banking organizations to measure credit risk, which is based in substantial part upon the Basel II standardized approach capital rules that were never adopted for U.S. banking organizations. Additionally, under section 171 of the Dodd-Frank Act - the so-called "Collins Amendment" - this generally applicable standardized approach serves as a risk-based capital floor for banking organizations subject to the advanced approaches risk-based capital rules. Under the U.S. Basel III Capital Rules effective January 1, 2015, the minimum capital requirements as determined by the regulatory capital ratios based on the standardized approach become the "generally applicable" capital requirements under the Collins Amendment.

[4] The FDIC adopted an interim final rule on September 7, 2013 and published a final rule on April 14, 2014 that, in part, revised the definition of regulatory capital. 78 Fed. Reg. 55,340 (Sept. 10, 2013) and 79 Fed. Reg. 20,754 (Apr. 14, 2014). The Federal Reserve and OCC adopted a final rule in October 2013 that is substantially identical to the FDIC's interim final rule and final rule. 78 Fed. Reg. 62,018 (Oct. 11, 2013).

[5] Sullivan & Cromwell LLP, Deposit Insurance Assessment System: FDIC Proposes Changes to Ratios and Ratio Thresholds to Align the Deposit Insurance System with U.S. Basel III Capital Rules (July 21, 2014), available at

[6] See, e.g., Letter from The Clearing House to the FDIC (Sept. 22, 2014), available at

[7] In general, the conditions are that: (1) for derivative contracts that are not cleared through a Qualified Central Counterparty, the cash collateral received by the recipient counterparty is not segregated (by law, regulation or an agreement with the counterparty); (2) variation margin is calculated and transferred on a daily basis on the mark-to-fair value of the derivative contract; (3) the variation margin transferred under the derivative contract or the governing rules for a cleared transaction is the full amount that is necessary to fully extinguish the net current credit exposure to the counterparty of the derivative contract, subject to the threshold and minimum transfer amounts applicable to the counterparty under the terms of the derivative contract or the governing rules for a cleared transaction; (4) the variation margin is in the form of cash in the same currency of settlement set forth in the derivative contract, provided that for the purposed of this paragraph, currency of settlement means any currency for settlement specified in the governing qualifying master netting agreement and the credit support annex to the qualifying master netting agreement, or in the governing rules for a cleared transaction; (5) the derivative contract and the variation margin are governed by a qualifying master netting agreement between the legal entities that are the counterparties to the derivative contract or by the governing rules for a cleared transaction, and the qualifying master netting agreement or the governing rules for a cleared transaction must explicitly stipulate that the counterparties agree to settle any payment obligations on a net basis, taking into account any variation margin received or provided under the contract if a credit event involving either counterparty occurs; (6) the variation margin is used to reduce the current credit exposure of the derivatives contract and not the potential future exposure; and (7) for the purpose of the calculation of the net-to-gross ratio, variation margin may not reduce the net current credit exposure or the gross current credit exposure. See 12 C.F.R. § 324.10(c)(4)(ii)(C)(1)-(7) (FDIC); 12 C.F.R. § 3.10(c)(4)(ii)(C)(1)-(7) (OCC); and 12 C.F.R. § 217.10(c)(4)(ii)(C)(1)-(7) (Federal Reserve). "Qualified Central Counterparties" are central counterparties that meet the standards established by the Committee on Payment and Settlement Systems (CPSS) and International Organization of Securities Commissions (IOSCO). See 78 Fed. Reg. at 62,097 and 78 Fed. Reg. at 55,414.

[8] Section 38 of the Federal Deposit Insurance Act (the "FDIA") directs the Federal banking agencies to take "prompt corrective action" to resolve the problems of IDIs at the least cost to the Deposit Insurance Fund. The five PCA categories under Section 38 of the FDIA are: "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized," and the FDIC is required to take certain actions (such as limits on capital distributions) if an IDI becomes undercapitalized. The Federal banking agencies have established capital thresholds for each of the PCA categories using the following capital measures: leverage ratio, Tier 1 risk-based capital ratio, total risk-based capital ratio, and common equity Tier 1 capital ratio. Additionally, the PCA leverage measure for advanced approaches IDIs includes the supplementary leverage ratio. 12 C.F.R. § 208.43.

[9] See 78 Fed. Reg. 62,184-85 and 78 Fed. Reg. 55,502.

The full and original memo was published by Sullivan and Cromwell on November 24, 2014 and is available here.

December 17, 2014
The Revolving Door And Steve Cohen
by David Zaring

The Times reports:

The billionaire investor, who managed to fend off a criminal insider trading investigation of himself, if not of his former hedge fund, is looking for a former prosecutor and several agents from the Federal Bureau of Investigation to join his new $10 billion investment firm, Point72 Asset Management, said several people briefed on the matter, who spoke on the condition of anonymity.

