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An Evaluation Of The U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives

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Kimberly Summe*

Derivatives, understood by few but disparaged by many, are often blamed for the collapse of the United States economy in the wake of Lehman Brothers’ bankruptcy in September 2008.[1] A legislative response to the crisis was inescapable and on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)[2] was signed into U.S. law. While the Dodd-Frank Act addresses many aspects of the financial markets, this Article will focus on Titles II and VII in order to examine how transacting in derivatives has changed in the aftermath of this legislation and to assess how the bankruptcy of a systemically important financial institution engaged in derivative transactions will be approached.

A Bid to Limit Systemic Risk and Failure

The Dodd-Frank Act has two primary objectives that relate to derivatives: first, to limit the systemic risk of modern finance, in part by changing the locus of trading in derivatives and the conduct of derivatives market participants; second, to limit the damage caused by the failure of a systemically important financial institution.[3] With respect to the first objective, the Dodd-Frank Act’s principal strategy required that certain derivatives be “cleared.” With respect to the second objective, the Dodd-Frank Act singled out the entities most likely to cause systemic problems if they failed and subjected them to a new bankruptcy process. This Article will focus on the second objective of the Dodd-Frank Act and in particular on how the failure of a systematically important financial institution would relate to the treatment of derivatives.

Reducing Systemic Risk

The estimated $632 trillion notional over-the-counter derivatives market[4] is in the early transformational stage of where and how such transactions are executed. Title VII of the Dodd-Frank Act requires that all eligible derivatives be cleared through a central clearinghouse, known colloquially as a “central counterparty” or “CCP.” Unlike an over-the-counter derivative transaction where each of the two parties face the risk that its counterparty might fail to perform its obligations, a cleared derivative transaction mitigates this risk of performance failure by having a third party, the CCP, stand between the two parties and absorb that risk.[5]

Two years after the passage of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) proposed that certain credit default swaps and interest rate swaps be cleared. The CFTC’s decision to focus initially on these two products was a function of their importance in the market and the fact that a significant percentage of those swaps were already being cleared. End users of derivatives, such as corporations, are not, however, required to clear swaps if such entities can demonstrate that the swap is being used to hedge or to mitigate commercial risk, the CFTC (or the Securities and Exchange Commission (SEC)) was notified as to how the end user generally meets the financial obligations associated with entering into uncleared swaps, and the entity’s Board of Directors approved such an approach.

Clearinghouses perform a valuable function in their mitigation of counterparty risk. To sustain this function, the clearinghouse’s financial resources must be sufficiently robust to meet its members’ obligations notwithstanding the default of one of its members. Given that J.P. Morgan Chase Bank, Citibank, Goldman Sachs Bank USA, and Bank of America are the four largest derivative counterparties in the United States, the collapse of any one of those institutions could mean the termination of anywhere between a $42.67 and $71.28 trillion notional derivatives portfolio—roughly seven to eleven percent of global notional derivatives value.[6] In addition to the financial resources marshaled by each clearinghouse, another critical component of the clearing model is the provision requiring collateral. The requirement that the parties post collateral every day underpins the purported safety of the clearing model.

Policymakers were correct to focus on collateralization as a risk-mitigation technique. The collateralization of over-the-counter derivative transactions has existed for twenty years, so the posting of collateral for cleared and uncleared transactions to mitigate exposure is not new. Before the economic crisis began, the International Swaps and Derivatives Association (ISDA) reported in its 2006 Margin Survey that the gross amount of collateral in use for over-the-counter derivative transactions was $1.335 trillion, with fifty-nine percent of mark-to-market credit exposure covered by collateral.[7] Today, large dealers reported that eighty percent of over-the-counter derivatives are subject to collateral arrangements, with ninety-six percent of credit derivatives exposure being collateralized.[8] The type of collateral is important as well. Cash has long been the preferred form of collateral. At the end of 2006, nearly eighty percent of collateral was cash, mostly provided in U.S. dollars, and nearly seven years later, similar percentage is true today.[9]

What shifted under the Dodd-Frank Act is that the CCP’s calculation of required collateral is substituted for the individual counterparty’s assessment of its risks. Counterparties to cleared swaps will be required to post initial (or upfront) collateral to the CCP based on the CCP’s assessment of the risk profile of that transaction.[10] In addition, each day the CCP will set the variation margin associated with each transaction by recalculating the value of the transaction and accordingly calling for or releasing collateral, ensuring that counterparties have neutral risk positions in relation to the value of the underlying asset. In other words, the goal is that the CCP receives margin payments every day from counterparties whose contracts moved against them to ensure that the CCP and those that participate through the CCP always have funds to satisfy their obligations under contracts.

The posting of collateral is closely related to how the derivative transactions of an insolvent clearinghouse member are handled. For example, LCH. Clearnet Group’s contract and related rules state that upon a clearing member’s default, the clearinghouse may close out and terminate the cleared transactions and will not transfer such positions. CME Clearing and ICE Trust, by contrast, allow cleared transactions and associated collateral to be transferred to another consenting clearinghouse member.[11] Had Lehman Brothers been a clearing member of CME Clearing, for example, upon its insolvency its $35 trillion notional derivatives portfolio (and associated collateral) would have been ported to another clearinghouse member. The concern in a marketplace where major participants such as Bank of America, Citibank and Morgan Stanley, among others[12] were vulnerable at that same time means that the portability of Lehman Brothers’ derivatives portfolio may not have allayed counterparty risk to the non-defaulting party population because arguably an equally unstable counterparty was receiving those transactions. Alternatively, a stronger clearing member may have rejected the transactions being proposed for transfer without some sort of government backstop for the unknowable counterparty risk being assumed.

Albeit one of the Dodd-Frank Act’s goals was to reduce systemic risk through clearing and collateralization of derivatives, little has changed in terms of how collateralization operates both before and after Lehman Brothers’ bankruptcy. A clearinghouse will determine the collateral required for cleared trades while for over-the-counter derivatives, the counterparties will agree to the extent of such collateralization. As the OCC Quarterly Reports demonstrate, there have actually been very limited counterparty credit losses incurred from over-the-counter derivatives trading activity by U.S. banks. At the end of June 30, 2013, eighteen U.S. banks (out of 1,400) reported a total of $61 million in charge-offs of over-the-counter derivatives exposures, down from $84 million in the first quarter of 2013.[13] Net current credit exposure or the netted amounts of contracts with positive values against those with negative values was reported as $339 billion at the end of the second quarter of 2013—a figure that peaked at $800 billion at the end of 2008.[14] These figures reflect the importance of collateralization and netting in the over-the-counter context and indicate that a very small fraction of the gross notional outstanding of derivatives held at U.S. banks is subject to net current credit exposure. Even with these high collateralization rates in place, at least as reported by U.S. banks, it should be noted that no consensus has formed as to whether there is sufficient collateral in place to mitigate counterparty loss. Researchers at the International Monetary Fund estimated that under-collateralization of derivatives relative to risks in the financial system may be $2 trillion.[15] The TABB Group contended that interest rate and credit derivative transactions’ migration to a clearinghouse would require an additional $240 billion in collateral.[16]

Dealing with Failure

If the Dodd-Frank Act’s first objective was to limit risk before an institution collapses, the second objective was to limit destruction after a systemically important financial institution has failed or is in danger of failing. To accomplish this second objective, the Dodd-Frank Act introduced a new framework in Title II to facilitate the “orderly liquidation” of systemically important financial institutions.[17] The population of systemically important financial institutions includes bank holding companies that have at least $50 billion in assets and nonbank financial institutions such as investment banks or insurance holding companies that the new Financial Stability Oversight Council (Council) deems to be systemically important.[18] At present, there are eight U.S. banks deemed systemically important, along with three Japanese banks, seventeen European banks, and one Chinese bank. Before the Title II orderly liquidation authority procedures apply, however, it must be demonstrated that the use of the U.S. Bankruptcy Code would not be appropriate in the resolution of the institution without the destabilization of the U.S. financial system or a resort to a taxpayer bailout being likely.

It seems certain that all systemically important financial institutions will transact in derivatives and those transactions are more likely today than in 2008 to be booked with a U.S. commercial bank. U.S. banks dominate as derivatives counterparties. The most recent OCC Quarterly Report on Bank Trading and Derivatives Trading reported that out of the 1,400 U.S. banks engaged in derivatives trading, four U.S. commercial banks hold ninety-three percent of that exposure.[19] The concentration of a small number of financial institutions in the derivatives market has not shifted much in many years, including prior to Lehman Brothers’ bankruptcy.[20] The vast majority of this derivatives trading activity focuses on interest rate swaps: in the OCC’s First Quarter Report in 2008, that figure was seventy-nine percent, whereas in the OCC’s Second Quarter Report in 2013, it was eighty-one percent.[21] Interest rate swaps are perhaps the least complicated derivative instrument, particularly as compared to the challenges historically associated with credit derivatives in terms of credit event triggers and settlement, the complex calculations and dependencies of equity derivatives, and the inherent volatility of commodity derivatives, so presumably there is less risk in trading interest rate swaps than other derivatives. In addition, the OCC reports that fifty-nine percent of the top four commercial banks’ net current credit exposure is to other banks and securities firms, with corporates representing thirty-two percent and hedge funds, the most overly collateralized group at 325 percent, being two percent of net credit exposure.[22]

Thus, our financial landscape is dominated by the world’s largest banks, which in turn are among the world’s largest derivatives counterparties. While these banks will be more closely regulated under Title I of the Dodd-Frank Act, the way in which their insolvency will be handled has shifted.

Banks have historically been excluded from application of the U.S. Bankruptcy Code[23] and instead bank insolvencies were addressed under the Federal Deposit Insurance Act (FDIA). The FDIA provides that the Federal Deposit Insurance Corporation (FDIC) may operate as a conservator to preserve the value of a failing bank and return it to financial health or the FDIC may operate as a receiver in order to liquidate a failed bank.[24] Unlike a proceeding under the U.S. Bankruptcy Code, an FDIC receivership or conservatorship is not subject to direct supervision by the courts.[25] In large part, this policy choice was designed to ensure that bank failures were not subjected to the assumed-to-be lengthy proceedings under Chapter 11 of the U.S. Bankruptcy Code and placed more discretion with the FDIC to act expeditiously.

Under an FDIC regime, upon bankruptcy the FDIC has limited repudiation and avoidance powers with respect to derivatives. For example, regardless of whether the FDIC is acting as a conservator or a receiver, it must either disaffirm or repudiate all or none of the qualified financial contracts (derivatives) between the failed bank and the same counterparty, together with associated credit support or collateral.[26] In addition, the FDIC has the right to transfer qualified financial contracts to creditworthy bridge depository institutions.[27] If the FDIC is acting as receiver, it must provide notice of the transfer by 5:00 p.m. EST on the business day after its appointment as receiver.[28] At that time, the counterparty to the failed bank may elect to terminate the qualified financial contract (that is, the non-defaulting counterparty to the failed bank could follow the termination and close-out provisions in Section 6 of the ISDA Master Agreement for derivative transactions). If the FDIC is acting as conservator, there is no time limit on its right to transfer qualified financial contracts and the counterparty may not terminate the qualified financial contracts unless the conservator defaults to a degree that would permit termination under applicable non-insolvency law.[29]

From available reports, it appears that in every recent case where a large U.S. bank has become subject to a receivership proceeding, all qualified financial contracts and associated collateral of the failed bank were transferred in their entirety to a single bridge bank or third party acquirer. When the assets of Washington Mutual Bank, the largest U.S. bank failure to date, were sold in September 2008 to J.P. Morgan Chase, the FDIC transferred to J.P. Morgan Chase all qualified financial contracts to which Washington Mutual Bank was a party. While that process seemed to go well, Washington Mutual was not exactly a powerhouse derivatives market participant. Thus, it is not known whether the FDIC is resourced effectively to be able to handle a systemically important financial institution’s bankruptcy, a clearinghouse’s bankruptcy or multiple simultaneous bankruptcies. To date, the FDIC has fortunately not had the opportunity to deal with a derivatives portfolio approaching anything even near the size of Lehman Brothers’ derivatives portfolio—and Lehman Brothers was not as significant a derivatives market participant as the four largest U.S. commercial banks that trade derivatives.

While it is impossible to know whether the FDIC could effectively administer the bankruptcy of a systemically important financial institution, it is known that Title II’s orderly liquidation authority shifts away from the legal certainty of the bankruptcy processes under the U.S. Bankruptcy Code by permitting the FDIC to engage in ad hoc interventions under Title II. In addition, Title II allows the FDIC to discriminate among similarly situated secured creditors in a bankruptcy. Under Section 506(a)(1) of the U.S. Bankruptcy Code, a creditor’s secured status is determined when the collateral securing the claim is sold or when the Chapter 11 plan is judicially confirmed.[30] In contrast, under the regulations implementing the Dodd-Frank Act, the collateral securing the debt of the covered financial company is valued as of the date of the receiver’s appointment.[31] If the FDIC is unable to find a third party to purchase the collateral, the FDIC may transfer that collateral to a bridge financial company that the FDIC has organized.[32] While the bankruptcy process under the U.S. Bankruptcy Code mandates that the use or sale of the debtor’s property can only occur after there has been due notice and hearing, thereby ensuring the highest price is paid for such assets, Title II allows the FDIC to be on both sides of the transaction and to determine the consideration paid for the assets, with no court or creditor oversight.

The deficiencies of Title II resulted in the development of a proposed new U.S. Bankruptcy Code Chapter 14.[33] Chapter 14 offers two distinct approaches: either a conventional reorganization or a two entity recapitalization of a holding company. Under the Dodd-Frank Act, the FDIC focused on a two entity recapitalization, with a systemically important financial institution’s holding company being recapitalized through the transfer of its assets and liabilities to a new bridge financial company, and this bridge financial company in turn dealing with its operating subsidiaries. By contrast, Chapter 14 provides that if a motion is approved for the transfer of assets and liabilities in the first forty-eight hours of a bankruptcy, then the systemically important financial institution’s operations and ownership of subsidiaries shifts to a new bridge company that is not in bankruptcy. Qualified financial contracts such as derivatives would be kept intact and transferred to the bridge company. Through the transfer, the new bridge company will be effectively recapitalized by leaving the long-term unsecured debt behind in the bankruptcy proceeding.

Conclusion

It was a foregone conclusion that policymakers would respond to the economic crisis in the aftermath of Lehman Brothers’ bankruptcy and the near-collapse of other financial institutions. While it is arguable that the effort to prevent systemic risk through the mandate of clearing derivatives is a useful step, it is not a prophylactic. It remains entirely possible that a clearinghouse itself is capable of failure, as several have failed in the past, and the concentration of derivatives trading in the largest global financial institutions has exacerbated this possibility. Certainly, having the clearinghouse as the counterparty mitigates counterparty credit risk, but there may be costs involved if we have simply migrated to a more focused nucleus of systemically important financial institutions that could possibly fail. In addition, addressing the potential or eventual failure of a systemically important financial institution could have been addressed in a more judicially sound manner than the ad hoc approach policymakers chose to burden the FDIC with. There are attractive features of Title II, such as coordination with foreign regulators, but not at the expense of due process and judicial review. While the markets have already moved to accommodate the clearing of mandated derivative transaction types, it is hoped that efforts can be made to revise Title II as it relates to how the failure of a systemically important financial institution is handled.

