SEC Issues Interpretive Guidance on Satisfying Rule 144 Holding Periods for Common Stock Acquired in Exchange for Real Estate Investment Trust (REIT) Operating Partnership Units


In March, the U.S. Securities and Exchange Commission (SEC) issued a no-action letter regarding satisfaction of the required holding period under its Rule 144 safe harbor for certain resales of “restricted securities” without registration under the Securities Act of 1933 (the “Securities Act”), in the context of sales of common stock of a public real estate investment trust (REIT) acquired in exchange for the same REIT’s operating partnership (OP) units. In contrast to the SEC staff’s general position that a holder exchanging a security of one issuer for a security issued by a different (albeit related) entity may not satisfy the safe harbor’s requirements by “tacking” its holding period for the two securities, this letter affirmed that when REIT common stock is received by holders in exchange for OP units in a customary umbrella partnership real estate investment trust (UPREIT) structure, notwithstanding that the REIT and its OP are not the “same issuer,” such holders generally may count their holding period for the OP units, plus their holding period for the REIT common stock following such exchange, in determining whether they meet Rule 144’s holding period requirement.

The Basics

Generally, securities issued without registration – which is normally the case for OP units issued in exchange for real property as well as common stock that may be issued in exchange for OP units in a typical UPREIT structure – are classified as “restricted securities” under the Securities Act. In order to avoid Securities Act registration for the resale of restricted securities by not being classified as “underwriters” pursuant to the Rule 144 safe harbor, a holder must satisfy a number of requirements, including a requirement under Rule 144(d) that such securities have been held for a period of at least six months[1] before they are transferred or sold.

UPREIT partnership agreements typically require that OP units issued in exchange for a contribution of real property assets must be held for a specified period (usually one year) before they may be exchanged for REIT common stock, which represents an economic interest in the underlying portfolio of real estate assets substantially identical to that of the OP units. Notwithstanding this fact, prior to this no action letter informal SEC guidance under Rule 144 indicated the SEC would not allow holders to “tack” the holding periods of the two securities. Thus, the REIT common stock had to separately satisfy the Rule 144(d) holding period before it could be sold without registration under Rule 144.  Under this new guidance, the holding period generally will begin to run as soon as the OP units are acquired.

The Application

The guidance issued will be applicable to transactions that conform to the facts and circumstances addressed in the underlying no-action request submitted on behalf of Bank of America, N.A, Merrill Lynch, Pierce, Fenner & Smith Incorporated (“BAML”). Because that request did not address a particular REIT or transaction, however, it should be applicable for all exchanges of UPREIT OP units that conform to the four factors cited by the SEC as the basis for its grant of the required “no action” relief:

  • Unit holders must pay the full purchase price for the OP units at the time they were acquired from the OP[2];
  • An OP unit must be the economic equivalent of a share of REIT common stock, representing the same right to the same proportional interest in the same underlying pool of assets;
  • The exchange of REIT common stock for OP units must be at the discretion of the REIT; and
  • No additional consideration is required to be paid by the OP unit holders for issuance of the shares of REIT common stock in exchange for the OP units.

The SEC noted that absence of any of these factors could result in a different conclusion concerning the application of the Rule 144(d)(1) holding period to the exchanged shares.

What This Means to You

This guidance should benefit both REITs and the holders of their OP units by eliminating the need, in most cases, for a “selling stockholder” registration statement or prospectus to be filed under the Securities Act before the REIT common stock issued in exchange for OP units may be sold into the public market by the exchanging holder. Where exchanging holders of OP units have been granted the right to have the REIT register their securities for public resale under the Securities Act, such agreements typically provide that no registration statement need be filed, or that an existing resale registration may be discontinued, if the selling holders are able to utilize the Rule 144 safe harbor for their transactions. The elimination or significant reduction of such resale registration statement filings will save REITs both time and money, and may also avoid potential conflicts with primary offerings by the REIT, under a shelf registration statement or otherwise, in other capital raising transactions.

OP unit holders also benefit from this guidance, which provides additional flexibility and certainty concerning their ability to freely transfer REIT common stock acquired upon the exercise of OP unit exchange rights without the delays previously associated with waiting for a resale registration to be completed or for the full Rule 144 holding period to run after acquiring their stock.

[1] The six month holding period applies to securities of issuers that are SEC reporting companies and are current in their Exchange Act reporting requirements.  For non-reporting companies, or for any reporting company that is not current in its Exchange Act filings, the required holding period is one year.