Look, one of the reasons to feel good about the revolving door is that it salts financial institutions with people who expect law compliance. So maybe that explains this development, and we should celebrate Cohen's search for g-men. Or maybe it is, as the Times reports, that he was heartened by the insider trading ruling of the Second Circuit requiring the trader to know both that he was trading on inside information and that the information was obtained in exchange for a benefit, and just wants to grow the enterprise on a number of different fronts.

I'm not sure he should be too heartened by that ruling. It only may free one of his convicted lieutenants, and certainly wouldn't do anything about Matthew Martoma, who both paid for and traded on information provided by a pharma insider.

December 17, 2014
SEC Continues To Focus On Microcap Fraud
by Tom Gorman

The Commission continues to focus on microcap fraud actions with two new manipulation cases involving penny stocks. In one a former registered representative acted as an unregistered broker and then engaged in a series of wash sales. In the Matter of Paul J. Pollack, Adm. Proc File No. 3-16316 (December 16, 2014). In the other an oil and gas company and five executives manipulated the share price of the company. SEC v. Blackburn, Civil Action No. 4:14-cv-00812 (E.D. Tex. Filed December 15, 2014).

Mr. Pollack and his controlled entity, Montgomery Street Research LLC, are Respondents in an action centered on alleged violations of Exchange Act Sections 10(b) and 15(a). While Mr. Pollack was a registered representative, he has never been registered with the Commission as a broker. Montgomery claims to provide equity research and consulting services.

In March 2010 Montgomery entered into a three year Letter Agreement with Company A to provide general advice on growth strategies and "position within the public capital markets." The focus of the undertaking was to raise money in the capital markets and introduce potential investors to the company. From November through April 2011 Respondents helped effect transactions for the company in its common stock. As a result of efforts by Respondents, nine investors purchased $445,000 of the company's common stock. This represented about 74% of the total offering.

Later in 2011 Respondents again solicited prospective investors for the firm, this time to acquire shares of preferred stock. About $5.2 million was raised in the offering. Approximately 40% came from the efforts of Respondents. At the conclusion of this offering it was agreed that Respondents would be paid 5% of the value of the preferred stock.

Mr. Pollack also controlled about 665,000 shares of the firm's common stock through the Letter Agreement. From December 2010 through October 2012 he had exclusive trading authority over ten online brokerage accounts at five brokers. During the period he used the accounts to purchase about 5.3 million shares of the company while selling about 5.6 million. These transactions yielded over $800,000 in net proceeds. Over a period of 300 trading days Mr. Pollack conducted 4,341 transactions. On some days accounts under his control accounted for over 90% of the reported trading volume.

During the period July 2011 through June 2012 eight of the accounts controlled by Mr. Pollack engaged in wash trading. The creation of this false activity created upward pressure on the share price. None of the 100 wash trades by various controlled entities resulted in a change of beneficial ownership. The transactions resulted in net trading proceeds of about $369,686.23. The proceeding will be set for hearing.

Blackburn centers around a scheme created by convicted felon Ronald Blackburn, Treaty Energy Corporation and its executives - Andrew Reid, CEO, Bruce Gwyn, co-CEO, Michael Mulshine, corporate secretary and Lee Schlesinger, CIO, each named as a defendant. Samuel Whitley, outside securities counsel is also named as a defendant.

The company was formed in December 2008 through a reverse-merger of a private oil and gas company and a dormant public shell by Mr. Blackburn. Its shares, 86% of which were controlled by Mr. Blackburn, were quoted on the OTC Bulletin Board. While the other defendants were appointed to various positions at the company, Mr. Blackburn controlled the firm behind the scenes - a fact not disclosed in its Commission filings.

In April 2010, through a joint venture agreement, Treaty obtained the drilling rights in Belize . Press releases were issued touting the merits of the program in July 2011. Later that year the company hired a stock promoter to post misleading information on message boards. The hype regarding the drilling program culminated in January 2012 with a press release announcing that Treat stuck Oil. The press release claimed the well had an estimated 5 to 6 million barrels of recoverable oil. The stock price shot up by 79.3% in one day. The announcement was false, according to the complaint. The same day the release was issued, a government agency in Belize published a release refuting the claim of the company. Nevertheless, Mr. Blackburn and the company officers continued to tout the claimed oil strike. A second release by the company again touting the strike halted the share price decline. The price did not return to pre-announcement levels for a months.

Between 2009 and 2013 Mr. Blackburn and others sold shares of the company in an unregistered public offering and using a Form S-8 to distribute shares to ineligible persons. About $3.6 million was raised from 90 investors.

By June 2013 Treaty depleted all of its authorized shares. Subsequently, the firm began offering investors oil and gas working interests in a well located in West Texas. Investors were told that the well had an initial production rate of 62 barrels per day with a life span of 20 years and that the investment was low risk. In reality the well produced far less. Nevertheless, 19 investors paid about $565,000 for interests. While the investors were told the funds would be invested in current oil and gas filed development much of the money was misappropriated.