 

Preferred citation: Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives, 4 Harv. Bus. L. Rev. Online 76 (2014), https://journals.law.harvard.edu/hblr//?p=3779.

[*] Kimberly Summe is the Chief Operating Officer and General Counsel at a multi-billion dollar San Francisco based investment advisor, Partner Fund Management, LP. She previously served as a Managing Director at Lehman Brothers and General Counsel at the International Swaps and Derivatives Association. Ms. Summe is a lecturer in law at the Stanford Law School and is a member of the Resolution Working Group at the Hoover Institution, which focuses on bankruptcy reform.

[1] On April 20, 2010, U.S. Treasury Secretary Timothy Geithner testified to the House of Representatives Financial Services Committee that “the market turmoil following Lehman’s bankruptcy was in part attributable to uncertainty surrounding the exposure of Lehman’s derivatives counterparties.” See Treasury Secretary Tim Geithner Written Testimony before the House Financial Services Committee, U.S. Dept. Treasury, (Apr. 20, 2010) http://www.treasury.gov/press-center/press-releases/Pages/tg645.aspx.

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[3] See id at 1376.

[4] Bank for Int’l Settlements, Quarterly Review, Table 19, (June 2013), http://www.bis.org/statistics/dt1920a.pdf. Notional, of course, does not reference the amount that is at risk and does not account for the effect of netting and the provision of collateral.

[5] See Dodd-Frank Act §723(h) at 1676.

[6] See Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013 (2013) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq213.pdf.

[7] Int’l Swaps and Derivatives Ass’n, ISDA Margin Survey 2007, 4, (Apr. 15, 2007) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. The ISDA Margin Survey covers U.S. and non-U.S. market participants. In 2007, for example, twenty-five percent of respondents were based in the United States, while fifty-two percent were based in Europe or South Africa. The OCC Quarterly Reports, by contrast, only cover U.S. national banking associations. Id.

[8] International Swaps and Derivatives Association, ISDA Margin Survey 2013, 2, (Jun. 21, 2013) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

[9] See id at 9; International Swaps and Derivatives Association, ISDA Margin Survey 2006, 4, (Apr. 15, 2006), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys.

[10] As it relates to uncleared swaps, the Dodd-Frank Act requires swap dealers and major swap participants to notify their uncleared swap counterparties of their right to segregate their initial margin with an independent third-party custodian. See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336-01 (Feb. 7, 2012).

[11] See CME Clearing Financial Safeguards, CME Group, (2012), http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

[12] Federal Reserve chairman Ben Bernanke testified to the U.S. Financial Crisis Inquiry Commission: “If you look at the firms that came under pressure in that period . . . out of . . . thirteen of the most important financial institutions in the United States, twelve were at risk of failure within a period of a week or two.” See Thomas Russo and Aaron J. Katzel, The 2008 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Group of Thirty 7, 11 (2011).

[13] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6 at 8.

[14] Id at 6.

[15] Manmohan Singh and James Aitken, Counterparty Risk, Impact on Collateral Flows and Roles for Central Counterparties, (International Monetary Fund, Working Paper 09/173, 2009).

[16] E. Paul Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange Traded Derivatives, TABB Group, 6 (November 2010), http://www.world-exchanges.org/files/statistics/pdf/V08-030%20Global%20Risk%20Transfer%20Market.pdf.

[17] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §204, 123 Stat. 1376 1454 (2010).

[18]  Title II is not limited to financial companies already designated as “systemically important” but can apply to any potentially failing entity the Council determines is systemically important and “in default or in danger of default.”

[19] Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at Graph 4.

[20] In the OCC Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, the five largest commercial banks represented ninety-seven percent of the total banking industry notional amount of derivatives trading activity. In order by notional, those institutions were JPMorgan Chase Bank, Bank of America, Citibank, Wachovia Bank, and HSBC Bank USA. In the OCC Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, Table 1, the five largest commercial banks in order by notional were JPMorgan Chase Bank, Citibank, Goldman Sachs Bank USA, Bank of America and HSBC Bank USA. The number of insured U.S. commercial banks engaged in derivatives trading has increased: at the end of the first quarter of 2008 there were 1,003 banks, see Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, 7, (2008) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq108.pdf, whereas at the end of the second quarter of 2013, there were 1,400. See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6.

[21] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at 1; Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, supra note 20, at 1.

[22] See id. at 7.

[23] See 11 U.S.C. § 109(b)(2) (2010).

[24] See 12 U.S.C. § 1821(c)(1) (2013).

[25] See § 1821(c)(6).

[26] See § 1821(e)(1)-(3).

[27] See § 1821(e)(9), (10)(C).

[28] See § 1821(10)(B)(i)(I).

[29] See § 1821(10)(B)(ii).

[30] See 11 U.S.C. §506(a)(1) (2005).

[31] See 12 C.F.R. § 380.1-380.53 (2011).

[32] See 12 U.S.C. §5390(h)(1) (2010).

[33] The Hoover Institution established a Resolution Project Working Group in 2009 (of which this author is a member) to develop an alternative approach to bankruptcy and related issues.

By

Making Equity Crowdfunding Work for the Unaccredited Crowd

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Jeff Thomas*

I.       Introduction

The idea behind equity crowdfunding is both simple and revolutionary. Entrepreneurs will be able to use the Internet to pitch business ideas to millions of potential investors and allow “anyone with a few dollars to spend [to] become an investor.”[1] While this may seem like an obvious use of the Internet, until now, securities laws have prohibited new ventures from using this approach[2] to raise capital from “average Joes” and other unaccredited investors.[3] However, the Jumpstart Our Business Startups (JOBS) Act[4] creates a new “crowdfunding exemption” that will allow companies to raise up to $1 million every twelve months by selling their stock (or other unregistered securities) to both accredited and unaccredited investors, provided that the sales are made through registered intermediaries.[5] This article summarizes why the crowdfunding exemption is important, explains how its expected costs are problematic, and proposes ways to mitigate those costs without sacrificing investor protection.

II.       Importance of the Crowdfunding Exemption

The crowdfunding exemption is important because it allows for new sources of capital for new ventures. New ventures, and the jobs they create, are significant to our economy.[6] New ventures also often need external capital,[7] but due to securities laws, it is difficult for them to raise that capital.[8] When selling stock and other securities, new ventures (and other issuers) must either register their securities under the Securities Act of 1933[9] (the Securities Act) or satisfy federal and state requirements for an exempt offering.[10]

On average, issuers must pay $2.5 million to initially register their securities under the Securities Act and an additional $1.5 million each year thereafter to comply with ongoing requirements, making registration impractical for most new ventures.[11] Without the crowdfunding exemption, unaccredited investors are limited in their ability to participate in exempt offerings,[12] and, as of 2010, only 7.4% of U.S. households were accredited based on the net worth standard.[13] Additionally, only a small percentage of the accredited households are likely to participate in exempt offerings.[14]

Thus, the crowdfunding exemption is critical because it will provide cash-hungry new ventures with access to a large and currently under-tapped source of capital—unaccredited investors.

III.      Crowdfunding Exemption’s High Expected Costs

In order to protect investors, the JOBS Act[15] and the Securities & Exchange Commission’s (SEC) Proposed Crowdfunding Rules[16] impose several requirements on issuers[17] and intermediaries.[18] Unfortunately, the costs associated with these requirements may threaten the usefulness of the exemption in practice. As one practitioner notes:

To produce an offering disclosure document, enlist a funding portal, run background checks and file an annual report with the SEC year after year might well cost upwards of $100,000. The high expenses compared to the low maximum amounts that can be raised by a company and invested by an individual make public equity crowdfunding one of the costliest forms of (legal) capital raising.[19]

The SEC also provides cost estimates for issuers and intermediaries in the Proposed Crowdfunding Rules. These costs are summarized below.

A.     SEC Estimates of Issuer Costs

The SEC estimates that issuers relying on the crowdfunding exemption would incur the following initial and ongoing annual costs for three different offering amounts[20]:

Offering Amount
$50,000 $300,000 $750,000
Initial Costs:
     Compensation to the intermediary[21] $5,000 $30,000 $75,000
     Cost to prepare and file initial disclosure document[22] $6,000 $6,000 $6,000
     Cost of review or audit of financials[23] N/A $14,350 $28,700
     Other initial costs[24] $460 $460 $460
Total Initial Costs $11,460 $50,810 $110,160
Initial Costs as a % of the Offering Amount 22.92% 16.94% 14.69%
Ongoing Annual Costs:[25]
     Cost to prepare and file annual disclosure document[26] $4,000 $4,000 $4,000
     Cost of review or audit of financials[27] N/A $14,350 $28,700
Total Ongoing Annual Costs $4,000 $18,350 $32,700
Ongoing Annual Costs as a % of the Offering Amount 8.00% 6.12% 4.36%

Thus, considering these estimates, a new venture that sells $50,000 of stock would initially net only $38,540 and it must continue to pay outside professionals an additional $4,000 each year to comply with ongoing reporting requirements. Although these costs already seem high, additional issuer costs, intermediary costs, and other costs must also be factored in.

B.     SEC Estimates of Intermediary Costs

To qualify for the crowdfunding exemption, issuers must use a registered broker or funding portal.[28] The SEC estimates the following initial and ongoing annual costs for three different types of intermediaries[29]:

 

Intermediaries That:

Register as Brokers

Register as Funding Portals

Are Already Registered as Brokers
Initial Costs:
     Registration and Membership Costs[30] $275,000 $100,000 N/A
     Compliance Costs[31] $245,000 $67,000 $45,000
     Platform Development Costs[32] $250,000 $250,000 $250,000
     Total Initial Costs $770,000 $417,000 $295,000
Ongoing Annual Costs:
     Registration and Membership Costs[33] $50,000 $10,000 N/A
     Compliance Costs[34] $180,000 $40,000 $30,000
     Platform Development Costs[35] $40,000 $40,000 $40,000
Total Ongoing Annual Costs $270,000 $90,000 $70,000

 

The SEC also estimates that, on average, intermediaries will generate $200,000 per year in revenue from offerings made under the crowdfunding exemption.[36] Thus, it may be difficult for intermediaries to cover these and additional overhead costs even if they are able to collect 10% of the amounts they help issuers raise.

C.     Other Costs

As mentioned above, the SEC estimates do not reflect all of the costs that issuers will have to bear when using the crowdfunding exemption. Additional issuer costs include an expected return for the investors[37] and the value of issuer time required to prepare and file the initial offering document[38] and ongoing annual disclosures.[39] Moreover, the SEC estimates do not include transactional costs that investors will incur. For instance, reasonable investors will require time to learn about an issuer’s business (for example, the issuer’s current and anticipated products, customers and revenue model) as well as the terms of the offering (such as the rights attached to the shares being offered, the number of shares outstanding, and the rights attached to the outstanding shares). Because some people will be investing only a few hundred dollars (or even just “a few dollars”)[40] it would be easy for an investor’s transaction costs to be a significant percentage of, or even exceed, her total investment amount.[41] Furthermore, costly disputes related to offerings may arise in the future.

IV.    Ways to Mitigate the Exemption’s Costs without Sacrificing Investor Protection

If the issuer, intermediary, and other costs are too high, use of the crowdfunding exemption will be limited. This will leave the large unaccredited investor market under-tapped and new ventures without the funds they need to thrive. There are, however, several ways to mitigate the expected costs without sacrificing investor protection. Five suggestions for mitigating costs are provided below.

A.     Allow Intermediaries to Acquire Equity Interests

Funding portals and other intermediaries should be allowed to take an equity interest in the issuers they service in lieu of at least a portion of the cash fees,[42] provided that intermediaries taking such an interest do so as a standard practice. While the Proposed Crowdfunding Rules prohibit intermediaries from doing this,[43] the JOBS Act itself does not.[44] Furthermore, the JOBS Act’s legislative history in fact supports the idea of allowing intermediaries to invest in issuers using their services in order to protect investors.[45] Granting an intermediary an equity interest would still result in an economic cost to issuers and doing so may not always improve an issuer’s cash position.[46] However, there would be many instances where granting equity in lieu of paying cash to an intermediary would improve an issuer’s cash position.[47] Reserving this additional cash is critical for issuers.[48] Moreover, intermediaries who acquire equity interests in issuers would likely service only those issuers they see unique value in—namely, ventures they believe are currently underpriced. This perceived discount by intermediaries could be shared with issuers in the form of a lower stated fee.[49]

B.     Let Unaccredited Investors Test into Accredited Status

The crowdfunding exemption is important because it gives new ventures bona fide access to unaccredited investors—a large source of potential capital. However, this access could be broadened by amending the accredited investor definition[50] to welcome currently unaccredited investors who demonstrate they are capable of investing in exempt offerings (for example, by passing an appropriate exam). These investors could then participate in “506(c) offerings” which are currently not subject to many of the crowdfunding exemption’s requirements such as: (i) the use of an offering document; (ii) an annual reporting obligations; (iii) the use of a registered intermediary; and, (iv) the $1 million offering amount cap.[51] Thus, changing the accredited investor definition could generate many of the benefits of the crowdfunding exemption, at a much lower cost, for those that pass the exam. Although such an exam would likely have imperfections, amending the accredited investor definition to consider an investor’s knowledge of exempt offerings would make the regulation smarter. Instead of concluding from an individual’s net worth and income levels that she is incapable of investing in exempt offerings, the exam would allow her to prove that she has the knowledge and experience in financial and business matters reasonably necessary to evaluate the risks and merits associated with investments in early stage ventures—and thus eliminate much of the need for costly protections assuming the opposite.[52] Perhaps this is why the SEC has requested comment on the current accredited investor definition.[53]

C.     Use Strategic Templates and Deal Structures

Intermediaries should require issuers to use essentially the same formation and financing documents or templates to organize entities and complete financings. Repeatedly using smart templates and deal structures should reduce transaction costs, promote consistency between documents and among transactions, protect entrepreneurs and investors, and help ensure compliance with laws and regulations.[54] This is why leading accelerator programs and attorneys who regularly represent venture capital-backed companies already use templates to form and finance the ventures they help.[55] Given that crowdfunding investors will typically invest smaller amounts than venture capitalists, and therefore transactions costs are likely to represent a larger percentage of their investment, templates seem even more important in the equity crowdfunding setting. Moreover, intermediaries could strategically design the templates and deal structures to make the most of the unique requirements imposed by the JOBS Act[56] and Proposed Crowdfunding Rules.[57] The JOBS Act’s legislative history[58] and Proposed Crowdfunding Rules[59] support intermediaries taking this approach. However, to further reduce the risk of engaging in the unauthorized practice of law, intermediaries should consider taking precautionary steps such as requiring issuers to use the templates and deal structures, instead of merely advising issuers on what to do. Furthermore, issuers should be encouraged to seek legal counsel.[60]

It is beyond the scope of this article to provide details about how equity crowdfunding templates and deal structures should be structured. However, by way of example, a funding portal could require issuers using its service to:

 

  • Be formed as Delaware C corporations, with the funding portal providing templates for issuers’ Certificate of Incorporation, Bylaws and initial corporate resolutions;[61]
  • Prepare an executive summary, pitch presentation, and business plan to be made available on the funding portal’s website, with the funding portal providing templates designed to ensure that the necessary information is provided in a logical and concise format;[62]
  • Use a two-class equity system whereby inexpensive common stock is granted to or reserved for employees and more expensive preferred stock, with special rights,[63] is sold to outside investors thereby allowing issuers to raise external funds with less demoralizing dilution to the employee-owners than would otherwise occur;[64]
  • Make their common stock subject to “vesting” to help ensure that employees earn their stock over time,[65] with the funding portal providing a template Common Stock Purchase Agreement and related forms;[66]
  • Raise exactly $100,000, thereby eliminating the need for reviewed or audited financial statements;
  • Use standard capitalization tables (for example, a fixed number of shares of common stock could be granted to or reserved for each issuer’s employees thereby allowing employees and investors to more quickly understand what their ownership interests represent and more easily compare valuations of different issuers); and,
  • Reserve the right to redeem their preferred stock at a multiple of the price it was originally issued at, thereby giving issuers a path to escape the ongoing annual costs imposed by the crowdfunding exemption.[67]

 

Repeated use of the same templates and deal structures should lead to familiar standards and even a “one size fits many” model.[68] In addition to significantly reducing transaction costs, such a model would help ensure that parties take necessary and desired steps, thereby increasing issuer compliance, investor protections, and economic value.