[2] Based on the assumptions set forth in BAML’s request and the SEC’s response, it seems clear that this includes issuances in exchange for real property contributed to an UPREIT’s operating partnership.

SEC Adopts Rules to Permit Crowdfunding – What You Need to Know

Overview.  Last week, the Securities and Exchange Commission (SEC) adopted new rules permitting “crowdfunding,” a method for growing businesses to raise capital over the Internet by soliciting small investments from a large number of individuals.  The new rules are the final significant rulemaking procedure required by the Jumpstart of Business Startups (JOBS) Act of 2012 and aim to increase access to capital for new companies nationwide.

For Companies Seeking to Raise Capital.  The crowdfunding rules permit issuers to raise up to $1 million in a 12-month period through a funding portal registered with the SEC or through specific online broker-dealer platforms.  Only one offering through one intermediary platform is allowed at any time, and advertisements of the offering outside of the platform are limited to information similar to traditional “tombstone” ads.  To protect investors from the inherent risks associated with crowdfunding offerings, the SEC requires each issuer to provide certain detailed information on a new Form C, including among other things: a detailed description of the business; the target offering amount; the price of the securities offered; the company’s financial statements (subject to scaled requirements based on the targeted offering size); the intended use of the proceeds; all related-party transactions; and the identities of all significant stakeholders, as well as updates when certain milestones are reached in the offering on a prescribed Form C-U.  Issuers will also be required to file annual reports with the SEC on a new Form C-AR and provide the same to investors.

Certain companies are not be eligible to be issuers, such as non-U.S. companies, Exchange Act reporting companies, certain investment companies, companies subject to prior disqualification, and companies with no business plan other than to execute a merger or acquisition.

For Individuals Seeking to Invest.  Under the new rules, the SEC established limits on the amounts that an individual can invest in crowdfunding offerings, based on the individual’s income level.  Investors with an annual income or net worth greater than $100,000 may invest up to ten percent of their income or net worth every 12 months (in total, across all crowdfunding platforms).  For investors with an annual income or net worth below $100,000, the aggregate investment limit is equal to the greater of (i) $2,000 or (2) five percent of their net worth.  Regardless of income level, the amount of securities sold to an investor may not exceed $100,000 in a 12-month period.

For Crowdfunding Platforms.  Each crowdfunding intermediary is required to register with the SEC and become a member of FINRA.  To reduce the risk of fraud, the new rules establish additional operating and process requirements for intermediaries, such as: providing investors with educational materials (on both the issuer and the investment process); reviewing and timely disseminating all issuer disclosures; providing clear channels for prescribed communications; and reasonably policing monetary exchanges.  The rules also prohibit certain intermediary activities, including: offering investment advice; having a financial interest in an issuer (unless received as compensation for its intermediary service, subject to restrictions); compensating promoters; and providing platform access to fraudulent companies.

What’s Next?  The new crowdfunding rules and forms will be effective 180 days after they are published in the Federal Register.  The forms enabling intermediaries to register with the SEC will be effective on January 29, 2016.

SEC Clawback Rules Have Executive Tax Consequences

The Securities and Exchange Commission (“SEC”) released a proposed rule on July 14, 2015 that will require publicly traded companies to create and enforce a clawback policy (called a “recovery policy” by the SEC) to recover incentive-based compensation (“IBC”) paid to executives for specific metrics for which the company has to issue revised financial statements because those metrics were overstated. While the rule is discussed in more length in a previous post, this blog post discusses two tax issues that companies and executives should be aware of when creating a clawback policy. The first issue arises if a company’s recovery policy were to provide for clawback from nonqualified deferred compensation before it becomes payable, which could result in a significant tax penalty on an affected executive under Section 409A of the Internal Revenue Code. The second issue arises when an executive has already paid taxes on the IBC, as the rule requires the clawback be equal to the bonus amount pre-tax, not the amount that the executive netted from the bonus.

Section 409A generally does not allow the payment of deferred compensation at times other than upon certain events specified in the statute (separation from service, disability, or death) or on a fixed date. Acceleration of payment is generally prohibited. Under the existing Section 409A guidance, the ability of a company to clawback IBC from deferred compensation that is not yet payable generally would violate the anti-acceleration rule of Section 409A, potentially triggering severe tax consequences for affected executives. Companies should draft their recovery policies so that clawback will come from sources other than deferred compensation subject to the anti-acceleration rule of Section 409A.