The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 13(a) and 16(a). The case is in litigation. See Lit. Rel. No. 23158 (December 15 2014).

December 17, 2014
Transcript: Proxy Access: A New World of Private Ordering
by Broc Romanek

We have posted the transcript for our recent popular webcast: "Proxy Access: A New World of Private Ordering."

I'm not a big SNL fan - but this recent bit about hobbits in the style of "The Office" is hilarious. Gandalf is Michael Scott; Gollum is Dwight...

A Rare No-Action Letter on Reg S

This new Bookbuilds no-action letter released by Corp Fin recently is nothing special as just applies to very narrow circumstances. But it's noteworthy only because it is a rare no-action letter under Reg S. There are just a handful of Reg S letters since adoption in 1990...

Thanks for the Gumball Mickey – Cooley, Palo Alto

In this 20-second video, the fine lawyers at Cooley in Palo Alto pay homage to the old Hasbro TV commercial. A real gumball machine in this one.

– Broc Romanek

December 17, 2014
Fee Shifting Bylaws and the "Supporting" Rationale (Part 1)
by J Robert Brown Jr.

Fee shifting bylaws have their supporters. Certainly those who benefit from them are supportive. They will reduce the number of law suits against directors and corporations. The Chamber supports this, having opposed the efforts by the Delaware legislature to do away with the bylaws. So does Steve Bainbridge.  

No one gives as a reason the need to insulate directors from liability for their bad acts. Instead, proponents of the bylaws argue that they are necessary to prevent frivolous or excessive litigation. Steve's post is titled "The case for allowing fee shifting bylaws as a privately ordered solution to the shareholder litigation epidemic." So bylaws are a solution to the "litigation epidemic."  

His post mostly focuses on litigation under the federal securities laws. His argument that securities cases are filed in excessive numbers is weak. He notes a number of studies from 2006 to 2007 that suggest the amount of securities litigation is excessive. These studies were always open to question. The idea that the decline in foreign listings on the stock exchanges could be explained by the fear of litigation risk (rather, say, than the increased quality of the exchange in the home market), was always questionable. But in any event the studies are based on data that is no longer accurate.

Thus, Steve notes the following: "Between 1997 and 2005 there was a steady increase in both the number of securities class action filings and the average settlement value of those suits." During the selected period, approximately 250 securities class action suits were filed each year - an average increased by the 498 actions filed in 2001 as a result of the raft of IPO allocation cases (The data is on the Stanford Securities Class Action Site). But an examination of the data since 2005? The nine year average from 2006 through Dec. 14, 2014 is 166, with 2014 on course to have the second lowest number of securities class action laws suits (144) since 1996.  

The numbers have likely come down because of the PSLRA (cases being dismissed for failing to demonstrate a "strong inference" of scienter) and the Supreme Court (Janus, for example). His analysis, therefore, does not take into account recent data, does not establish that there is a litigation epidemic, and certainly doesn't explain how the market will benefit from reducing the number of class actions below 144. Indeed, he concedes the "obvious benefits" of an "effective anti-fraud regime."    

December 16, 2014
No Knowledge, No Jail: Second Circuit Clarifies Scope of Tippee Insider Trading Liability
by Jason M. Halper

On December 10, 2014, the Second Circuit issued an important decision (U.S. v. Newman, No. 13-1837, 2014 WL 6911278 (2d Cir. Dec. 10, 2014)) that will make it more difficult in that Circuit for prosecutors, and most likely the SEC, to prevail on a "tippee" theory of insider trading liability. Characterizing the government's recent tippee insider trading prosecutions as "novel" in targeting "remote tippees many levels removed from corporate insiders," the court reversed the convictions of two investment fund managers upon concluding that the lower court gave erroneous jury instructions and finding insufficient evidence to sustain the convictions. The court held, contrary to the government's position, that tippee liability requires that the tippee trade on information he or she knows to have been disclosed by the tipper: (i) in violation of a fiduciary duty, and (ii) in exchange for a meaningful personal benefit. Absent such knowledge, the tippee is not liable for trading on the information.

Tippee liability differs from "classical" or "misappropriation" theories of insider trading, where the person trading on inside information is a corporate insider or one who misappropriates non-public information from a company. A tippee's liability, in contrast, "derives only" from the insider's fiduciary duty and not from trading on inside information. As articulated in 1983 by the Supreme Court in Dirks v. SEC, 463 U.S. 646, 647 (1983), tippee liability requires that: (i) the tipper "has breached his fiduciary duty to the shareholders by disclosing the [material nonpublic] information to the tippee"; (ii) the tippee "knows or should know that there has been a breach"; (iii) the tippee trades on the basis of the transaction; and (iv) the tipper receives some personal benefit in return for the disclosure.