D.     Leverage Educational Organizations

Having a “one size fits many” model would give schools exciting new ways to connect their students in the classrooms to real world new ventures. Instead of simply reading about different types of business entities and seed financings, students could complete projects using the same templates used by live issuers relying on the crowdfunding exemption. Among other things, this would empower more students and alumni to launch their own ventures. Schools could even form, or develop a relationship with, funding portals.[69] Reputable entrepreneurship programs at prestigious universities have already undertaken initiatives to help their students and others raise capital for new ventures.[70] A funding portal could revolutionize this process and create new ways to engage students, parents, alumni, and others—and to raise funds to support entrepreneurship education.[71] To the extent that schools and other organizations, such as accelerators, can extract educational value from the equity crowdfunding process, the high costs of the exemption would become more tolerable. That is, the costs would support both the exempt offerings and entrepreneurship education objectives. Further, if alumni and others are motivated to invest in student ventures for both economic and non-economic reasons, expected returns should become more issuer-friendly and participating unaccredited investors would receive an education while experiencing the thrill of being angel investors.

Moreover, expenditures already being made could help reduce the incremental cost of building and running a funding portal. For example, a university’s existing business plan competitions, social networks,[72] and news publications could all be used to help drive potential issuers and investors to funding portals and thus reduce issuer search costs and intermediary marketing costs. Additionally, business plan competitions could adopt rules mirroring the crowdfunding exemption’s requirements, thus reducing future compliance costs for ventures choosing to pursue equity crowdfunding. By way of further example, law school clinics already assisting entrepreneurs[73] could be tapped to provide issuers with affordable assistance. If there is a “one size fits many” model, law students and clinicians could more easily “ramp up” and offer clients a defined and meaningful new service, such as offering entrepreneurial ventures assistance with the crowdfunding exemption process.

E.     Arbitrate Disputes in a Forum Designed for Equity Crowdfunding

Issuers, investors, and intermediaries should agree to arbitrate disputes related to offerings made under the crowdfunding exemption. These parties should also agree to use a forum that specializes in equity crowdfunding and is willing to become familiar with its unique players, rules, templates, deal structures, and repeat issues. The Financial Industry Regulatory Authority  (FINRA) currently operates the largest dispute resolution forum in the securities industry.[74] Given the need to mitigate costs further in the equity crowdfunding setting, and its potential educational nature, perhaps an organization like FINRA could work with law school clinics to develop something that resembles a chain of minor league dispute resolution forums.[75] In addition to respecting the laws and practical issues surrounding equity crowdfunding, such an organization could provide expedient and affordable services to issuers, investors, and intermediaries while also creating unique experiential learning opportunities for students.

V.      Conclusion

New ventures are important to our economy. We can support these ventures by giving them better access to capital. In theory, the crowdfunding exemption will open the door to unaccredited investors—a large and currently under-tapped source of capital. However, the crowdfunding exemption is expected to impose significant costs on issuers, intermediaries, and investors. In order to make equity crowdfunding work for the unaccredited crowd, we must mitigate those costs without compromising investor protection.

 

 

Preferred citation: Jeff Thomas, Making Equity Crowdfunding Work for the Unaccredited Crowd, 4 Harv. Bus. L. Rev. Online 62 (2014), https://journals.law.harvard.edu/hblr//?p=3773.

[*] Jeff Thomas is the Chair of the School of Business at Johnson & Wales University in Charlotte, NC. He also serves on the Board of Directors of Queen City Forward, an accelerator for social ventures. He has extensive experience in counseling entrepreneurial ventures through law firms and law school clinics in Chicago and Silicon Valley.

[1] C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 10 (2012).

[2] See, e.g., Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, 13 Transactions: Tenn. J. Bus. L. 63, 75 (2011) (“[S]ecurities laws . . . are a formidable barrier to investment crowdfunding in the United States.”).

[3] Unaccredited investors (also referred to as non-accredited investors) are investors who are not within the definition of an “accredited investor.” The term accredited investors includes natural persons: “whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000”; “who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year”; or, who serve as a “director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.” See 17 C.F.R. § 230.501 (2013).

[4] Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, 126 Stat. 306 (2012) (codified at scattered sections of 15 U.S.C.A. (West 2012)).

[5] See JOBS Act §§ 301–05, 15 U.S.C.A. §§ 77–78 (West 2012).

[6] See, e.g., Vision Statement: Can Start-Ups Help Turn the Tide?, Harv. Bus. Rev., Sept. 2012, at 30 (“[N]ew businesses—and the jobs they create—are more important than ever.”). An abstract is available at http://hbr.org/2012/09/can-start-ups-help-turn-the-tide/ar/1.

[7] See, e.g., 2013 State of Entrepreneurship Address, Ewing Marion Kauffman Foundation, Financing Entrepreneurial Growth 2 (2013), http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2013/02/soe%20report_2013pdf.pdf (“For the fast-growing (but mostly small) companies on the 2012 Inc. 500 list . . . one-third said access to external capital had been essential to company growth.”).

[8] See, e.g., Burkett, supra note 2, at 82–92.

[9] 15 U.S.C. §§ 77e–77f (2012).

[10] See Bradford, supra note 1, at 42–47.

[11] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428, 66,509 (proposed Nov. 5, 2013) (to be codified at scattered parts of 17 C.F.R.) (citing two surveys).

[12] See id. at 66,510–11.

[13] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,793 (July 24, 2013) (to be codified at 17 C.F.R. pts. 230, 239 & 242) (citing data from the Federal Reserve Board’s Triennial Survey of Consumer Finances 2010).

[14] See id. at 44,794 (citing an analysis by the Securities & Exchange Commission’s (SEC) Division of Economic and Risk Analysis that was based on the stock holdings of retail investors from more than 100 brokerage firms covering more than 33 million accounts during the period June 2010–May 2011).

[15] See §302(b), 15 U.S.C.A. § 77d1(a), (b) (West 2012).

[16] See Proposed Crowdfunding Rules, 78 Fed. Reg. 66,428.

[17] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b) (West 2012). Examples of issuer requirements include: (i) providing the SEC, intermediaries, and investors with a description of issuer’s (a) business, including its anticipated business plan, (b) financial condition (and, in some cases, reviewed or audited financial statements), (c) anticipated use of the offering proceeds, (d) ownership and capital structure, and (e) method for valuing the securities being offered; (ii) not advertising the terms of the offering, although issuers may direct investors to intermediaries; and (iii) reporting the results of operations (and, in some cases, providing reviewed or audited financial statements) each year to the SEC and investors. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,552–54 (stating proposed regulations regarding these requirements).

[18] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a) (West 2012). Examples of intermediary requirements include: (i) registering with the SEC and a self-regulatory organization; (ii) providing investor-education materials; (iii) ensuring each investor (a) reviews the investor-education materials, (b) affirms she understands that she may lose her entire investment and can bear such a loss, and (c) demonstrates she understands the applicable investment risks; (iv) obtaining background checks on officers, directors and stockholders holding 20% of each issuer; and (v) making each issuer’s information, see supra note 17, available to the SEC and potential investors at least 21 days prior to the sale of issuer’s securities. See id.; see also Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (stating proposed regulations regarding these requirements).

[19] Brian Korn, SEC Proposes Crowdfunding Rules, Forbes.com (Oct. 23, 2013, 2:41 PM), http://www.forbes.com/sites/deborahljacobs/2013/10/23/sec-proposes-crowdfunding-rules/.

[20] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & n.918 (midpoints of the offering amount ranges provided by the SEC were used for this section). The SEC used both its ranges and these same midpoints to estimate items. See id.

[21] See id. (compensation to the intermediary is assumed to be 10% of the offering amount, which is the midpoint of the SEC’s estimated range of an intermediary compensation fee of 5–15%).

[22] See id. The Form C would be used to provide the required initial offering information about the issuer and the offering. See id. at 66,524. The SEC estimates it will take 60 hours to prepare and file the Form C and any amendment to disclose material information. See id. at 66,540. The SEC estimates that 75% of that burden, or 45 hours, would be carried by the issuer but that the other 25%, or 15 hours, would be carried by outside professionals charging $400 per hour. Id. Thus, the $6,000 amount reflects only the cost of outside professionals working for 15 hours at $400 an hour—it does not include any cost for the estimated 45 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $2,250. Total Initial Costs would then be $13,710 for a $50,000 Offering Amount, or 27.42% of the Offering Amount.

[23] See id. at 66,521. For offerings of more than $500,000, the financial statements must be audited; for offerings of more than $100,000, but not more than $500,000, the financial statements must be reviewed by an independent public accountant; and offerings of $100,000 or less require merely that the issuer’s principal executive officer certify that the financial statements are true and complete in all material respects. See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(b)(1)(D) (West 2012).

[24] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,521 & nn.919–20 (assuming a cost of $60 to obtain an EDGAR access code on Form ID and $400 to prepare and file progress updates on Form C-U).

[25] These costs must be incurred until: (i) “issuer becomes a reporting company required to file reports under Section 13(a) or Section 15(d) of the Exchange Act [of 1934]”; (ii) “issuer or another party repurchases all of the securities issued in reliance on [the crowdfunding exemption]”; or (iii) “issuer liquidates or dissolves its business in accordance with state law.” Id. at 66,554.

[26] See id. at 66,521. The Form C-AR would be filed annually with the SEC, beginning the year after the initial offering. See id. at 66,540–41. It would include information substantially similar to that reported via the Form C. See id. at 66,541. The SEC estimates it will take 40 hours to prepare and file each Form C-AR. See id. The SEC estimates that 75% of that burden, or 30 hours, can be carried by the issuer but that the other 25%, or 10 hours, would be carried by outside professionals charging $400 per hour. See id. Thus, the $4,000 amount reflects only the cost of outside professionals working for 10 hours at $400 an hour—it does not include any cost for the estimated 30 hours of issuer time. If, for example, issuer time was valued at $50 per hour, this would increase estimated costs by $1,500. Total Ongoing Annual Costs would then be $5,500 for a $50,000 Offering Amount, or 11% of the Offering Amount.

[27] See supra text accompanying note 23. Costs to review or audit financial statements may be required in connection with each year’s Form C-AR. See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,554.

[28] See JOBS Act, § 302(a), 15 U.S.C.A. § 77d(a)(6)(C) (West 2012).

[29] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,526–28.

[30] See id. at 66,528. The initial and ongoing costs for an entity to register as a broker would be higher than the initial and ongoing costs for an entity to become a funding portal since the SEC assumes brokers would provide a broader range of services, such as providing investment advice, soliciting investors, and managing customer funds and securities. See id. at 66,527. For intermediaries already registered as brokers, there would be no incremental registration or membership costs. See id. at 66,541. The SEC also estimates it would take an intermediary approximately 220 hours to register as a broker-dealer compared to 110 hours to register as a funding portal, and that it would cost intermediaries $10,000, on average, to register with a national securities association. See id. at 66,542.

[31] See id. at 66,528.

[32] See id. This equals the midpoint of the range provided by the SEC, which varies from $100,000 to $400,000 and depends on whether an intermediary can tailor an existing platform to comply with the JOBS Act or would need to develop a new platform from scratch. See id. at n.987.

[33] See supra note 30.

[34]See supra note 31.

[35] See supra note 32.

[36] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,539, 66,543 (estimating that each offering will average $100,000, that each intermediary will facilitate an average of 20 offerings annually, and that each intermediary will be compensated with 10% of the offering amount).

[37] Early stage investors generally expect large returns given the risk of their early stage investment. See, e.g., Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 137 (3d ed. 2008) (“Venture capitalists generally are not interested in investing unless the expected return is in the range of 35 to 45% compounded annually.”).

[38] See supra note 22.

[39] See supra note 26.

[40] Bradford, supra note 1.

[41] For example, if X is contemplating an investment of $200 into venture V and X’s time is worth $200 an hour, once X spends just one hour learning about V’s business and the terms of the offering, X’s transactional costs will equal 100% of the contemplated investment amount.

[42] See supra note 21 (estimating that an intermediary’s fee will be 5% to 15% of the offering amount).

[43] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,555–56 (to be codified at 17 C.F.R. pt. 227) (“An intermediary . . . may not have a financial interest in an issuer that is offering or selling securities in reliance on [the crowdfunding exemption] through the intermediary’s platform, or receive a financial interest in an issuer as compensation for services provided to or for the benefit of the issuer in connection with the offer or sale of such securities.”).

[44] See JOBS Act § 302(b), 15 U.S.C.A. § 77d-1(a)(11) (West 2012) (prohibiting an intermediary’s “directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services” but not prohibiting the intermediary itself from having such an interest).

[45] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Scott Brown) (“[I]ntermediaries should also be allowed to take an equity stake in offerings. This however, does not mean that intermediaries should be able to choose which offerings to participate in but rather it should be a standard process for any offering that the intermediary facilitates. This will incentivize an intermediary to focus on issuer quality over quantity, providing more vetting for investors and greater alignment of interests.”).