The second issue arises when the executive has already paid taxes on IBC, but the amount to be recovered is on a pre-tax basis.   The executive generally should be able to claim the clawback repayment as a miscellaneous itemized deduction in the year of the repayment. However, there will be instances where the tax benefit from this deduction will not completely offset the amount of additional taxes incurred in the year the IBC was received (e.g., when the executive’s tax rate is different in the year of receipt of the IBC than the year the clawback takes place and due to limitations on miscellaneous itemized deductions). While Section 1341 generally provides relief in the situation where the deduction in the year of repayment does not fully compensate a taxpayer for the additional taxes previously paid on such repaid amount, tax practitioners are skeptical that Section 1341 will always be available to executives in these situations. This issue likely will not affect how companies draft their policies; rather, it will inform how executives make financial and tax decisions, particularly given that executives will generally have to make the clawback repayment of (and therefore will generally be “out of pocket” for) the full pre-tax amount of the bonus before realizing any tax benefits from the repayment.

SEC Opens the Door to Additional Audit Committee Disclosures

On July 1, 2015, the Securities and Exchange Commission published a Concept Release on Possible Revisions to Audit Committee Disclosures. This comes on the heels of a PCAOB request for comments regarding whether public accounting firms are required to release the name of audit engagement partners and certain participants in audits. While not strictly related, these new possible rules highlight regulators’ renewed concern for audit disclosures. At this time, the SEC is seeking comments regarding (1) the idea of revisions to the existing requirements in general, and (2) specific areas of possible disclosure. The SEC cites some shareholders expressing the view that the existing “rules do not provide investors with sufficient useful information regarding the role and responsibilities carried out by the audit committee in public companies.” The SEC is particularly careful to point out that many companies “voluntarily provide information beyond the disclosures required by [the SEC’s] current rules.” The areas of possible disclosure seem to cover a wide array of issues, indicating that the SEC may be strongly influenced by the input from comments.

Below are some of the areas that the SEC is considering for additional disclosures:

  • the audit committee’s oversight of the auditor, including: communications between the committee and auditor (which would provide information about actions taken in the most recent fiscal year); meetings between the auditor and audit committee; committee review of the auditing firm’s internal controls; and how the committee reviews the auditor’s objectivity and professional skepticism;
  • the audit committee’s process for appointing and retaining the auditor, including assessments, proposals, and shareholder input;
  • qualifications of the audit firm, such as the engagement team and number of years the firm has audited the company;
  • whether the audit committee disclosures should be included in IPO and other registration statements; and
  • requirements for smaller and emerging growth companies.

While some of these disclosures appear to be less difficult than others, such as how long an auditor has audited a company, others appear to be more in depth, such as requiring disclosure of the committee’s review of the auditor’s internal controls, or others that could be hard to explain, such as why ABC Co. chose KPMG over PWC. It is unclear from the SEC’s release how these disclosures will help the average investor make wise investment decisions. Arguably the process would be more transparent, but the flip-side is that it becomes more burdensome on companies to disclose more and more, and may overload investors with information. However, the SEC is seeking comment, and issuers may be able to influence the direction and scope of the rules by submitting comments.

It is clear from the SEC’s broad request for comments that the necessity, demand, and scope of the rules is not yet clear, which is good reason for reporting companies to take advantage of the request for comments. Companies should consider the effect this may have on small versus large companies, as well as the possible disclosures regarding justification – and what burden that might entail. Additionally, there are also forthcoming PCAOB regulations requiring public disclosures that might make some of these rules redundant, and perhaps the SEC rules would be better created after the scope of the PCAOB regulations is determined. If companies wish to submit comments to the SEC, Husch Blackwell LLP is here to help.

Alex Gross, a summer associate at the firm, assisted in the preparation of this post.

SEC Proposes Broad Rule Requiring Companies to Develop and Implement Policies to Clawback Erroneous Executive Compensation

On July 1, 2015, the Securities Exchange Commission (“SEC”) took action to fulfill the final executive compensation rulemaking mandate of Section 954 of the Dodd-Frank Act. The SEC proposed a rule that directs national securities exchanges and associations to establish listing standards that would require companies to develop and implement executive compensation clawback policies. Under the proposed rule, if a company is required to prepare an accounting restatement due to a material noncompliance with any financial reporting requirement, executive officers—defined in the proposed rule to include the same “officers” subject to Section 16 short-swing trading disclosures under SEC Rule 16a-1(f)—must relinquish the compensation they received in excess of what would have been received based on the restated financial results. Proposed Rule 10D-1 would apply to incentive-based compensation that current and former executives received for any of the three completed fiscal years preceding the date the company is required to prepare a covered restatement.