Newman arose out of the U.S. Attorney's Office for the Southern District of New York's high-profile probe into suspected insider trading at hedge funds. In January 2012, that Office brought insider trading and conspiracy charges against Todd Newman and Anthony Chiasson, portfolio managers at two hedge funds, Diamondback Capital Management and Level Global Investors. According to the government, lower-level financial analysts at Diamondback and Level Global received nonpublic earnings information from insiders at two public technology companies, and passed this information on to their portfolio managers (including Newman and Chiasson), who then executed trades on the basis of this information. The prosecution of Newman and Chiasson was noteworthy given the remoteness of the defendants from the corporate insiders: the earnings information was passed through several third-party analysts before it came to anyone at Diamondback or Level Global, meaning that Newman and Chiasson were three or four levels removed from the inside tippers.

At trial, the defendants moved for a judgment of acquittal, arguing that the government had offered no evidence that the corporate insiders provided the information "in exchange for a personal benefit," and even if they had, there was no evidence that Newman or Chiasson knew about it. Alternatively, defendants requested a jury instruction that, to prevail, the government must have proved that Newman and Chiasson knew that the tipper disclosed confidential information "for personal benefit." The district court (Judge Richard Sullivan, S.D.N.Y.) denied the motion for a judgment of acquittal, and rejected defendants’ requested instruction. Instead, the court instructed the jury that, in order to obtain a conviction, the prosecution must only prove that defendants knew the information was disclosed "in violation of a duty of confidentiality." The jury returned a verdict of guilty on all counts, and in May of last year, the court sentenced Newman and Chiasson to prison for more than four and six years, respectively, and imposed multi-million dollar fines and forfeitures. The defendants appealed.

In its opinion, the Second Circuit vacated Newman and Chiasson's convictions. First, the appellate court found that an insider breaches a fiduciary duty only when he or she discloses inside information in exchange for a personal benefit. In other words, the exchange of confidential information for personal benefit is not separate from the breach, but instead "is the fiduciary breach." As a result, the rule articulated in Dirks—that tippees (here, Newman and Chiasson) may be liable only when the tippee knows of the insider's breach—necessarily means that tippee liability requires knowledge that the insider disclosed information in exchange for personal benefit. The district court erred by not instructing the jury that "the government had to prove beyond a reasonable doubt that Newman and Chiasson knew that the tippers received a personal benefit for their disclosure."

Second, the appellate court found insufficient evidence for the jury to find that the corporate insiders received a benefit or that the tippees knew of such a benefit. The court observed that while the benefits need not be "immediately pecuniary," they must be "of some consequence." Here, the government's evidence of personal benefits amounted to no more than "career advice" and friendship, and all parties denied that any quid pro quo existed. The court, citing Dirks, also rejected the premise that an insider who discloses confidential information necessarily does so for personal benefit. Finally, the court rejected the government's argument that the timing and specificity of the information provided to the tippees supported an inference that the tippees had the requisite knowledge. For instance, the defendants presented evidence showing that their internal financial models run prior to receiving any inside information produced results that were "very close" to the company's actual reported earnings. This and other evidence undermined any suggested inference of guilt on the part of the tippees.

Reactions to the decision were swift and numerous. Lawyers for the defendants described the ruling as a "resounding victory for the rule of law" and "vindication" of their clients. On the other hand, the U.S. Attorney, Preet Bharara, condemned the court's "narrow" decision, stating that it will "limit the ability to prosecute people who trade on leaked inside information." SEC Chair Mary Jo White echoed that assessment, indicating her concern that the Second Circuit took "an overly narrow view of the insider trading law."

The U.S. Attorney's office in the Southern District of New York has made insider trading prosecutions, and in particular prosecutions of tippees, a centerpiece of its enforcement strategy. Wednesday's ruling dealt that strategy a substantial blow. Several high profile cases currently pending at the trial or appellate level raise similar issues and may result in vacated convictions or acquittals. For example, the conviction of Michael Steinberg, formerly of SAC Capital Advisors, earlier this year on similar charges is now decidedly in doubt. The Newman decision also reduces risk to individuals who trade on inside information in certain circumstances. Even if an outsider knows that information they receive is "inside" information, he or she does not face liability unless the outsider knows that the information was disclosed by the insider in exchange for personal benefit.

December 16, 2014
Wachtell Lipton discusses Second Circuit Decision Overturning Insider Trading Convictions
by John F. Savarese

[On December 10, 2014] the Second Circuit Court of Appeals issued an important decision overturning the insider trading convictions of two portfolio managers while clarifying what the government must prove to establish so-called "tippee liability." United States v. Newman, et al., Nos. 13-1837-cr, 13-1917-cr (2d Cir. Dec. 10, 2014). The Court's decision leaves undisturbed the well-established principles that a corporate insider is criminally liable when the government proves he breached fiduciary duties owed to the company's shareholders by trading while in possession of material, non-public information, and that such a corporate insider can also be held liable if he discloses confidential corporate information to an outsider in exchange for a "personal benefit."