[46] For example, an issuer’s cash position would not improve if: (i) the issuer is selling $1 million of stock; (ii) there is sufficient investor demand; and, (iii) the shares being granted to the intermediary for its services “count” towards the JOBS Act’s $1 million offering cap. See supra text accompanying note 5.

[47] For example, when an issuer grants its stock to an intermediary for services and those shares are in addition to shares the issuer would have otherwise sold to investors. This would be the case if the shares to the intermediary would not cause the offering to exceed the $1 million JOBS Act cap or if the shares would not “count” towards the amount being raised (for example, if the SEC adopts final rules both allowing intermediaries to take equity interests and stating that said equity does not count towards the offering amount). Moreover, the issuance of the additional shares must not trigger incremental costs, such as kicking in the requirement to provide audited financial statements, that would offset the amount of cash saved by not paying the intermediary’s fee in cash.

[48] See, e.g., Guy Kawasaki, Reality Check: The Irreverent Guide to Outsmarting, Outmanaging, and Outmarketing Your Competition 107 (2008) (quoting the great Silicon Valley corporate finance lawyer, Craig Johnson: “The leading cause of failure of startups is death, and death happens when you run out of money.”).

[49] For example, if intermediary Z values venture V’s shares at $1 each while investors are expected to value V’s shares at $0.60 each, Z and V could split the $0.40 per share difference in valuations. That is, if intermediaries typically charge a 10% fee and V is raising $600,000, Z would require only 60,000 shares to equal the $60,000 fee and not 100,000 shares (even though 100,000 shares would need to be sold to investors to bring in a $60,000 cash fee). Further, both V and Z would prefer a transaction with 80,000 V shares to a $60,000 cash fee. When using the investor value, this would suggest V is paying only an 8% fee ($48,000/$600,000) even though Z would value 80,000 shares at as much as a 13.33% cash fee ($80,000/$600,000). While one may argue it is illogical to consider more than one value for the same V’s shares, new ventures are unique. First, as a typical Shark Tank episode illustrates, it is common for people (and Sharks) to disagree about the value of new ventures. Second, whatever the “objective” value is, it is based on assumptions that can quickly change and, when those assumptions change, the impact can be significant. For example, one new client contract could cause a venture to quadruple its total sales. Regardless, if intermediaries are allowed to take an equity stake in issuers, they have an economic incentive to welcome those they see as good bets. The intermediaries thus would serve a vetting role, leading to greater capital flow from more confident investors.

[50] See supra note 3 and accompanying text.

[51] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,771, 44,804 (July 24, 2013) (to be codified at 17 C.F.R. §230.506(c)). 506(c) offerings also allow issuers to “offer securities through means of general solicitation, provided that . . . all purchasers of the securities [are] accredited investors” and several other requirements are met. See id. at 44,776 (“Issuers relying on Rule 506(c) for their offerings will not be subject to the prohibition against general solicitation found in Rule 502(c).”).

[52] However, to protect against investors losing too much, there could be limits on the amount people may invest in such offerings (for example, limits based on a percentage of an investor’s net worth and/or income levels).

[53] See Amendments to Regulation D, Form D and Rule 156, 78 Fed. Reg. 44,806, 44,830 (proposed Jul. 24, 2013) (request from the SEC for comment on whether the net worth and income tests are “the appropriate tests for determining whether a natural person is an accredited investor” and, if not, “what other criteria should be considered as an appropriate test for investment sophistication”).

[54] See Model Legal Documents, National Venture Capital Association, http://www.nvca.org/index.php?option=com_content&view=article&id=108&Itemid=136 (last visited Mar. 28, 2014) (expressing similar goals with respect to a set of model documents the National Venture Capital Association makes available for venture capital financings: “The model documents aim to: reflect and in a number of instances, guide and establish industry norms; be fair, avoid bias toward the [investor] or the company/entrepreneur; . . . include explanatory commentary where necessary or helpful; anticipate and eliminate traps for the unwary (e.g., unenforceable or unworkable provisions); provide a comprehensive set of internally consistent financing documents; promote consistency among transactions; and reduce transaction costs and time.”).

[55]  See, e.g., Leena Rao, YC-backed Clerky Helps Startups Save Time And Money On Legal Incorporation, Stock Issuance Forms And More, TechCrunch (Mar. 11, 2013), http://techcrunch.com/2013/03/11/yc-backed-clerky-helps-startups-save-time-and-money-on-legal-incorporation-stock-issuance-forms-and-more/. For an example of actual templates for startups, see Open Sourced Model Seed Financing Documents, Techstars.com, http://www.techstars.com/docs/ (last visited Mar. 28, 2014) (publishing templates prepared by Cooley LLP).

[56] See supra notes 17 & 18.

[57]See supra notes 17 & 18.

[58] See 158 Cong. Rec. S2231 (daily ed. Mar. 29, 2012) (statement of Sen. Michael Bennet) (“[F]unding portals should be allowed to engage in due diligence services. This would include providing templates and forms, which will enable issuers to comply with the underlying statute. In crafting this law, it was our intent to allow funding portals to provide such services.”).

[59] See Proposed Crowdfunding Rules, 78 Fed. Reg. at 66,560 (to be codified at 17 C.F.R. §227.402(b)) (“A funding portal may . . . [a]dvise an issuer about the structure or content of the issuer’s offering, including assisting the issuer in preparing the offering documentation.”).

[60] For example, legal counsel could advise on the risks associated with using the templates and assist with matters not covered by the templates, such as becoming “qualified to do business” in the state where the issuer’s offices are physically located. In this way, attorneys will become familiar with the templates and be able to efficiently provide add-on services.

[61] Orrick, Herrington & Sutcliffe LLP provides examples of such templates. See Start-Up Forms: Corporate Formation, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Corporation.aspx (last visited Mar. 28, 2014).

[62] See, e.g., Kawasaki, supra note 48, at chs. 8, 9, & 17 (providing rules of thumb for what should be included in an executive summary, investor pitch, and business plan—as well as how to format such items).

[63] An example of such a right is a “liquidation preference.” A liquidation preference ensures that, if a company is acquired (or otherwise liquidated), any assets remaining after payment of the company’s debts get distributed first to the preferred stock holders—until they receive an amount at least equal to their original investment plus any accrued and unpaid dividends. See e.g., Bagley & Dauchy, supra note 37, at 150; Fenwick & West LLP, Venture Capital for High Technology Companies 13 (2010) [hereinafter Fenwick VC Guide], http://www.fenwick.com/FenwickDocuments/venture_capital_final_2010.pdf.

[64] See, e.g., Bagley & Dauchy, supra note 37, at 64–65; Fenwick VC Guide, supra note 63, at 13.

[65] See, e.g., Bagley & Dauchy, supra note 37, at 93–94; Fenwick VC Guide, supra note 63, at 2.

[66] Orrick, Herrington & Sutcliffe LLP provides such templates, including a Common Stock Purchase Agreement with vesting provisions, an “Assignment of IP and Other Assets” form, and paperwork to help with 83(b) elections. Start-up Forms: Founders’ Stock Purchase, Orrick, Herrington & Sutcliffe LLP, http://www.orrick.com/Practices/Emerging-Companies/Startup-Forms/Pages/Forms-Founders.aspx (last visited Mar. 28, 2014).

[67] See supra note 25.

[68] When items need to differ from the standard, they will be highlighted on a concise schedule of exceptions, thereby making it easy for parties to see what changes are needed for particular deals.

[69] To reduce liability exposure, the funding portals would be set up as separate entities.

[70] See, e.g., U-M Based Student-Led Investment Funds, The Samuel Zell & Robert H. Lurie Institute for Entrepreneurial Studies, http://www.zli.bus.umich.edu/wvf/ (last visited Mar. 28, 2014) (providing summaries for three different “Wolverine/Student Venture Funds”: the Wolverine Venture Fund, the Zell Lurie Commercialization Fund, and the Social Venture Fund); About the Irish Entrepreneurs Network, The Irish Entrepreneurs Network, https://www.business.nd.edu/gigot/irishangels/about_ia.cfm (last visited Mar. 28, 2014) (describing the Irish Entrepreneurs Network as consisting of “a select group of Notre Dame alumni and friends having experience with entrepreneurial endeavors” and having a mission to “serve as a focal point for entrepreneurially-minded members of the Notre Dame family worldwide”).

[71] Instead of itemizing charitable deductions, people who invest in for-profit ventures that fail could take a more favorable ordinary loss deduction. See I.R.C. § 1244 (2012).

[72] Social network ties have been found to be important in non-equity crowdfunding. See, e.g., Ethan Mollick, The Dynamics of Crowdfunding: An Exploratory Study, 29 J. Bus. Venturing 14 (2014).

[73] See e.g., Law School Entrepreneurship Clinics, Ewing Marion Kauffman Foundation, http://www.entrepreneurship.org/entrepreneurship-law/law-school-entrepreneurship-clinics.aspx (last visited Mar. 28, 2014) (listing U.S. law school clinics that provide assistance to entrepreneurs and innovators).

[74] See Arbitration & Mediation, FINRA, http://www.finra.org/ArbitrationAndMediation/index.htm (last visited Mar. 28, 2014).

[75] To avoid potential conflicts, some clinics could help with exempt offerings while others could assist with arbitrating disputes.

By

The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://journals.law.harvard.edu/hblr//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

The Equity Façade of SEC Disgorgement

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Russell G. Ryan*

In its civil law enforcement cases under the federal securities laws, the Securities and Exchange Commission (SEC) routinely seeks disgorgement of ill-gotten gains, and courts routinely grant it.[1] The SEC commonly describes disgorgement as an equitable remedy,[2] and courts similarly begin their disgorgement analyses by assuming as axiomatic the equitable nature of disgorgement.[3]

But what if that premise is wrong? What if disgorgement is an equitable remedy only some of the time? What if in many cases it is actually a remedy at law, or even a punitive remedy? And what if in some cases the very label of disgorgement is a misnomer?

This Article attempts to answer these critical but largely overlooked questions. It begins with a brief summary of the history and context of disgorgement among the various SEC enforcement remedies.[4] It then explains why disgorgement in SEC cases is often not a remedy in equity at all, but rather a classic remedy at law in the form of a personal liability to pay a sum of money—independent of whether the defendant still possesses the tainted profits, or ever possessed them at all.[5] Finally, the Article explores the potential legal and statutory ramifications of removing the façade of equity from the disgorgement remedy.[6]

Disgorgement in Context

In carrying out its law enforcement role, the SEC is statutorily empowered to pursue a wide range of remedies against securities law violators. These remedies include injunctions,[7] administrative cease-and-desist orders,[8] monetary penalties,[9] and various forms of bars and suspensions.[10] The SEC can unilaterally order some of these remedies through administrative proceedings, while others are available only if the SEC files a lawsuit and obtains an order or judgment from a federal district court.[11]

Congress has never explicitly included disgorgement among the remedies the SEC can seek in federal court.[12] Despite this silence, the SEC has been seeking disgorgement for decades, and courts have been granting it for nearly as long.[13] Courts initially held that disgorgement—or “restitution,” as some courts and commentators labeled it early on—was a remedy ancillary to the court’s statutory power to order equitable injunctive relief.[14] Over time, courts came to accept as a truism the notion that disgorgement is inherently an ancillary equitable remedy.[15]

Significantly, most of the seminal SEC disgorgement cases were decided before Congress first empowered the agency in 1990 to seek monetary penalties against securities law violators.[16] Until then, the temptation for the SEC to request and the courts to grant disgorgement based on questionable theories was understandable, lest securities law violators appear to avoid punishment by suffering a mere injunction against future wrongdoing without any accompanying monetary sanctions. Today, however, there are no compelling reasons to stretch disgorgement beyond its limits.[17] In recent decades, Congress has granted the SEC and the courts a vast array of options to impose harsh monetary and other sanctions against wrongdoers in virtually all kinds of securities cases, regardless of whether disgorgement is available as an additional remedy.[18] Indeed, with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, the SEC can now administratively impose severe financial penalties, subject to only limited and deferential after-the-fact review by a federal court of appeals.[19]

More importantly for purposes of this Article, SEC disgorgement law developed mostly before the Supreme Court’s 2002 decision in Great-West Life & Annuity Insurance Co. v. Knudson.[20] As discussed at length below, Great-West articulated the Court’s most recent and authoritative teaching on whether and under what circumstances a restitutionary remedy constitutes equitable relief, as opposed to legal relief, in the context of a federal statute that explicitly allows the former but not the latter.[21] Great-West is especially significant because, within months after it was decided, Congress added a similar provision for equitable relief to the federal securities laws as part of the Sarbanes-Oxley Act of 2002.[22] Although that provision did not explicitly mention disgorgement, the widespread assumption that disgorgement was invariably a form of equitable relief has since emboldened the SEC and courts to cite it as statutory authority for ordering disgorgement.[23] Still, whether the power to order disgorgement derives from a district court’s inherent equitable powers or from the explicit statutory authority of Sarbanes-Oxley—or both—it can lawfully be ordered only if it in fact constitutes equitable relief rather than legal relief.

Courts have also given the SEC substantial procedural and evidentiary advantages in disgorgement cases based on the premise that it is an equitable remedy. For example, the SEC is required to proffer only a “reasonable approximation” of the alleged ill-gotten gains, at which point the evidentiary burden shifts to the defendant to disprove the SEC’s calculation.[24] Based on the presumption that disgorgement is an inherently equitable remedy, courts also generally hold that defendants facing SEC disgorgement claims enjoy neither the protection of any statute of limitations[25] nor the right to a jury trial.[26] Courts have also accepted the SEC’s position that a disgorgement order is enforceable through contempt sanctions[27] and is not a debt that triggers the protections normally afforded to judgment debtors under the Federal Debt Collection Procedures Act.[28] All of these advantages, however, would presumably be swept aside in any given case if the disgorgement sought by the SEC were determined not to be an equitable remedy.

The Equity Façade and the Disgorgement Misnomer

As noted at the outset of this Article, the SEC and the courts have commonly described disgorgement as an equitable remedy, designed to deprive wrongdoers of unjust enrichment and to deter others from violating the securities laws.[29] It is also generally acknowledged that disgorgement cannot be used punitively, and thus must be limited to an amount causally connected to the alleged wrongdoing.[30] Beyond that, however, any resemblance to a truly equitable remedy largely disappears in most cases. For example, the SEC and the courts generally say that disgorgement can be ordered even against defendants who no longer possess or have access to the tainted profits, or never possessed them at all.[31] They further say that a defendant can be held jointly and severally liable for other people’s gains as long as the participants were closely related or had collaborated in their scheme.[32] These attributes call into question whether the label of equity accurately describes disgorgement.