The driving principle behind the rule is that “executive officers should not be permitted to retain incentive-based compensation that they should not have received in the first instance, but did receive because of material errors in their companies’ publicly reported financial statements,” as SEC Chair Mary Jo White stated. Executives will be prevented from keeping “erroneously awarded” compensation without any regard to fault, misconduct, or an executive’s responsibility for the financial statements that prompted the accounting restatement, which is not required by the Dodd-Frank Act. Ms. White and other supporters hope the rule will “result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the market.” SEC Commissioner Luis A. Aguilar commented that the proposed rule rests on the perceived foundational idea that “Americans believe you should earn your money” and that “if you did not earn your compensation, you should not keep it.”

Not all incentive-based compensation will fall under the proposed rule’s scrutiny and be subject to recovery. As proposed, the rule defines incentive-based compensation as “any compensation that is granted, earned, or vested based wholly or in part upon the attainment of any financial reporting measure.” Financial reporting measures may include three pieces of information: accounting-related metrics used to prepare a company’s financial statements, stock price, or total shareholder return. For example, compensation that could be subject to a clawback policy includes stock options, non-equity incentive plans, bonuses paid from a bonus pool, and other compensation that was earned or granted based wholly or in part on satisfying a performance goal tied to a financial reporting measure. Excluded from the proposed rule’s contemplated umbrella of incentive-based compensation are salaries, discretionary and time-vested awards that don’t depend on financial reporting metrics, and incentive compensation awarded based on the occurrence of a non-financial event, such as consummating a merger, opening a certain number of stores, or obtaining regulatory approval of a product. However, the clawback requirement would apply to all incentive-based compensation that is “received” for any portion of the covered three-year period – which would include compensation paid out after the end of such period based on the achievement of any specified financial reporting measure during the period in question.

Proposed Rule 10D-1 would also require all listed companies—except certain registered investment companies to whom the rule would not apply—to file their clawback policy as an exhibit to their annual reports and disclose actions they’ve taken pursuant to their policy. Significantly, this means that companies which happen to list only debt securities—and previously have not been required to identify which of their executives are “officers” for purposes of equity-based Section 16 compliance—will need to do so to comply with this new rule. Additionally, companies will have to disclose, in any proxy statement that requires executive compensation disclosure, whether during the most recent fiscal year the company completed an accounting restatement that required recovery of erroneously paid excess compensation, and whether there was an outstanding unrecovered balance of excess incentive-based compensation from the application of the company’s clawback policy to a prior restatement. Companies that fail to adopt any compensation recovery policy, fail to disclose such policy in accordance with the rule, or fail to comply with their clawback policy could face delisting.

One of the distinctive characteristics of the proposed rule is that boards of directors will be able to exercise discretion not to recover any excess incentive-based compensation only if: (1) recovery would violate the home-country laws of a foreign private company; or (2) the expense of enforcing recovery would be expected to exceed the amount of incentive-based compensation that would be recovered. Commenters noted in response to a preliminary SEC proposal that boards should have this discretion because the costs of recovering excess incentive-based compensation may outweigh the benefits of obtaining it. The proposed rule recognizes this fact, but also notes that allowing boards to exercise too much discretion could undermine the entire purpose of the rule—to bar an executive officer from retaining incentive-based compensation that he or she did not earn.

On the other hand, some commenters argue that allowing a board to forego the costs of recovering erroneous compensation based on the impracticality of pursuing the compensation would align with investors’ interests. But as SEC Commissioner Piwowar noted, the breadth of the proposal—requiring companies to pursue a clawback unless it would be “impracticable” to do so—may end up unnecessarily committing more shareholder resources to clawbacks. Under the proposed rule, the only criteria that would factor into a determination of “impracticability” are those related to whether the recovery would be cost effective. Thus, before a company can conclude the costs of recovering excess incentive-based compensation impractically outweigh the benefits, they may need to first make a reasonable attempt to recover the incentive-based compensation, and then determine it would not be cost-effective. By engaging in this process, companies may still end up expending more shareholder resources than the excess compensation would justify.