In reversing these convictions, however, the Court clarified that a "tippee" (i.e., an outsider who receives confidential corporate information) can be found criminally liable only if the government establishes that he knew of the tipper's "personal benefit" and that the benefit is "objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature." In reaching this result, the Court chastised "the doctrinal novelty" of the government's recent insider trading prosecutions that have, in the Court's words, "increasingly targeted... remote tippees many levels removed from corporate insiders," and pointedly noted that the government had not been able to cite "a single case in which tippees as remote [as the two defendants] have been held criminally liable for insider trading."

The Court of Appeals' opinion sets forth a careful review of the Supreme Court's insider trading precedents, concluding that, in order to sustain an insider trading conviction, the government must prove beyond a reasonable doubt that the tippee knew not only (1) that an insider "disclosed confidential information," but also (2) that the insider "did so in exchange for a personal benefit." The Court rejected the government's theory that proof of the first element alone was sufficient to sustain a conviction. In the case of Messrs. Newman and Chiasson, the Court found the evidence presented at trial insufficient to sustain their convictions for two reasons: first, the government failed to show that the tippers themselves had received a personal benefit from which the tippees' liability could be derived; and second, the government failed to show that the defendants knew that the information obtained from insiders had been "divulged [in exchange] for personal benefit."

In a broad discussion that will certainly have an impact on other prosecutions, the Court emphatically rejected the various forms of proof of a supposed "personal benefit" offered by the government, including evidence that the corporate tipper and immediate tippee were "alumni of the same school," "attended the same church," or on occasion "swapped career advice." While recognizing that personal benefit is broadly defined to include "not only pecuniary gain," but also "reputational benefit," the Court made clear that this otherwise permissive standard does not enable the government to prove receipt of a personal benefit "by the mere fact of a friendship, particularly of a casual or social nature." As the Court explained, if that were enough, "practically anything would qualify." Rather, proof of "a relationship between the insider and the recipient that suggests a quid pro quo" or "an intention to benefit the [tippee]" is required.

The Court's decision narrows the universe of cases in which a successful insider trading prosecution may be brought against a tippee. At the same time, we caution against reading too much into this case. The defendants were third- and fourth-level tippees - that degree of attenuation between the source of information and the trading makes the government's burden in satisfying the standard articulated by the Court particularly difficult. Previous successful insider trading prosecutions have generally involved a closer connection between the source of information and the trading.

Notwithstanding the continuing development of the law of tippee liability, it is of course critical that companies and individuals in possession of confidential information maintain their vigilance with respect to insider trading compliance. The government remains intensely focused on cracking down on unlawful insider trading (see our prior memo, here), and that focus is unlikely to abate as a result of this setback.

The full and original memorandum was circulated by Wachtell, Lipton, Rosen & Katz on the day of the decision, December 10, 2014.

December 16, 2014
AICPA, SEC Discuss COSO Transition
by Edith Orenstein

While the U.S. Securities and Exchange Commission has yet to give industry a deadline to switch to a new internal control framework, auditors should question their clients' "tone at the top" if they haven't made significant headway in a voluntary move to the standards.

"If organizations have not transitioned - and not for good sound business reasons - I would think about whether or not that impacts my assessment of controls in tone at top," said AICPA vice president and COSO Board Member Chuck Landes, at the AICPA's Annual Conference on Current SEC Developments last week."If somebody is just blowing off making that transition, that is some evidence that tone at the top is not where it should be and is not tone that would support an effective system of internal control."

No SEC 'Deadline' Yet, But...

At the event practitioners and regulators discussed the transition to the Committee of Sponsoring Organizations of the Treadway Commission's (COSO's) updated internal control framework published in 2013 ("COSO 2013").

Officials speaking at the conference responded to questions about whether there was an SEC "deadline" for companies and their auditors to switch from the 1992 COSO framework to COSO 2013.

"We have not yet set a particular deadline," SEC Deputy Chief Accountant Brian Croteau told attendees. However, if the switch to COSO 2013 is not accomplished by the Dec. 15, 2014 transition date, "I would envision you would see comments from Corp Fin," Croteau explained. He added, "for this year-end, I wouldn't expect you'd see questions from SEC staff."

Although the SEC may give companies a pass this year on whether they have completed their move to COSO 2013, Landes advised auditors that they should ask questions of their clients and consider the nature of why the client has not yet moved to the new COSO framework.

During his prepared remarks Croteau spoke at length about continuing concerns regarding potential underreporting or misreporting of material weaknesses in internal control over financial reporting (ICFR).

Speaking on a separate panel at the conference, Senior Associate Chief Accountant Kevin Stout devoted his entire remarks to internal control over financial reporting, acknowledging there has been a "recent focus on the impact of immaterial errors on ICFR through the Disclosure Review Program," but adding the focus on ICFR "is not intended to be a 'gotcha' exercise."

One of the most talked about elements of Stout's speech was what he termed "the could factor."