In determining whether SEC disgorgement claims seek truly equitable relief, the starting point should be the Supreme Court’s analysis in Great-West,[33] which interpreted the phrase “equitable relief” in Section 502(a)(3) of the Employee Retirement Income Security Act of 1974.[34] The plaintiffs were an insurer and a company-sponsored employee health plan seeking reimbursement of funds previously paid to a beneficiary after an auto accident.[35] They claimed that certain agreements entitled them to reimbursement from the proceeds of a settlement the beneficiary later recovered from a third-party tortfeasor.[36] In a 5-4 decision, the Supreme Court rejected several alternative attempts to classify the requested monetary relief as equitable rather than legal.[37] Most relevant for present purposes, the Court rejected the argument that the plaintiffs were seeking equitable restitution.[38]

The Court acknowledged that some forms of restitution are equitable in nature but emphasized that others are available only at law.[39] The Court quoted earlier precedent holding that “equitable relief,” as used in the statute at issue, “must refer to ‘those categories of relief that were typically available in equity.’”[40] The Court then distinguished between “restitution at law” and “restitution in equity,” holding that only the latter fell within the court’s equitable powers.[41]

The Court’s description of “restitution at law” fittingly captures the essence of the disgorgement remedy typically sought by the SEC:

In cases in which the plaintiff “could not assert title or right to possession of particular property, but in which nevertheless he might be able to show just grounds for recovering money to pay for some benefit the defendant had received from him,” the plaintiff had a right to restitution at law through an action derived from the common law-writ of assumpsit. In such cases, the plaintiff’s claim was considered legal because he sought “to obtain a judgment imposing a merely personal liability upon the defendant to pay a sum of money.”[42]

The Court then distinguished the separate concept of restitution in equity:

In contrast, a plaintiff could seek restitution in equity, ordinarily in the form of a constructive trust or an equitable lien, where money or property identified as belonging in good conscience to the plaintiff could clearly be traced to particular funds or property in the defendant’s possession. A court of equity could then order a defendant to transfer title (in the case of the constructive trust) or to give a security interest (in the case of the equitable lien) to a plaintiff who was, in the eyes of equity, the true owner. But where “the property [sought to be recovered] or its proceeds have been dissipated so that no product remains, [the plaintiff’s] claim is only that of a general creditor,” and the plaintiff “cannot enforce a constructive trust of or an equitable lien upon other property of the [defendant].” Thus, for restitution to lie in equity, the action generally must seek not to impose personal liability on the defendant, but to restore to the plaintiff particular funds or property in the defendant’s possession.[43]

Because the plaintiffs in Great-West sought to impose the kind of personal monetary liability described by the Court as legal restitution, the Court held that the remedy was beyond the district court’s equitable powers.[44]

Many SEC disgorgement orders do not fit within Great-West’s description of equitable relief because the defendant does not possess the allegedly illicit gains that flowed from the securities law violation, and thus the disgorgement seems most akin to a personal liability to pay a substitutionary sum of money approximating the illicit gains. Common examples include insider-trading cases in which tippers are ordered to disgorge not only their own profits but also those of their tippees.[45] Other cases involve defendants who have spent, squandered, or transferred their ill-gotten gains before being caught by the SEC, yet are still ordered to disgorge what they no longer possess.[46] In these cases, courts often rely in part on the concept of joint and several liability,[47] a dubious approach for reasons that exceed the scope of this Article.[48] In any event, the so-called disgorgement does not purport to order specific performance, a constructive trust, or an equitable lien over specific funds or property derived from the alleged wrongdoing, all of which would, of course, be impossible. Instead, courts simply require the defendant to pay a substitutionary sum of money calculated as an approximation of ill-gotten gains the defendant does not possess. Not surprisingly, the SEC’s collection rate in these cases is dismal.[49]

In ordering disgorgement, courts typically consider it irrelevant that the defendant no longer possesses the ill-gotten gains,[50] which seems incompatible with Great-West. One influential example is the D.C. Circuit’s opinion in SEC v. Banner Fund International.[51] Rejecting the defendant’s claim that he no longer had access to his illicit gains, and thus could not disgorge them, the court asserted that the defendant’s approach would create a “monstrous doctrine” and lead to “absurd results,” because it might incentivize securities law violators to spend or transfer their tainted profits before getting caught.[52] In hindsight, however, this aspect of Banner Fund cannot be squared with the Supreme Court’s Great-West opinion two years later.

Like most disgorgement decisions, Banner Fund assumed that disgorgement is an inherently equitable remedy. But the court’s literal language and rationale, when read in contrast with the Supreme Court’s subsequent opinion in Great-West, leaves little doubt that Banner Fund was actually describing a legal remedy rather than an equitable one:

The SEC in turn contends that . . . the disgorgement order imposes an obligation upon [the defendant] personally, which he may satisfy using his own assets. Because disgorgement is an equitable obligation to return a sum equal to the amount wrongfully obtained, rather than a requirement to replevy a specific asset, we reject [the defendant’s] challenge and affirm the district court.

. . . As the SEC points out, the requirement of a causal relationship between a wrongful act and the property to be disgorged does not imply that a court may order a malefactor to disgorge only the actual property obtained by means of his wrongful act. Rather, the causal connection required is between the amount by which the defendant was unjustly enriched and the amount he can be required to disgorge. To hold, as [defendant] maintains, that a court may order a defendant to disgorge only the actual assets unjustly received would lead to absurd results. . . .

. . . [A]n order to disgorge establishes a personal liability, which the defendant must satisfy regardless whether he retains the selfsame proceeds of his wrongdoing.[53]

Banner Fund flatly rejected the notion that disgorgement requires current possession of, or access to, the “actual property” representing the ill-gotten gains; the court instead explicitly equated disgorgement with the mere payment of a sum of money “equal to the amount wrongfully obtained.”[54] Two years later in Great-West, however, the Supreme Court made clear that the kind of remedy described in Banner Fund (and similar cases) is actually a legal one rather than an equitable one.[55] Specifically, Banner Fund’s literal description of disgorgement as imposing a “personal liability” to pay “a sum equal to the amount wrongfully obtained,” rather than an obligation to return “the actual assets wrongfully received,” eerily presaged the nearly verbatim language Great-West later used to describe restitution at law.[56] Moreover, contrary to what Banner Fund incorrectly assumed, whether a defendant “retains the selfsame proceeds from his wrongdoing” is not only relevant to the distinction between equitable and legal remedies that seek the repayment of money, it is largely dispositive under Great-West.[57]

Indeed, in cases like Banner Fund, the very label of disgorgement is a misnomer. The federal securities laws do not define the terms “disgorge” or “disgorgement,” but in common parlance they mean to eject or discharge the contents of something.[58] These terms presuppose that the contents remain extant in order to be disgorged. In the securities law context, true disgorgement should similarly mean that the defendant in fact possesses or at least has access to the asset being disgorged. Otherwise, calling the remedy “disgorgement” is akin to a doctor advising an emaciated patient to disgorge last year’s Thanksgiving dinner. When the order makes no pretense of requiring the actual disgorgement of anything the defendant possesses or has access to, it is neither disgorgement nor an exercise of equitable power. It is a mere personal liability to pay a money judgment—the quintessence of a remedy at law.

Additionally, disgorgement fails Great-West’s test for equitable relief in several other ways. First, disgorgement is a relatively modern concept, particularly in the context of law enforcement. It does not appear to have even been known to historical courts of chancery, much less typically granted by them, the key determinant of equitable relief under Great-West.[59] Indeed, disgorgement was not known, contemplated, or typically awarded even when Congress enacted the federal securities laws. One commentator found “only 11 cases in federal and state case law that were published between 1800 and 1960 that use the term ‘disgorgement’ in any context.”[60] The Government Accounting Office has likewise reported that “[t]he use of the disgorgement sanction in securities law violation cases is a relatively recent phenomenon,” and that “[d]isgorgement was first ordered in a securities law violation case in 1970.”[61] The closest historical antecedent to modern disgorgement is probably restitution, which as previously noted was the label some early disgorgement cases used,[62] and which was the very remedy the Supreme Court analyzed in Great-West.

Moreover, the federal securities laws explicitly include disgorgement among the many remedies the SEC is empowered to order administratively without ever seeking the imprimatur of a federal court sitting in either law or equity.[63] By explicitly authorizing disgorgement as an administrative remedy, capable of being ordered by an independent executive branch agency carrying out its law enforcement functions, Congress must have recognized that disgorgement is not invariably a remedy in equity. It seems highly doubtful that Congress would—or constitutionally could, consistent with separation of powers—bestow one of the core judicial powers of an Article III court of equity upon a law enforcement agency of the executive branch.[64]

To be sure, some disgorgement might fairly be characterized as equitable under Great-West. For example, the SEC sometimes moves with alacrity to preserve suspected ill-gotten funds through a temporary restraining order, a preliminary asset freeze, the appointment of a receiver, a voluntary agreement, or otherwise. Sometimes the ill-gotten gains remain extant and identifiable even in the absence of affirmative steps by the SEC to preserve them. If and when the SEC obtains a disgorgement order in these types of cases, there is a specific pool of money that can be turned over to the SEC. Not coincidentally (and not insignificantly), in these cases the SEC has a relatively high success rate in collecting the resulting disgorgement judgments.[65] But these cases, based on the author’s two decades of anecdotal experience on both sides of SEC enforcement cases, represent a small fraction of SEC disgorgement cases.[66]

Potential Ramifications

If the above analysis is correct—if disgorgement is often not an equitable remedy in SEC enforcement cases but rather a legal remedy akin to a simple money judgment—there would be several practical ramifications for SEC enforcement.

First, whenever disgorgement is legal rather than equitable, the SEC has no lawful power to seek it in federal court proceedings, and the courts have no lawful power to award it. Being purely a creature of statute, the SEC can lawfully seek in court only those remedies Congress has authorized it to seek, and disgorgement at law is not among those remedies.[67] Likewise, being courts of limited jurisdiction, federal courts can lawfully impose only those remedies at law that Congress has authorized in the relevant statutes.[68] As discussed above, ever since disgorgement was first accepted as a lawful remedy in SEC enforcement, the only plausible sources of authority cited to support it are either the courts’ inherent power to grant equitable remedies ancillary to their explicit statutory power to grant injunctive relief[69] or the recent statutory provision for “equitable relief” added by Sarbanes-Oxley.[70] If and when disgorgement is not in fact an equitable remedy, neither source of lawful authority is available.

Second, notwithstanding the colorful warnings of Banner Fund and other cases, the resulting partial demise of disgorgement would not raise an alarm in the realm of SEC enforcement. As previously discussed, the SEC has a vast arsenal of other equitable and punitive remedies to address securities law violations even in cases where disgorgement is unavailable or inappropriate.[71] Violators are also subject to potential criminal prosecution[72] as well as money damage awards in private lawsuits.[73] In short, securities law violators do not get off scot-free simply because the SEC cannot seek disgorgement in a particular case.

Moreover, even under a strict adherence to the principles of Great-West, the SEC would have several options to deprive securities law violators of the profits caused by their violations. As previously noted, the agency often moves swiftly to preserve tainted profits—through court orders, voluntary agreements, or otherwise—before those profits can be transferred or dissipated, and in other cases the funds remain available even without any affirmative steps being taken to preserve them.[74] In such cases, the court could presumably order truly equitable disgorgement consistent with Great-West.[75] As also previously noted, whenever the SEC finds a securities law violation it can order disgorgement from the violator administratively, without having to go to court at all (although subject to deferential judicial review).[76] The SEC can also ask federal courts, when imposing statutory penalties against a defendant, to calculate that penalty as an amount equal to “the gross amount of pecuniary gain to [the] defendant as a result of the violation.”[77] Of course, if these remedies are insufficient, the SEC can always seek help from Congress, which has accommodated similar requests in recent decades.[78]

To be sure, if courts began acknowledging that some SEC disgorgement demands seek legal rather than equitable relief—yet concluded they could still award it (or the SEC prevailed upon Congress to authorize disgorgement at law by statute)—the distinction between legal and equitable disgorgement would affect a host of collateral issues and rights affecting SEC disgorgement defendants. For example, based largely on the premise that SEC disgorgement claims seek inherently equitable relief, courts have generally denied defendants the repose of any statute of limitations[79] and the right to a jury trial.[80] For similar reasons, courts have allowed the SEC to enforce disgorgement judgments through contempt sanctions (including incarceration) rather than limiting the agency to the writ of execution normally used to enforce money judgments.[81] One federal circuit has even held that an SEC disgorgement order is not a “debt” owed to the government that triggers the protections ordinarily afforded under the Federal Debt Collection Act.[82] Removing the façade of equity would severely undermine the prevailing approach to all of these issues.[83]

Conclusion

The prevailing notion that SEC disgorgement is an inherently equitable remedy ought to be thoughtfully revisited. Courts award the SEC billions of dollars in disgorgement each year, yet in many cases the premise of equity seems squarely at odds with the Supreme Court’s analysis of restitution in Great-West. Given the amounts at stake in these cases, as well as the significant procedural disadvantages a defendant confronts when a court acts in equity rather than at law, the long-standing premise of equity warrants a higher degree of skepticism and scrutiny than it has received thus far.

 

Preferred citation: Russell G. Ryan, The Equity Façade of SEC Disgorgement, 4 Harv. Bus. L. Rev. Online 1 (2013), https://journals.law.harvard.edu/hblr//?p=3528.

* Russell G. Ryan, a former Assistant Director of the SEC’s Division of Enforcement, is a partner in the Washington, D.C., office of King & Spalding LLP. Mr. Ryan represented the petitioner in Cahill v. SEC, 133 S. Ct. 28 (2012) (denying certiorari), and in related proceedings in the lower courts, certain opinions from which are cited in this Article.

[1] The Securities and Exchange Commission (SEC) has secured more than $1.8 billion in aggregate disgorgement orders in each of its four most recent fiscal years—far more than the agency has been awarded in statutory penalties over the same period. See Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2012, 2 tbl. 1, available at www.sec.gov/about/secstats2012.pdf ($2.1 billion in disgorgement and $1 billion in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2011, 2 tbl. 1, available at www.sec.gov/about/secstats2011.pdf ($1.9 billion in disgorgement and $928 million in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2010, 2 tbl. 1, available at www.sec.gov/about/secstats2010.pdf ($1.8 billion in disgorgement and $1 billion in penalties); Secs. & Exch. Comm’n, Select SEC and Market Data, Fiscal 2009, 2 tbl. 1, available at www.sec.gov/about/secstats2009.pdf ($2.1 billion in disgorgement and $345 million in penalties).

[2] As an example, in a recent case the SEC asserted this premise in the second sentence of the argument section of its brief. Brief of the Secs. & Exch. Comm’n, Appellee at 15, SEC v. Whittemore, 659 F.3d 1 (D.C. Cir. 2011) (No. 10-5321) (quoting SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989)). Similarly, in a report on disgorgement submitted by the agency to Congress, the second sentence of the SEC’s background discussion of disgorgement stated: “Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of ‘ill-gotten gains.’” Secs. & Exch. Comm’n, Report Pursuant to Section 308(c) of the Sarbanes Oxley Act of 2002, 2­–3 (2003) [hereinafter SEC Disgorgement Report], available at www.sec.gov/news/studies/sox308creport.pdf.