Concerning the exercise of Board discretion, the SEC is seeking comment on a variety of topics, including: (1) whether this discretionary provision will hinder effectuation of the rule’s purpose; (2) whether the provision grants companies a substantial loophole to avoid compliance; (3) whether the standard for exercising discretion not to recover should be limited to situations in which it is impracticable; and (4) whether other circumstances exist in which companies should be allowed not to pursue recovery.

Opponents of Proposed Rule 10D-1 argue the rule as proposed could have the unintended effect of increasing the overall compensation of executive officers. In opposing the rule, SEC Commissioner Michael Piwowar pointed to the fact that the rule will breed uncertainty in executive compensation. Due to the threat that some of their compensation may ultimately be subject to a “clawback” triggered by a financial restatement even in the absence of any misconduct, executives are likely to demand higher salaries or insist that a smaller portion of their compensation come from incentive-based awards. These consequences could potentially defeat the purpose of the increased emphasis on pay-for-performance in designing executive compensation.

The method for calculating certain types of compensation subject to recovery constitutes another source of uncertainty. Unlike incentive-based compensation that bears a clear relationship to the financial reporting measure that triggered the payment, erroneously-awarded compensation that is based on stock price or total shareholder return cannot be recalculated with mathematical precision from the new information in an accounting restatement. In recognition of this difficulty, the rule proposes to allow companies to use a reasonable estimate of the effect of the accounting restatement on the stock price or total shareholder return on which the erroneous compensation was based. Companies would have to document their methodology in determining such a reasonable estimate and provide the information to their national securities exchange. We expect a number of comments to question whether this is feasible or would require too many assumptions, or result in additional, unnecessary expense to shareholders as companies engage third party experts to provide support for their estimates.

Others who have spoken out against the proposed rule criticize its scope. Tom Quaadman, the Vice President of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness has called the plan “extremely prescriptive” in that it includes more executive officials than the statute contemplated. The rule has expanded on the Sarbanes-Oxley Act’s clawback provisions, which only apply to CEOs and CFOs, by applying to any president, principal financial officer, principal accounting officer, vice president in charge of a principal business unit, division, or function, or any other person who performs a similar policy-making function at the company. Some have argued that the rule’s aggressive “no fault” clawback policy should apply to a smaller group of executives who are responsible for the preparation of the financial statements. Alternatively, some argue the proposed rule could apply to a larger group of executives, but the application of the rule should be limited to only those who had a hand in causing the financial misstatement.

The proposed rule also raises certain questions concerning how the clawback amount will be treated for tax purposes. For instance, while the proposed rule would allow “erroneously awarded” compensation to be recovered over time from an executive’s future salary or other incentive awards, companies should be careful to ensure that any amounts recovered through an offset against future awards of deferred compensation do not result in an impermissible acceleration of deferred compensation payments that could trigger tax penalties under Section 409A of the Internal Revenue Code. Additionally, the clawback is calculated on a pre-tax basis, but the officers would be returning the compensation with after-tax money, requiring them to seek to recover any resulting overpayment of income tax from the IRS.

Under the SEC’s clawback proposal, each exchange will have 90 days after the date the SEC adopts Rule 10D-1 in definitive form to file its proposed listing standards to implement the new rule, and its rules must become effective no later than one year following the publication date of the exchange’s proposed rules. Listed companies would be required to have a clawback policy in place that complies with such rules no later than 60 days after the date on which their exchange’s rules become effective. Accordingly, while these rules are not likely to be applicable until early 2017, listed companies of all sizes should begin now to proactively evaluate the impact they may ultimately have on existing company policies and on the design of their executive compensation programs.

Madison Benedict, a summer associate at the firm, assisted in the preparation of this post.

SEC Continues Focus on Cybersecurity Preparedness and Disclosure

Investigators at the U.S. Securities and Exchange Commission are on the lookout for violations such as poor risk controls or lax disclosures relating to hacking and other cyber breaches, David Glockner, director of the SEC’s Chicago Regional Office, said at the 2015 SEC Speaks Conference in Washington, D.C. last month.  “Cybersecurity . . . is an area where we have not brought a significant number of cases yet, but is high on our radar screen,” Mr. Glockner noted during his remarks.  “Cybersecurity threats know no boundaries.  That’s why assessing the readiness of market participants and providing investors with information on how to better protect their online investment accounts from cyber threats has been and will continue to be an important focus of the SEC,” said SEC Chair Mary Jo White.