Specifically, Stout suggested companies consider how an internal control weakness relating to an immaterial misstatement could potentially cause a material misstatement if circumstances were to change. He also said that companies should consider whether a lack of resources or other control environment factors leading to an 'immaterial' misstatement could raise questions about "what other amounts or disclosures could be impacted by the lack of resources and how the Control Environment and Risk Assessment components of COSO had been evaluated."

Mike Maloney, Chief Accountant in the SEC's Division of Enforcement, emphasized the importance of ICFR as well. "The risk of weak or nonexistent internal controls can be very impactful," Maloney noted, imploring preparers, auditors and audit committees to "stay very vigilant" in addressing ICFR weaknesses.

Some Opt to Adopt in 2015; 'Switching Back' Raises Questions

Without a mandate from the SEC to transition to COSO 2013 this year - and with the 1992 COSO framework still a recognized framework for purposes of Sarbanes-Oxley assertions - some companies are opting to fully adopt the new COSO framework in 2015 opening up the questionof what the "effective date" for regulatory purposes.

"We've received emails and letters asking COSO to extend the effective date," Landes said. "We have no authority, we are not standard-setters; it isn't something within our power to extend the effective date."

As noted in a widely cited speech earlier this year by PCAOB Board Member Jeanette Franzel, companies are being strongly encouraged to use the opportunity of implementing COSO 2013 as more than just a 'checklist' exercise, but also to look for areas where controls could be improved.

As a practical matter, many companies may be running COSO 2013 and COSO 1992 on parallel tracks as part of the transition process, until they are satisfied they are ready to switch.

"Some have asked if they switch to COSO 2013, and find a material weakness, can they switch back?" SEC's Croteau said. "It would be surprising to me if you found a material weakness under the new COSO framework that wasn't (there) under the old."

Landes agreed, saying, "Anecdotally, we've heard some people say 'well, I'm not sure I can pass under the 2013 framework. If you can't pass under [the] 2013 [framework], I'm not sure how you could under '92."

Other Audit Considerations

PwC Partner Stephen Soske, speaking on the same AICPA panel, aid that his firm is strongly recommending that clients use the updated framework for periods ending after Dec. 15, 2014.

However, he added, "Some companies, because of sound business reasons, have decided to adopt [the 2013 framework] in the future," Soske said. "We would respect that. We would follow our client's lead," s

Soske added that, in accordance with PCAOB rulemaking, the auditor would apply the same generally accepted control framework that management does.

Additional insights from the COSO panel at last week's AICPA conference can be found in: COSO Internal Control Patrol Says Mind Your ELCs, POFs, OSPs.

COSO Chairman Robert (Bob) Hirth is slated to speak on a December 16 webcast sponsored by FEI and BlackLine Systems.. Hear what Hirth has to say on the day after COSO's December 15 'transition' date, along with insights from Grant Thornton Partner Mike Rose and BlackLine System's Susan Parcells.


The post AICPA, SEC Discuss COSO Transition appeared first on Financial Executives International Daily.

December 16, 2014
Guest Post: Second Circuit Rules for Defendants in Landmark Insider Trading Case
by Kevin LaCroix

In the following guest post, Susanna Buergel, Charles Davidow, Andrew Ehrlich, Brad Karp, Daniel Kramer, Richard Rosen and Audra Soloway, all of whom are litigation partners at Paul, Weiss, Rifkind, Wharton & Garrison LLP who are members of the Firm's Securities Litigation Practice group explain the significance of the Second Circuit's decision United States v. Newman. A version of this article previously appeared as a Paul, Weiss client alert. Mark Pomerantz, a retired Paul, Weiss partner, argued the appeal for co-defendant Anthony Chiasson.

I would like to thank Richard Rosen of the Paul Weiss law firm for submitting this article as a guest post. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post. Here is the guest post from the Paul Weiss law firm.


Last week, the United States Court of Appeals for the Second Circuit issued a long-anticipated ruling dismissing with prejudice indictments against two insider trading defendants in United States v. Newman. Two aspects of the decision are particularly important. First, the Court ruled that the government must prove that a remote tippee knows of the personal benefit received by a tipper in exchange for disclosing nonpublic information. Second, the Court held that the government must prove that the personal benefit is "of some consequence," and determined that the benefits alleged by the government in United States v. Newman were not sufficient to support a conviction. The ruling likely will have major ramifications for the future prosecutions of insider trading cases in the Second Circuit.

The Newman and Chiasson Case

In United States v. Newman, the Second Circuit considered appeals from the insider trading convictions of Todd Newman, a former portfolio manager at Diamondback Capital Management, LLC, and Anthony Chiasson, a former portfolio manager at Level Global Investors, LP.[i] Newman and Chiasson were accused of trading Dell and NVIDIA securities based upon material, nonpublic information they received from their respective analysts. According to the testimony elicited during trial, the allegedly material, nonpublic information originated within Dell and NVIDIA, but it passed through numerous intermediaries before it was received by Newman and Chiasson, who contended that there was insufficient evidence that the tipper received any personal benefit in exchange for the tip, and, in any event, that they certainly did not know of any such benefit. Newman and Chiasson were each convicted after a five-week trial. They appealed to the Second Circuit, arguing, among other points, that they were convicted based on an improper jury instruction and that the evidence was insufficient to support their convictions.