[3] See infra notes 15 & 29 and accompanying text. A recent Lexis search of cases in which the SEC was a named party and the opinion contained the exact phrase “disgorgement is an equitable remedy” returned 81 hits. Moreover, this author’s routine weekly electronic search and review of new court opinions issued in SEC enforcement cases has revealed dozens of opinions each year in which courts begin their disgorgement analysis with the assumed premise that disgorgement is equitable. For several recent examples, see SEC v. O’Meally, 2013 U.S. Dist. LEXIS 33487, at *7 (S.D.N.Y. March 11, 2013) (“Disgorgement is a form of equitable relief.”); SEC v. Murray, 2013 U.S. Dist. LEXIS 32460, at *4 (E.D.N.Y. March 6, 2013) (“Once the district court has found federal securities law violations, it has broad equitable power to fashion appropriate remedies, including ordering that culpable defendants disgorge their profits.”); SEC v. Art Intellect, Inc., 2013 U.S. Dist. LEXIS 32132, at *69 (D. Utah March 6, 2013) (“Actions for disgorgement of improper profits are equitable in nature, because the purpose of disgorgement is to prevent unjust enrichment.”).

[4] See infra notes 7–28 and accompanying text.

[5] See infra notes 29­–66 and accompanying text.

[6] See infra notes 67–83 and accompanying text.

[7] See, e.g., Securities Act of 1933 § 20(b), 15 U.S.C. § 77t(b) (2012); Securities Exchange Act of 1934 § 21(d)(1), 15 U.S.C. § 78u(d)(1).

[8] See, e.g., 15 U.S.C. §§ 77h-1(a), 78u-3(a).

[9] See, e.g., 15 U.S.C. §§ 77t(d), 78u(d)(3), 78u-1 to -2.

[10] See, e.g., 15 U.S.C. § 77h-1(f), 77t(e) (bars and suspensions from service as public company officer or director); 15 U.S.C. § 78u(d)(2), 78u-3(f) (same): 15 U.S.C. § 78o(b)(4), (b)(6) (bars and suspensions from service as or association with broker-dealers); Investment Advisers Act of 1940 § 203(e), (f), 15 U.S.C. § 80b-3(e) to (f) (2012) (bars and suspensions from service as or association with investment advisers).

[11] Compare 15 U.S.C. §§ 77h-1, 78u-2 to -3 (administrative remedies) with 15 U.S.C. §§ 77t, 78u, 78u-1(federal court remedies).

[12] This is not merely a legislative oversight, as Congress has explicitly empowered the SEC to order disgorgement administratively without having to go to court at all. See, e.g., 15 U.S.C. §§ 77h-1(e),78u-2(e), -3(e). As noted by one commentator, the legislative history of these provisions “makes clear that Congress assumed that disgorgement was already available as a remedy in judicial proceedings.” Barbara Black, Should the SEC Be a Collection Agency for Defrauded Investors?, 63 Bus. Law. 317, 321 (2008) (citing S. Rep. No. 101-337, at 8 (1990)). In practice, for reasons that exceed the scope of this article, the SEC rarely uses administrative proceedings to pursue contested disgorgement claims, preferring instead to file and litigate such claims in federal court. Nevertheless, the fact that Congress has explicitly granted the SEC, an independent executive branch agency, the power to order disgorgement administratively as part of its law enforcement functions, weighs heavily against any presumption that disgorgement is a remedy in equity. See infra notes 63–64 and accompanying text.

[13] The SEC first sought and obtained disgorgement in SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 92–94 (S.D.N.Y. 1970); aff’d in part and rev’d in part, 446 F.2d 1301, 1307–08 (2d Cir. 1971), and has done so innumerable times since. See generally John D. Ellsworth, Disgorgement in Securities Fraud Actions Brought by the SEC, 1977 Duke L.J. 641, 641–42 n.3 (1977); SEC Disgorgement Report, supra note 2, at 3 n.3 (citing cases).

[14] See, e.g., SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989) (holding that because the Exchange Act does not restrict the equitable remedies of district courts, disgorgement is available “simply because the relevant provisions . . . vest jurisdiction in the federal courts”); SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1103–04 (2d Cir. 1972); Texas Gulf Sulphur, 446 F.2d at 1307–08.

[15] See, e.g., SEC v. Wang, 944 F.2d 80, 85 (2d Cir. 1991) (“The disgorgement remedy [the district court judge] approved in this case is, by its very nature, an equitable remedy . . . .” (emphasis added)); First City Fin, 890 F.2d at 1230 (“Disgorgement is an equitable remedy . . . .”); SEC v. Certain Unknown Purchasers of Common Stock of and Call Options for Common Stock of Santa Fe Int’l Corp., 817 F.2d 1018, 1020 (2d Cir. 1987) (“The disgorgement remedy approved by the district court in this case is, by its nature, an equitable remedy.” (emphasis added)).

[16] See infra note 18.

[17] See generally John K. Robinson, A Reconsideration of the Disgorgement Remedy in Tipper-Tippee Insider Trading Cases, 62 Geo. Wash. L. Rev. 432 (1994).

[18] See, e.g., Securities Enforcement Remedies and Penny Stock Reform Act, Pub. L. No 101-429, secs. 101, 202, §§ 20(d), 21B, 104 Stat. 931, 932­–33, 937–38 (1990) (codified in relevant part at 15 U.S.C. §§ 77t, 78u-2) (authorizing the SEC to seek, and courts to impose, among other things, monetary penalties, officer-director bars, and penny-stock bars against any violator and authorizing the SEC to impose monetary penalties and other sanctions administratively against persons and entities in SEC-regulated industries); Sarbanes-Oxley Act, Pub. L. 107-204, §§ 305, 603, 807, 1105 and 1106, 116 Stat. 745, 778–79, 794–95, 804, 809–10 (2002) (codified in relevant part at 15 U.S.C. § 78u(d)(2), 78u(d)(6), 78u-3(f), 78ff(a), & 18 U.S.C. § 1348) (lowering the SEC’s burden of proof to obtain officer-director bars; authorizing the SEC to impose such bars administratively and without court approval; authorizing the SEC to obtain penny-stock bars in federal court cases; adding new criminal penalties for securities fraud involving public companies; and increasing maximum penalty amounts for violations generally).

[19] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, sec. 929P, § 308, 124 Stat. 1376 (2010). SEC administrative sanctions are set aside by courts only if “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” See 5 U.S.C. § 706(2)(A); KPMG, LLP v. SEC, 289 F.3d 109, 121 (D.C. Cir. 2002); Graham v. SEC, 222 F.3d 994, 999–1000 (D.C. Cir. 2000); accord VanCook v. SEC, 653 F.3d 130, 137 (2d Cir. 2011) (holding that the SEC’s choice of administrative sanction disturbed only if “unwarranted in law or without justification in fact”).

[20] 534 U.S. 204 (2002).

[21] See infra notes 34–44 and accompanying text.

[22] Sarbanes-Oxley Act § 305(b), codified at 15 U.S.C. § 78u(d)(5).  The amendment inserted a new subsection (5) into Section 21(d) of the Securities Exchange Act of 1934, providing that “[i]n any action or proceeding brought or instituted by the Commission under any provision of the securities laws, the Commission may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.” Id.

[23] E.g., SEC v. Whittemore, 659 F.3d 1, 4 (D.C. Cir. 2011).

[24] E.g., id. at 7; SEC v. Happ, 392 F.3d 12, 31 (1st Cir. 2004); SEC v. First City Fin. Corp., 890 F.2d 1215, 1231–32 (D.C. Cir. 1989) (citing cases from other circuits).

[25] See, e.g., Riordan v. SEC, 627 F.3d 1230, 1234 (D.C. Cir. 2010); SEC v. Rind, 991 F.2d 1486, 1492–93 (9th Cir. 1993); SEC v. Gabelli, 2010 U.S. Dist. LEXIS 27613, at *12–13 (S.D.N.Y. 2010).

[26] See, e.g., Rind, 991 F.2d at 1493; SEC v. Commonwealth Chem. Sec., Inc., 574 F.2d 90, 94-96 (2d Cir. 1978).

[27] See, e.g., SEC v. Huffman, 996 F.2d 800, 803 (5th Cir. 1993) (holding that a disgorgement order is enforceable by contempt because it is “more like a continuing injunction in the public interest than a debt” (citing Pierce v. Vision Investments, Inc., 779 F.2d 302, 307–08 (5th Cir. 1986))); SEC v. Goldfarb, 2012 U.S. Dist. LEXIS 85628, at *10–17 (N.D. Cal. 2012) (contempt available). But see SEC v. New Futures Trading Int’l Corp., 2012 U.S. Dist. LEXIS 55557, at *5–6 (D.N.H. 2012) (striking provision in SEC’s standard settlement template purporting to allow the agency to enforce the disgorgement provision through contempt sanctions).

[28] See, e.g., Huffman, 996 F.2d at 802–03.

[29] E.g., SEC v. First Pac. Bancorp, 142 F.3d 1186, 1191 (9th Cir. 1998); SEC v. Hughes Capital Corp., 124 F.3d 449, 455 (3d Cir. 1997) (quoting First City Fin., 890 F.2d at 1230).

[30] E.g., First City Fin., 890 F.2d at 1231 (citing cases from other circuits).

[31] See, e.g., SEC v. Whittemore, 659 F.3d 1, 9–10 (D.C. Cir. 2011) (quoting SEC v. Banner Fund Int’l, 211 F.3d 602, 617 (D.C. Cir. 2000) and Platforms Wireless, 617 F.3d at 1098); SEC v. Benson, 657 F. Supp. 1122, 1134 (S.D.N.Y 1987).

[32] E.g., Whittemore, 659 F.3d at 10–12; SEC v. Calvo, 378 F.3d 1211, 1215–16 (11th Cir. 2004); Hughes Capital, 124 F.3d at 455.

[33] 534 U.S. 204.

[34] 29 U.S.C. § 1132(a)(3).

[35] See Great-West, 534 U.S. at 207–08.

[36] Id.

[37] Id. at 210–20.

[38] Id. at 212–18.

[39] Id. at 212­–14.

[40] Id. at 210 (quoting Mertens v. Hewitt Assocs., 508 U.S. 248, 256 (1993)).

[41] Id. at 212–14.

[42] Id. at 213 (citations omitted) (quoting 1 Dan B. Dobbs, Law of Remedies: Damages-Equity-Restitution § 4.2(1), at 571 (2d ed. 1992); Restatement of Restitution § 160 cmt. a (1936)).

[43] Id. at 213–14 (alterations in original) (second & third emphases added) (citations omitted) (quoting Restatement of Restitution § 215 cmt. a (1936)). In footnoted dictum, the Court noted “a limited exception for an accounting for profits,” a remedy not at issue in that case. Great-West, 534 U.S. at 214 n.2. “If, for example, a plaintiff is entitled to a constructive trust on particular property held by the defendant, he may also recover profits produced by the defendant’s use of that property, even if he cannot identify a particular res containing the profits sought to be recovered.” Id. In the context of SEC enforcement, this remedy is most closely akin to the prejudgment interest that is routinely awarded on top of a lawfully ordered disgorgement award.

[44] Id. at 214.

[45] See, e.g., SEC v. Clark, 915 F.2d 439, 453–54 (9th Cir. 1990); SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 89 (S.D.N.Y. 1970). For a strong articulation and analysis of the illogic of ordering disgorgement from non-trading tippers, see John K. Robinson, supra note 17, at 432.

[46] See, e.g., SEC v. Whittemore, 659 F.3d 1, 9–12 (D.C. Cir. 2011).

[47] E.g., Whittemore, 659 F.3d at 10–12; SEC v. Calvo, 378 F.3d 1211, 1215–16 (11th Cir. 2011); SEC v. Hughes Capital Corp., 124 F.3d 449, 455 (3d Cir. 1997).

[48] In short, applying a tort-damage theory like joint and several liability to a purportedly equitable law enforcement remedy is the jurisprudential equivalent of forcing a square peg into a round hole. Unlike a private plaintiff, the SEC is not an injured victim suing to recover for compensable loss, injury, or damages that it has suffered. Cf. Gabelli v. SEC, 133 S. Ct. 1216, 1218 (2013) (noting that as a law enforcement agency, the SEC is “a different kind of plaintiff” seeking “a different kind of relief”). Although the SEC often sues to remedy misconduct that resulted in investor losses, the purpose of disgorgement is not to compensate those losses but rather to deprive the wrongdoer of his ill-gotten gains. See, e.g., Zacharias v. SEC, 569 F.3d 458, 471 (D.C. Cir. 2009) (quoting earlier cases). Thus, the disgorgement amount can be higher or lower than the damages sustained by those injured by the wrongdoing, and indeed the very question of whether anyone suffered a loss is “irrelevant” to the appropriateness and calculation of any disgorgement award. Id. Moreover, allowing the SEC the expediency of joint and several liability introduces risks of unfairness, favoritism, and the arbitrary exercise of prosecutorial discretion, because many securities fraud cases present more than one potential defendant, and the ability to hold any one of them jointly and severally liable for everyone else’s gains presents the SEC with disquieting incentives when picking and choosing who among them it will charge.

[49] See SEC Disgorgement Report, supra note 2, at 20–21; U.S. Gov’t Accountability Office, GAO-02-771, SEC Enforcement: More Actions Needed to Improve Oversight of Disgorgement Collections 12–14 (2002), available at www.gao.gov/new.items/d02771.pdf.

[50] See SEC v. Banner Fund Int’l, 211 F.3d 602, 617 (D.C. Cir. 2000) (noting that a contrary rule would lead to “absurd results”); SEC v. Whittemore, 691 F. Supp. 2d 198, 207 (D.D.C. 2010) (holding that whether a defendant retained the funds is “not germane” and how she spent them is “irrelevant”); SEC v. Benson, 657 F. Supp. 1122, 1134 (S.D.N.Y. 1987) (noting that the manner in which defendants “chose to spend” their gains is “irrelevant” to disgorgement).

[51] 211 F.3d 602.

[52] Id. at 617.

[53] Id. (emphasis added).

[54] Id.

[55] Great-West, 534 U.S. at 213.

[56] Banner Fund, 211 F.3d at 617.