U.S. policymakers have been paying close attention to cybersecurity over the past few years in the wake of high-profile attacks against public companies like Target, Home Depot and JPMorgan Chase.  In 2011, the SEC issued informal guidance for public companies on whether to disclose cyberattacks and their impact on a company’s financial condition.  Though some have said the SEC should do more on this front, SEC Chair Mary Jo White has said the informal guidance appears to be working well.  For now, the informal guidance is all that public companies have to rely on from the SEC regarding appropriate disclosures on cybersecurity risks; however, public companies can and should observe the SEC’s focus on the protection of customer information held by investment advisers and broker-dealers to get a sense for the SEC’s view on cybersecurity preparedness and associated risks.

On February 3, 2015, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert summarizing findings of its examinations of over 100 registered investment advisers and broker-dealers.  Here’s a summary of OCIE’s key findings:

  • Nearly 80% of investment advisers conduct periodic firm-wide risk assessments.
  • Over 70% of investment advisers have experienced cyber-related attacks.
  • The majority of investment advisers conduct firm-wide inventorying, cataloguing or mapping of their technology.
  • Less than a quarter of the investment advisers incorporate cybersecurity requirements into their contracts with vendors and business partners.
  • In contrast to the broker-dealers examined, only a third of the investment advisers designate a Chief Information Security Officer.  Instead, investment advisers typically designate the responsibility to their Chief Technology Officer or assign other senior officers to liaise with a third-party consultant.

OCIE is conducting further studies of cybersecurity preparedness among registered firms and has identified cybersecurity as one of its examination priorities for 2015.  According to Mr. Glockner, the two areas of emphasis are (1) the cybersecurity controls that companies have in place to protect market integrity and (2) the adequacy of public disclosures regarding material cyber events.

SEC Proposes Rules Related to Proxy Disclosure of Hedging by Directors, Officers and Employees

On Monday, February 9, 2015, the SEC proposed amendments to implement Section 14(j) of the Exchange Act which was added by Section 955 of the Dodd-Frank Act.

The proposed rules, if adopted, would require any proxy statement which involves the election of directors to include disclosure of whether employees (and officers) or members of the board of directors are permitted to engage in transactions to hedge or offset any decrease in the market value of equity securities granted as compensation or held directly or indirectly by the employee (and officers) or board members.

For a summary of the proposed rules and what it could mean for reporting companies, click here.

The D.C. Circuit’s en banc opinion in American Meat Institute and the Conflict Minerals Rule

On July 29th, in American Meat Institute v. U.S. Department of Agriculture, the U.S. Court of Appeals for the D.C. Circuit, sitting en banc, held that country-of-origin labeling of meat products is not unconstitutionally compelled speech in violation of the First Amendment.  This outcome increases the likelihood that the full D.C. Circuit will rehear the court’s earlier decision National Association of Manufacturers v. SEC, in which a three-judge panel struck down the portion of the SEC’s Conflicts Mineral Rule that required companies to describe certain products as not “DRC conflict free”, as unconstitutionally compelled speech.

In National Association of Manufacturers, the court declined to apply the more lenient standard of review set forth in Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626 (1985), under which mandated disclosures do not violate the First Amendment if they are limited to purely factual and uncontroversial information and are reasonably related the government’s interest in preventing consumer deception.  The court rejected the SEC’s argument that Zauderer should be applied more broadly to disclosure requirements that serve other government interests, such as those related to the disclosure of conflict minerals.   Because the Conflict Minerals Rule is not related to the State’s interest in preventing consumer deception, the court applied the higher intermediate standard of scrutiny for commercial speech articulated in Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). Under Central Hudson, the government must show that a substantial government interest that is directly and materially advanced by the restriction, and that the restriction is narrowly tailored to serve the substantial government interest.  The disclosure requirements in the Conflict Minerals Rule failed to meet this higher standard.

The SEC subsequently requested an en banc rehearing of National Association of Manufacturers, pending the outcome of American Meat Institute.   Now, the full court has explicitly rejected the panel’s narrow application of Zauderer: “To the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.”  Specifically, the court, applying Zauderer, upheld the Department of Agriculture’s regulation requiring country-of-origin labeling for meat products, even though the government interest was not the prevention of deception, but rather the context and long history of country-of-origin disclosures that enable consumers to choose American-made products, the consumer interest in extending such requirements to food products, and the individual health concerns and market impacts that arise in an outbreak of a food-borne illness.