The Supreme Court's Decision in Dirks v. SEC

The Second Circuit agreed with Newman and Chiasson, concluding that the jury instructions were improper and that the evidence was insufficient to sustain a conviction. The opinion turned on the Court's reading of Dirks v. SEC, a thirty-one-year old Supreme Court decision. 463 U.S. 646 (1983).

In Dirks, the Supreme Court held that, under the "classical theory" of insider trading liability,[ii] tippers are liable - and, by extension, tippees are liable - only when tippers breach a duty to the shareholders of a publicly traded company. Dirks, 463 U.S. at 660. Before deciding Dirks, the Supreme Court had held in Chiarella v. United States that, without more, trading on material, nonpublic information is not illegal, as there is no "general duty between all participants in market transactions to forgo actions based on material, nonpublic information." 445 U.S. 222, 233 (1980). Dirks built on Chiarella by setting forth when a tippee has a duty to disclose or abstain from trading on material, nonpublic information: a duty arises "only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know there has been a breach." Dirks, 463 U.S. at 660. Put another way, the tippee's duty derives from the tipper's duty, and the tipper's duty is created because of a fiduciary relationship with shareholders.

Further, according to Dirks, courts will look to whether the tipper received a personal benefit to determine if the tipper breached a duty by disclosing nonpublic information. Id. at 662. Courts have defined "personal benefit" quite broadly.

The Second Circuit's Opinion

In directing that the indictment be dismissed, the Court's opinion clarified the standard set out in Dirks. The Court - Circuit Judges Ralph K. Winter, Jr., Peter W. Hall, and Barrington D. Parker - held that a tippee must know of the personal benefit received by the tipper. The Court explained that it was not sufficient for the government to show that the tippee received information that was material and nonpublic, or that the tipper was an insider, or even that the tipper breached a duty to the source of the information. "[W]hile we have not yet been presented with the question of whether the tippee's knowledge of a tipper's breach requires knowledge of the tipper's personal benefit," the Court wrote, "the answer follows naturally from Dirks." Based on Dirks's explanation of the nature of an insider's fiduciary breach, "we conclude that a tippee's knowledge of the insider's breach necessarily requires that the insider disclosed confidential information in exchange for personal benefit."

In so holding, the Court once again rejected the notion that the federal securities laws require parity of information among investors. The opinion quoted some of the most important language from Dirks and Chiarella: that there is no "general duty between all participants in market transactions to forgo actions based on material, nonpublic information"; that the law does not require symmetry of information among all participants in the marketplace; that not every instance of "financial unfairness" is punishable under Section 10(b); and that insider trading liability exists only when a duty of confidentiality was breached in exchange for a personal benefit. As such, the Court held that the district court's instruction, which did not require the jury to find knowledge of a personal benefit, was erroneous, and, moreover, that the error was not harmless.

Further, the Court concluded that the evidence was insufficient to support the government's theory that the tipper received any personal benefit in exchange for providing inside information. Although the government contended that the evidence showed that the Dell tipper had sought career advice from the friend who was the initial tippee and that the NVIDIA tipper was a "family friend" of the initial tippee, the Court held that the "circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips." If the evidence of personal benefit proffered by the government was enough, the Court explained, "practically anything would qualify." For evidence of a personal benefit to be sufficient, the Court wrote, there must be "proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."

The Court also rejected the government's argument that the "specificity, timing, and frequency" of the information received by the defendants were so "overwhelmingly suspicious" that it provided support for the government's theory that the defendants must have known, or consciously avoided knowing, that the information they were receiving was coming from an insider in breach of his duties and that the tipper must have received a personal benefit. The Court reasoned that the financial estimates received by the defendants could also be obtained through "legitimate financial modeling using publicly available information and educated assumptions about industry and company trends." It noted trial testimony to the effect that companies' investor relations departments would routinely provide guidance to investment professionals about the accuracy of their models, and evidence showing that companies would routinely "leak" estimates of their earnings data in advance of earnings announcements. While explaining that there could be cases where a defendant receives information that is so "detailed and proprietary" to support an inference that the information must have come from an insider source, the Court concluded that the inference is "unwarranted" with respect to Newman and Chiasson, as they were several layers removed from the source of information and the information they received was similar to information they regularly received through legitimate means.