[57] Supporters of prevailing SEC disgorgement law might cite by analogy to the Second Circuit’s opinion in FTC v. Bronson Partners, LLC, 654 F.3d 359 (2d Cir. 2011). However, Bronson was interpreting the Federal Trade Commission Act and is otherwise distinguishable. The relevant statute in Bronson, unlike the Exchange Act and the statute at issue in Great-West, was silent regarding the kinds of relief a court could award beyond injunctions. Id. at 365 (quoting statute). Bronson relied heavily on Porter v. Warner Holding Co., 328 U.S. 395 (1946), to suggest that this statutory silence gave courts almost limitless power to award monetary relief ancillary to a statutory injunction. 654 F.3d at 365–66.  The relevant section of the Exchange Act, however, is noticeably different from the statutes in Porter and Bronson, and for practical purposes is identical to the statute in Great-West. Whereas Porter involved a statute that granted courts power to issue any “other order” in addition to injunctions, and Bronson involved a statute that was silent on the matter, both the Exchange Act and the statute in Great-West empower courts to issue injunctions plus other “equitable relief.” As Great-West made clear, the qualifier “equitable” would be meaningless if not read to limit the available remedies to those in equity. 534 U.S. at 209–10. Moreover, the fact that Congress added this phrase to the Exchange Act in 2002, just months after Great-West interpreted the identical phrase in another federal statute, strongly suggests that the phrase should have the same import as it did in Great-West. Additionally, the appellant in Bronson did not argue the specific point raised in this article, as both the parties and the court appear to have simply assumed that disgorgement (unlike restitution) is equitable; the dispute ultimately centered on how disgorgement should be calculated and whether “equitable tracing” rules should apply. 654 F.3d at 372–75. Finally, Bronson’s literal description of disgorgement—like that in Banner Fund—actually echoes the themes articulated in Great-West to describe what an equitable remedy is not. Id. at 373–74 (noting that the disgorgement plaintiff “does not claim any entitlement to particular property” or “priority over the other creditors of the defendant,” but “asks only to have a judgment for the amount of [the] ill-gotten gains, which . . . will simply permit [the plaintiff] to share with other creditors on an equal basis”).

[58] See, e.g., Merriam-Webster’s Collegiate Dictionary 332 (10th ed. 1993).

[59] See Great-West, 534 U.S. at 211.

[60] See George P. Roach, A Default Rule of Omnipotence: Implied Jurisdiction and Exaggerated Remedies in Equity for Federal Agencies, 12 Fordham J. Corp. & Fin. L. 1, 47 n.175 (2007).

[61] U.S. Gov’t Accountability Office, GAO/GGD-94-188, Securities Enforcement: Improvements Needed in SEC Controls Over Disgorgement Cases 2, n.3 (August 1994) (citing SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77 (S.D.N.Y. 1970)), available at www.gao.gov/assets/230/220095.pdf.

[62] See generally SEC v. First Pac. Bancorp, 142 F.2d 1186, 1192–93 (9th Cir. 1998) (declining to “engage in a rather scholastic argument about whether restitution and disgorgement are really just about the same thing” and citing cases going both ways on the point). But see SEC Disgorgement Report, supra note 2, at 2–3 (acknowledging that courts at times use the terms disgorgement and restitution interchangeably, but arguing that they are distinct concepts).

[63] See, e.g., 15 U.S.C. § 78u-2(e), -3(e). Like other administratively ordered sanctions, an administrative disgorgement order is subject only to limited and deferential review by a court of appeals, and thus will be set aside only if “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” See supra note 19 and cases cited therein. For reasons beyond the scope of this article, the SEC rarely brings contested disgorgement claims in administrative proceedings, preferring instead to pursue them in federal court.

[64] Even Article I courts—which are at least courts of some kind rather than law enforcement agencies of the executive branch—have been held to lack general equitable powers. See, e.g., Bowen v. Massachusetts, 487 U.S. 879, 905 (1988) (federal Court of Claims lacks equitable powers of a district court); Comm’r v. McCoy, 484 U.S. 3, 7 (1987) (Tax Court lacks general equitable powers); cf. Comm’r v. Gooch Milling & Elevator Co., 320 U.S. 418, 420–21 (1943) (Board of Tax Appeals, an executive branch administrative predecessor of the Tax Court, lacks equity jurisdiction).

[65] See SEC Disgorgement Report, supra note 2, at 1, 9, 22.

[66] The author recently argued the relevance of Great-West to SEC disgorgement on behalf of a client in a petition for an en banc rehearing in the D.C. Circuit and a subsequent petition for certiorari in the Supreme Court, but both petitions were denied without comment. See SEC v. Whittemore, No. 05-cv-00869 (D.C. Cir. Dec. 22, 2011) (unpublished order denying rehearing en banc); cert. denied, 133 S. Ct. 28 (2012). Only two district court opinions appear to have squarely considered the relevance of Great-West to SEC disgorgement, and both ruled in the SEC’s favor. SEC v. DiBella, 409 F. Supp. 2d 122, 132–33 (D. Conn. 2006); SEC v. Buntrock, 2004 U.S. Dist. LEXIS 9495, at *6–9 (N.D. Ill. May 25, 2004). However, both cases examined the issue in the context of a motion to strike, and neither appeared to have involved a scenario where the illicit gains had been transferred to other parties as part of the relevant scheme and thus were no longer available to disgorge. Moreover, as one commentator has noted, Buntrock essentially “assume[d] away the issue” and thus “failed to undertake the analysis established in Great-West” and even “flout[ed] the Supreme Court’s message in Great-West.” See Roach, supra note 60, at 48.

[67] See, e.g., Am. Bus Ass’n v. Slater, 231 F.3d 1, 8 (D.C. Cir. 2000) (Sentelle, J., concurring) (“Congress’s failure to grant an agency a given power is not an ambiguity as to whether that power has, in fact, been granted. On the contrary, and as this Court persistently has recognized, a statutory silence on the granting of a power is a denial of that power to the agency.”).

[68] See, e.g., Kokkonen v. Guardian Life Ins. Co. of Am., 511 U.S. 375, 377 (1994) (holding that federal courts, being courts of “limited jurisdiction,” “possess only that power authorized by Constitution and statute, [] which is not to be expanded by judicial decree” (internal citation omitted)).

[69] See supra notes 13–15 and accompanying text.

[70] See supra notes 22–23 and accompanying text.

[71] See supra notes 18 & 19 and accompanying text.

[72] See 15 U.S.C. §§ 77x, 78ff.

[73] See Janus Capital Grp., Inc. v. First Derivative Traders, 31 S. Ct. 2296, 2301 (2011) (acknowledging private right of action under section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder).

[74] See supra note 65 and accompanying text.

[75] Cf. Sereboff v. Mid Atl. Med. Servs., Inc., 547 U.S. 356, 362–63 (2006) (distinguishing Great-West where plaintiff sought recovery of “specifically identifiable” funds that were “within the possession and control” of the defendant because the parties had previously stipulated the funds would be set aside and preserved pending final determination of the merits of the lawsuit).

[76] See supra notes 12 (citing relevant statutes) and 19 (describing standard of review for SEC administrative sanctions and citing cases).

[77] See, e.g., 15 U.S.C. § 78u(d)(3)(B).

[78] See supra notes 18 & 19 and accompanying text.

[79] See supra note 25.

[80] See supra note 26.

[81] See supra note 27. Compare Fed. R. Civ. P. 69(a)(1) (enforcement of money judgment is through writ of execution) with Fed. R. Civ. P. 70(e) (contempt available for failure to obey judgment for a specific act).

[82] See, e.g., Huffman, 996 F.2d 800, 802–03 (5th Cir. 1993).

[83] The SEC’s ability to obtain an equitable preliminary asset freeze at the start of an enforcement case would also be doubtful whenever the SEC could not identify the specific assets representing the fruits of the securities law violation because the Supreme Court has held that such preliminary equitable remedies are not available to secure assets prior to trial where a plaintiff seeks only legal relief in the form of a money judgment. See Grupo Mexicano v. Alliance Bond Fund, 527 U.S. 308, 321 (1999); SEC v. ETS Payphones, Inc., 408 F.3d 727, 734 (11th Cir. 2005) (distinguishing Grupo Mexicano on the ground that disgorgement is an equitable remedy).

 

By

SPACs and the JOBS Act

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Usha Rodrigues †

Public Inroads in Private Equity

The law has long confined the average investor to trading in public securities[1] while allowing wealthy—or “accredited”[2]—individual investors access to a panoply of private securities, including investment vehicles such as hedge funds and private equity funds. Nevertheless, pressure to let the general public into private equity has been growing. Two forces have contributed to this mounting pressure. First, public investors are eager to try their hand at investing in private enterprise. Second, private firms need capital. In the face of these forces, the sharp line that has long separated public and private firms has become increasingly blurred.[3]

Consider the story of the emerging growth company (EGC), or “Initial Public Offering (IPO) on-ramp,” provision of the Jumpstart Our Business Startups Act (JOBS Act). In its first few months on the books, this provision had effects far different from what its drafters envisioned. The JOBS Act’s IPO on-ramp was intended to ease regular companies’ path to going public; instead, it has inadvertently made it easier for the average investor to get a taste of private equity via special purpose acquisition corporations (SPACs). This piece will briefly describe SPACs, the IPO on-ramp, and how shell companies have taken advantage of a legislative provision intended to bring cash-hungry young companies directly to market. This piece will close with a few thoughts on lessons the story of SPACs’ interaction with the JOBS Act may offer regarding the increasingly indistinct line that divides public and private investment.

 Introducing SPACs

A SPAC is a type of “blank-check” company that goes public to raise a pool of cash and then begins a hunt for a target.[4] The bulk of the IPO proceeds are locked up in a trust account, invested in government-backed securities, and kept safe from the interference of the managers.[5] Once a target is identified, the SPAC managers disclose material financial information about it to shareholders, who then have a say on whether the acquisition occurs by way of voting or opt-out rights.[6] If no suitable target is found, or if a shareholder is unhappy with the deal, she can receive most of her money back—an average of ninety-eight cents on the dollar—from the trust account.[7] But if a SPAC shareholder does like the deal, then she will end up having owned a piece of an acquisition vehicle—in essence, a one-off private equity fund.[8]

The beauty of the SPAC model is that it bifurcates the process of going public, making it faster and cheaper. When the SPAC itself goes public, it is basically an empty shell, so any disclosures required under the Securities Act of 1933 (1933 Act) are minimal and cheap.[9] The SPAC’s Securities Exchange Act of 1934 (Exchange Act) filings are likewise minimal; in essence, they involve nothing more than reporting the rate of return generated in the trust account.[10] If and when the SPAC acquires a target—usually a private company—that target immediately becomes public without the hassle, disclosures, and delay that accompany a typical IPO.[11]

JOBS Act and SPACs

SPACs offered a rare chance for the average investor to participate in the rarified world of investing in private targets, while simultaneously offering those targets an easy route to an IPO. The JOBS Act took a decidedly different approach to blurring the line between public and private investment. Rather than letting the general public into private equity investments, the drafters tried the converse: encouraging more private firms to go public. Yet despite the JOBS Act’s focus on making it easier to bring traditional operating companies to the public market, its provisions have proven unexpectedly appealing for SPACs. Thus, legislation intended to help conventional companies go public is also facilitating a form of private equity investment.

SPACs’ business structure was in place long before the passage of the JOBS Act; indeed, they predated the Act by more than a decade.[12] The whole point of the JOBS Act’s EGC provision was to coax small-cap companies into going public by reducing the burdens of public disclosure and ongoing federal regulation, thereby providing the benefit of access to the public capital markets previously unavailable to them. I thought surely the passage of the JOBS Act was bad news for SPACs. Why agree to be acquired by a SPAC when you can easily go public on your own? The JOBS Act, however, had an unanticipated effect on the SPAC market because the JOBS Act’s IPO on-ramp provision makes it easier and cheaper for any small corporation to go public.[13]

As it turned out, the JOBS Act was not all bad news for SPACs because many SPACs themselves decided to go public using the IPO on-ramp. Indeed, in the eight weeks after the JOBS Act’s passage, over a dozen of the companies taking advantage of the new on-ramp option were SPACs.[14] Four months after the JOBS Act’s passage, one out of every nine EGCs was a SPAC.[15] The trend has not abated; in the first half of August 2012, one out of five firms that made use of the IPO on-ramp provision were SPACs.[16] To say the least, SPACs are making good use of the EGC option.

At first blush, SPACs’ use of the JOBS Act’s on-ramp seems counter-intuitive. It already was, and still is, easy for SPACs to go public under the conventional 1933 Act registration process. After all, SPACs’ disclosures at the start-up phase are largely boilerplate, along the lines of “this is who we are, this is how much money we plan to raise, this is how much we are setting aside in trust.”[17] If it is so easy for SPACs to register under the 1933 Act, why should they bother with the on-ramp provision offered by the JOBS Act?

The answer to this question stems from economic realities. As it turns out, successful SPACs—that is, SPACs that complete acquisitions—can save a lot of money in securities regulation compliance costs by making use of the IPO on-ramp. The payoff comes from greatly reduced ongoing reporting requirements imposed by the Exchange Act.In particular, EGC status under the JOBS Act lasts up to five years, as long as revenues, market capitalization, and debt issuances stay low,[18] and with that status come “scaled-back disclosures, certain exemptions to executive-compensation disclosures and attestation requirements for the auditors.”[19] These features make EGC SPACs comparatively more attractive to potential targets. A private company looking to go public on the cheap (i.e., at even less expense than the JOBS Act’s on-ramp promises) might well favor an EGC SPAC acquirer that promises lower disclosure burdens over a traditional public company acquirer—or, for that matter, a non-EGC SPAC—both of which would require the Exchange Act’s more in-depth disclosure. Time will tell whether EGC SPACs prove to be more successful acquirers than traditional acquirers and non-EGC SPACs.

In sum, despite reformers’ best intentions, many of the first companies to file as EGCs were not small operating companies rushing to access the capital markets as soon as regulatory barriers fell away. Instead, they were firms looking to acquire private firms down the road and take them public. Even so, the net effect may be what the JOBS Act’s drafters intended: if these new EGC SPACs have their way, they will acquire private firms, and thus bring more small firms to the public markets. Yet the SPAC EGCs will accomplish this goal in a roundabout way. More small firms will go public, as the JOBS Act envisioned, but by way of shell companies that allow the general public to participate in the uniquely public form of private equity that SPACs offer. While successful EGC SPACs will thus bring more firms public, they will at the same time allow their own investors to participate in a species of private equity investment, a kind of investment traditionally reserved for accredited investors. All of this supports a telling conclusion: both regulators and the market itself are exerting pressure on the line separating public and private investment, and these two separate forces can combine to produce unanticipated results.

Blurring the Line Between Public and Private

In conclusion, SPACs and the JOBS Act, both considered singly and taken together, signal the mounting pressure building over the divide between public and private investment. SPACs are mechanisms that let the public make private equity-like investments. The IPO on-ramp is an attempt to entice private companies to the public markets. Yet even more tellingly, these separate phenomena have recently interacted in an unexpected way, revealing how difficult it can be for reformers to revise the public-private boundary with any degree of certainty.