Even if the D.C. Circuit grants the SEC’s request for an en banc rehearing of National Association of Manufacturers, which now seems likely, it remains uncertain whether the panel’s decision will be reversed.  The key question will be whether the government’s interest in conflict minerals disclosure requirements falls within this broader interpretation of Zauderer’s government interest prong.  There are marked differences between the government’s interest in country-of-origin food labeling and in conflict mineral disclosures.

SEC Waives “Voluntary” Requirement, Awards $400,000 to Whistleblower

An announcement by the SEC of a $400,000 award to a whistleblower highlights the need for companies to properly investigate and address complaints raised internally.

On July 31, the SEC announced that it paid an award to a whistleblower who first reported fraud internally (several times, according to the SEC press release), only to have his claims ignored.  The whistleblower eventually took his claims to the SEC Office of the Whistleblower.

The SEC’s Office of the Whistleblower oversees the SEC whistleblower program, which was created by the Dodd-Frank Act.  The program rewards high-quality, original information that leads to an enforcement action resulting in sanctions over $1 million.  Awards can range from 10 percent to 30 percent of the money collected.  The SEC received 3,328 tips and complaints in 2013 alone.

Under the SEC program, whistleblowers are eligible for an award if they “voluntarily provided original information to the Commission that led to the successful enforcement” of the claim.  The claim in this matter did not meet the “voluntary” requirement as implemented by the SEC’s Rule 21F-4(a), because the matter had been subject to a prior inquiry by a self-regulatory organization (“SRO”).  The SEC nonetheless found that it was appropriate to waive the regulatory “voluntary” requirement and grant the award, because the whistleblower had worked “aggressively internally” to bring the violations to the attention of appropriate personnel, and because the SRO inquiry was based, in part, on the whistleblower’s efforts in identifying the issue, as told to the SRO by a third party.  “When it became apparent that the company would not address the issue, the whistleblower came to the SEC in a final effort to correct the fraud and prevent investors from being harmed.”

The award highlights the need for companies to have robust internal reporting procedures, to follow through with proper investigations of claims, and to take necessary steps to address complaints that are raised.

New York Proposes “BitLicense” for Virtual Currency Trading

On July 17, 2014, New York became the first state to propose guidelines to regulate virtual currencies such as Bitcoin.  The proposed rules issued by the New York Department of Financial Services (“NYDFS”) would require entities engaged in the “virtual currency business” to obtain a “BitLicense” and comply with other regulations if their activities involve the state of New York or a New York Resident.  The “BitLicense” rules cover virtual currency exchanges and companies that secure, store or maintain custody or control of the virtual currency on behalf of customers. Merchants that accept virtual currency for payment would not need to apply for a license.  The proposal is the product of a nearly yearlong review, and includes rules on consumer protection, the prevention of money laundering, and cybersecurity. 

The rules were published in the New York State Register on July 23, which began a 45 day public comment period, after which the NYDFS intends to make changes to the rules and send them back out for review before they are finalized. 

According to Benjamin Lawsky, the Superintendent for the NYDFS, the rules for virtual currency companies are in line with New York’s existing regulations for banks and other financial institutions, but are also tailored to address the specific issues facing virtual currencies. For example, the rules would require such companies to have stronger cybersecurity programs because they are more vulnerable to such risks.  “We have sought to strike an appropriate balance that helps protect consumers and root out illegal activity – without stifling beneficial innovation. Setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets,” Superintendent Lawsky said of the new rules.

Although Bitcoin began five years ago primarily as a currency for computer hackers, it has since grown into a viable online payment form that has attracted investors seeking to profit from fluctuating values.  Despite its growing popularity, securities regulators have not yet enacted regulations applicable to the currency – both the SEC and FINRA have said the currency is risky but neither has enacted regulations.  Highlighting the riskiness of the currency is the collapse of Mt. Gox, one of the largest Bitcoin exchanges, which in February 2014, went dark and filed for bankruptcy in Japan amid reports that nearly 800,000 Bitcoins had been stolen by hackers.  Following the announcement of the bankruptcy filing, prices for the already volatile currency dropped 23 percent.

The NYDFS’s proposed regulations are a good first step towards making the currency safer and more stable, however, until other regulators establish their own guidelines, being licensed in New York can only go so far because many of these companies operate across state lines and international boundaries.