After Newman, it will be considerably more difficult for both the Justice Department and the SEC to win cases involving tips. In particular, the government will likely find it more challenging to prosecute remote tippees for insider trading, especially when the tippees are several levels removed from the source of the information. The opinion focused specifically on recent prosecutions fitting this description: "The Government's overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders."[iii] Additionally, it will be more difficult for the government to prove cases where the tipper does not receive money or other material consideration, but instead receives only an intangible benefit or the hope of a future benefit. In future decisions, courts will be forced to grapple with when such benefits support a finding that a trader has engaged in insider trading.

Because of its holdings regarding remote tippees and the personal benefit standard, the opinion has also clarified the rules for investment professionals who regularly trade on information obtained through the marketplace. It is now clear that the tipper must receive a personal benefit "of some consequence" to support a finding of insider trading liability. Additionally, the opinion provides that tippee liability exists only when the tippee knows or should know that the information was confidential and divulged for personal benefit. It is now evident that, going forward, the fact that a remote tippee receives improperly disclosed information, without more, will not be enough to support an insider trading case.

[i] Paul, Weiss was counsel for Anthony Chiasson on this appeal and was lead counsel at the Second Circuit argument.

[ii] Two theories of insider trading liability are available to prosecutors: the "classical theory" and the "misappropriation theory." The prosecutions of Newman and Chiasson were brought under the "classical theory" of insider trading liability, which applies when a "corporate insider trades in the securities of his corporation on the basis of material, nonpublic information." United States v. O'Hagan, 521 U.S. 642, 651-52 (1997). The "misappropriation theory," by contrast, applies when an investor "misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information." Id. at 652.

[iii] In the passage in the opinion before this sentence, the Court discussed how, in an attempt to demonstrate that it need not prove that tippees know of the personal benefit received by the tipper, the government's brief had parsed dicta from previous decisions.

December 16, 2014
The Political Economy and the Regulatory Sine Curve
by Usha Rodrigues

The answer to David's question, Will The Swaps Pushout Rule Die In The Cromnibus?, was... no!

Here's the bill itself. A short-and-sweet 5 pages, it exempts from 716 all "non-structured finance swap activities," and any structured finance swap that are for "hedging or risk management purposes" or later exempted by the relevant agencies in rulemaking. So there's still some room for industry lobbying at the agency rulemaking level, although it is a one-way ratchet that will only exempt more swaps from regulation.

Here is some commentary, via banking colleague and friend Mehrsa Baradaran:

I've been thinking a lot about the political economy, of which more later. In The Political Economy of Dodd-Frank, John Coffee basically responds to Steve Bainbridge, Roberta Romano, and the late, great, Larry Ribstein's fretting over bubble laws and quack federal intervention into corporate governance and securities laws by saying: don't worry, folks. Even if post-crisis regulation goes overboard, the regulators will inevitably step in and modulate."

I am no banking expert, but my sense for Dodd-Frank is that Coffee's so-called Sine Curve of agency-level deregulation has in fact occurred (e.g., the Volcker rule). Business as usual.

So why the banking industry's power play of asking for regulatory relief at the congressional level? American Banker above suggests it was a mistake to deviate from the standard playbook of fighting at the less-public agency level:

Observers said the fight was a public relations nightmare for Citigroup and the big banks. "They've taken a lot of reputational hits now, a lot of people saying, 'You're trying to blackmail us and not fund our government until you get your way,'" said Sheila Bair, the former chairman of the Federal Deposit Insurance Corp., in an interview on CNBC before the House vote.

My takeaway is that there's a tradeoff to the political economy. Legislation is attractive because it's virtually immune from judicial review--as opposed to time-consuming, D.C.-Circuit-vulnerable agency rulemaking. But lobbying at the agency level flies largely under the radar, and that's a very good thing post-crisis. My hunch is the banks calculated they could fly the Section 716 provision under the radar--just 5 pages in a big, big bill!

If so, clearly they were wrong--the question is whether the gain to their bottom line is worth the reputational hit. And Elizabeth Warren's reputational gain.

12/17/2014 posts

CLS Blue Sky Blog: Sullivan & Cromwell discusses FDIC Final Rule Issued to Align the Deposit Insurance Assessment System with Basel III Capital Rules
Conglomerate: The Revolving Door And Steve Cohen
SEC Actions Blog: SEC Continues To Focus On Microcap Fraud Blog: Transcript: Proxy Access: A New World of Private Ordering
Race to the Bottom: Fee Shifting Bylaws and the "Supporting" Rationale (Part 1)
Securities Litigation and Regulatory Enforcement Blog: No Knowledge, No Jail: Second Circuit Clarifies Scope of Tippee Insider Trading Liability
CLS Blue Sky Blog: Wachtell Lipton discusses Second Circuit Decision Overturning Insider Trading Convictions
Financial Executives International Daily » Financial Reporting: AICPA, SEC Discuss COSO Transition
The D&O Diary: Guest Post: Second Circuit Rules for Defendants in Landmark Insider Trading Case
Conglomerate: The Political Economy and the Regulatory Sine Curve

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