SPACs and the JOBS Act’s IPO on-ramp are but two examples of recent trends that suggest that the line separating the public and private investment spheres may be blurring. Another example, the CROWDFUND Act, applies pressure on the other side of the public-private line: rather than making it easier for more private companies to access the public markets, it allows unaccredited investors a chance to invest limited sums in private companies for the first time.[20]

Securities regulation ultimately involves a delicate balancing act, with investors’ need for protection and firms’ thirst for capital pulling in opposite directions. The traditional balance reserved robust investor protection for the public markets, and allowed wealthy investors exclusive access to more risky, and potentially more profitable, private firm investment.[21] But SPACs are a sign that the general public also desires to furnish capital to private firms in exchange for the chance to earn a higher rate of return.  At the same time, the JOBS Act signals a desire on the part of regulators and firms alike to allow companies to enjoy the benefits of being public while reducing some of the burdens that have traditionally accompanied public status.  Such examples thus, in different ways, indicate that the public-private boundary may be shifting dramatically.

 

Preferred citation: Usha Rodrigues, SPACs and the JOBS Act, 3 Harv. Bus. L. Rev. Online 17 (2012), https://journals.law.harvard.edu/hblr//?p=2488.

† Associate Professor of Law, University of Georgia School of Law.  I thank Mike Stegemoller and the staff of the Harvard Business Law Review.  Any errors are my own.

[1] See, 15 U.S.C.A. § 77d (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[2] Rule 501 of Regulation D describes several categories of accredited investors, including certain banks, charitable organizations, and certain high net worth individuals, who may invest in securities that are not registered. 17 C.F.R.  § 230.501(a) (2012). Most notably, individuals with a net annual income of over $200,000 or a total net worth of over one million dollars may invest in securities that are not registered provided that those securities meet the general disclosure requirements of Rule 502. 17 C.F.R. § 230.502 (2012).

[3] For a few recent scholarly discussions of the public-private divide, see Donald C. Langevoort & Robert B. Thompson, “Publicness” in Contemporary Securities Regulation After the JOBS Act (Georgetown Law and Econ. Research Paper, No. 12-002, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1984686; Adam C. Pritchard, Revisiting “Truth in Securities” Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good (Univ. of Mich. Law & Econ. Research Paper No. 12-010, 2012) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2103246; Usha Rodrigues, Securities Law’s Dirty Little Secret, 81 Fordham L. Rev. (forthcoming 2013) (on file with the author).

[4] Usha Rodrigues & Mike Stegemoller, Exit, Voice, and Reputation: The Evolution of SPACs, 37 Del. J. Corp. L. (forthcoming 2012).

[5] Id.

[6] Id.

[7] Id.

[8] See Steven M. Davidoff, Black Market Capital, 2008 Colum. Bus. L. Rev. 172, 225 (2008) (“SPACs are a species of private equity: these are capital pools organized to acquire individual businesses. But because of the general requirement that the initial acquisition comprise eighty percent of its assets, SPACs typically only acquire a single privately-held business. Despite these important distinctions, SPACs otherwise attempt to mimic private equity returns by employing comparable structures and practices. For example, SPACs utilize similar leverage to increase the size and potential returns of their acquisitions. The managers of SPACs are also typically provided twenty percent of the initial share offering at nominal amounts; ownership they are required to maintain until and after consummation of an acquisition.”).

[9] Daniel S. Riemer, Special Purpose Acquisition Companies: Spac and Span, or Blank Check Redux?, 85 Wash. U.L. Rev. 931, 950–51 (2007) (describing typical SPAC registration disclosure).

[10] Rodrigues & Stegemoller, supra note 4.

[11] Some call SPACs back-door IPOs, but SPACs differ from the seedier reverse mergers that led to so many Chinese companies with questionable accounting practices going public. Id.

[12] Riemer, supra note 9, at 944–45.

[13] For example, emerging growth companies need to disclose only two years of audited financial information prior to going public. 15 U.S.C.A. 77g(a)(2)(A) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). They are not subject to Sarbanes-Oxley’s dreaded internal controls provision. 15 U.S.C.A. § 7262(b) (West 2009& Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[14] Emily Chasan, Meet the JOBS Act’s Jobs-Free Companies, Wall St. J., June 4, 2012, at B1.

[15] Chris Hitt, “I Am Shocked, Shocked”: Blank Check Companies and the “Scandal” of the JOBS Act, Blogmosaic (Aug. 16, 2012), http://blogmosaic.knowledgemosaic.com/2012/08/16/spacs-as-egcs/.

[16] Id.

[17] See, e.g., Acquicor Tech. Inc., Registration Statement (Form S-1) (Sept. 2, 2005).

[18] 15 U.S.C.A. 77b(a) (West 2009 & Supp. 2012) amended by Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

[19] Chasan, supra note 14.

[20] Title III of the JOBS Act, the CROWDFUND Act, allows issuers to sell up to one million dollars of securities in a twelve-month period without Securities Act of 1933 registration. Any investor can invest in these companies—they are not reserved for accredited investors only. If an investor’s annual net worth or income is less than $100,000, she can invest no more than 5% of her net worth or annual income or $2,000, whichever is greater. Jumpstart Our Business Startups Act, Pub. L No. 112-106, sec. 302, § 4(a)(6)(B)(i), 126 Stat. 306, 315 (2012). If an investor’s annual net worth or annual income is equal to or more than $100,000, then she can invest no more than the greater of 10% of her net worth or annual income and $100,000. Id.

[21] Individuals qualify as accredited investors by having a net annual income of over $200,000 or a total net worth of over one million dollars. 17 C.F.R. § 230.215 (2012).  SEC regulations and industry practice dictates that only this special class of individual investors can invest in hedge funds, private equity funds, and venture capital funds. Thus, historically at least, ordinary investors have been shut out of the private market, except via pension funds that in effect pool the resources of many investors into an accredited-investor fund. No private market mutual funds currently exist.

By

Complexity of Regulation

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Chester S. Spatt†

It is a great pleasure to provide keynote remarks at this weekend’s conference on “Complexity and Change in Financial Regulation” at the Harvard Law School. In my comments tonight I will try to build from my experiences as a former Chief Economist of the U.S. Securities and Exchange Commission (SEC) from 2004 through 2007 and as a close observer of the evolution of financial regulation in the aftermath of the financial crisis to focus upon the “Complexity of Regulation.” While our financial system is itself very complex, our financial regulators would benefit in many cases by designing simple and robust approaches that build off of basic principles and that emphasize the role and importance of economic incentives and markets.

While I recognize that to some degree complexity in financial structure breeds complexity in regulation, often the causality is reversed. Complexity in regulation leads to complexity in financial structures and systems, particularly in light of the efforts of market participants to mitigate the costs and complications induced by regulation, including attempts to engage in regulatory arbitrage. Consequently, much of the costs of regulation in my view are associated with its intricacies. It also is useful to recognize that complexity in regulation leads to huge entry barriers associated with the cost of regulatory compliance. Instead of addressing “too big to fail,” this can lead to maintaining “too big to fail” institutions. This is a connection that appears to be underappreciated by our financial regulators.

Given these broad perspectives, you might not be surprised to hear that I feel that the extent of complexity in financial regulation has been, to a degree, excessive. For example, regulators often would do far better in accomplishing their regulatory goals by adapting relatively simple standards and principles that force market participants to internalize the consequences of their actions.

Economic principles emphasize the importance and power of relatively robust regulation, but in many contexts there has been little effort to try to utilize robust alternatives. An example that I will emphasize is the case of bank capital. While bank capital standards have risen in the aftermath of the financial crisis, they have not risen to levels that would internalize the full costs of risk-taking by heavily-leveraged institutions.[1] Note that the terminology “bank capital” refers to the bank’s equity, as distinct from its debt financing, which just reflects how the bank funds or finances itself. But the essence of the “too big to fail” problem is the government backstopping the risk-taking by banks by preventing failure and default on debt in the face of systemic risk. Consequently, the pricing of debt on an ex ante basis does not sufficiently penalize the firm for the costs of its risk-taking. In contrast, governments have been willing to allow the value of a bank’s equity to collapse. High capital standards would essentially provide a solution to the “too big to fail” problem as it would internalize the costs of failure within the bank’s funding cost, rather than seeking support from taxpayers. A high capital or equity requirement forces the firm to deleverage. But as financial theory teaches a) equity and debt are substitutes in funding the firm and b) the overall cost of funding the enterprise is not substantially influenced by how the firm chooses to fund itself—at least absent governmental subsidies.[2] This is a basic precept in financial theory, the Nobel Prize-winning Modigliani-Miller theory, understood by most recent MBA graduates. While some observers suggest that equity capital is dramatically more expensive than debt,[3] this is inconsistent with the basic principles of efficient pricing on which our markets are built and does not reflect the true underlying riskiness and marginal costs of equity and debt.

Requiring a bank to have sufficiently high capital, such that the capital would bear any risks that the bank creates, would be a much more robust approach to the “too big to fail” problem in my judgment than the routes designed by our legislators and regulators.[4] For example, as a byproduct of the financial crisis regulators have not attempted to scale back mega institutions and indeed, have permitted many to grow through acquisition of weak institutions (to address the immediate problems of the day). While the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) requires that systemically important institutions have “living wills”[5] and the FDIC be empowered with “resolution authority” to resolve mega institutions,[6] does the marketplace and the pricing of debt contracts reflect a belief that the largest financial institutions would be resolved cleanly in the event of a perceived systemic crisis? The answer to that is no. The basic point that I would emphasize is that the complexity of these institutions, as illustrated by the difficulties with “global resolution,” undercuts the credibility of Washington’s solutions to “too big to fail.” I should note that a fundamental source of complexity is the global nature of our institutions and the national structures to regulation, which leads to considerable regulatory competition and only limited coordination.

A closely related example is the Volcker Rule, which essentially bans proprietary trading by the major financial institutions.[7] Some aspects of what is envisioned seem rather simple and clear-cut, but other features illustrate the inherent complexity of this regulation. On the one hand, it is relatively straightforward for the major financial services firms to give up their proprietary trading and hedge fund units, and indeed many of the Wall Street firms divested these activities in the immediate aftermath of the passage of the Dodd-Frank Act.[8] On the other hand, the dealer and market-making function to facilitate the trading activities of firm customers is a central activity of financial intermediaries. Distinguishing trades that are undertaken to facilitate customer business from those that are motivated by the firm’s interest in creating trading profits can be challenging. At the heart of the regulatory proposals underlying the Volcker Rule is an attempt to develop “metrics” to try to distinguish such trades. But this is a tough distinction indeed—and at the heart of the complexity of Volcker. Indeed, recent headlines are highlighting the difficulty in implementing Volcker by the statutory deadline this summer.[9] Recently, Congressman Barney Frank has even called for the implementation of a simplified version.[10]

Yet what are we really trying to accomplish with Volcker? Most everyone agrees that we are not trying to block legitimate market-making, but instead we are trying to prevent the presence of “too big to fail” guarantees applying to proprietary trading and ensure that large banks and financial institutions bear the consequences of their risk-taking. Of course, the potential focus on complex “metrics” leads to considerable complexity in the proposed implementation and potential serious distortions in the market-making process. Ironically, government officials have exempted U.S. Treasuries from Volcker,[11] appearing to acknowledge that Volcker would raise the liquidity costs of trading Treasuries—certainly suggesting that the costs for market making are real. Now European sovereigns are seeking similar relief for their bonds trading in the U.S.[12] and not adopting analogues for firms supervised by their jurisdictions.[13] Yet there is a potential broad solution for the types of risk-taking that Volcker is designed to confront and other types of excessive risk-taking, namely high capital standards.

Much of the focus on hard-to-implement and very complex standards, such as the Volcker Rule, would be far less significant if major financial institutions simply were forced to bear the consequences of their actions by high equity (and capital) standards. To the extent that it is apparent that government would not bail out equity, but will bail out creditors, high equity is crucial to ensuring the internalization of funding consequences and costs.

This highlights a central aspect to financial regulation in the aftermath of the financial crisis, namely that in many cases alternative approaches could be used to address key features of the same underlying problem. In the language of economics, alternative regulations would provide imperfect substitutes for one another. In the case of such substitutes there may be miscounting of the benefits relative to the costs in cost-benefit analysis. In these types of situations we might expect that the benefits, such as those associated with the reduction or elimination of “too big to fail,” may be substantially duplicated and thus overstated, while the costs of simultaneously adopting different approaches may be closer to additive. In effect, there would be diminishing returns to multiple approaches to a regulatory problem.

An interesting example of the theme that regulations can be substitutes for one another arises in the treatment of credit rating agencies under the Dodd-Frank Act. On the one hand, the Dodd-Frank Act directs regulators to remove references to credit ratings in various financial regulations.[14] This limits the ability of rating agencies to sell regulatory treatment and limits the extent of systemic risk when a rating agency misjudges the underlying risk. Removing reliance on ratings for regulatory purposes suggests that regulators should be comfortable with rating agencies establishing their own norms, leading to competition in the definition of ratings. However, the Dodd-Frank Act also pursues a second theme with respect to rating agencies, stressing the importance of close supervision of the rating agencies by the regulator and relatively uniform standards and definitions.[15] This is just the opposite of encouraging competition. Indeed, the case for uniform rating standards and definitions under tight supervision of the regulator would be much more compelling if the regulator were to use the ratings for determining regulatory treatment. As you can see, these two broad perspectives—reducing reliance on ratings for regulatory purposes and tighter supervision and more uniformity in standards—serve as substitutes for one another.

Credit ratings point to a number of interesting examples of how governments think about the information generated by market participants.[16] On the one hand, there is the desire to outsource aspects of the regulatory process, but on the other hand huge suspicion by government officials of the information that would arise from such processes with respect to sovereign credits. By way of illustration, this has emerged vividly on many fronts with concerns about the quality of sovereign credits. For example, in the aftermath of the downgrade of the United States by Standard and Poor’s, the Treasury said that S&P had engaged in “terrible judgment.”[17] In Italy, the police even raided a credit rating agency in the face of an adverse judgment.[18] The European sovereign debt crisis led to a ban on naked credit default swaps and short selling of financials in some European countries as well as attempts to undercut the definition of a “credit event” in Greece.[19] There can be tremendous information in credit default swap pricing—at least if there is not an attempt to manipulate the underlying credit event. On other fronts, “the European Union’s (EU) application of Basel bank capital rules placed ‘zero risk weight’ on EU sovereign debt, as if these instruments were not subject to credit risk, creating huge artificial incentives for banks to hold these sovereign credits.”[20] Instead of being motivated by investor protection, such treatment appears to be an attempt to increase the demand for sovereign debt and the ease with which incumbent officials can continue to issue it.[21] Even the purchases of sovereign debt by the European Central Bank would inflate its demand, thereby artificially raising the price and complicating the problem of sorting out the natural private sector interest in the bonds.[22]

This broad class of government policies, “by weakening the integrity of market pricing”, can reduce the sovereign’s own access to funding over time.[23] It certainly would have been difficult to see how these could be acts of investor protection, which is a core justification for much of financial regulation. It is important for government officials around the globe to have a healthy respect for market institutions rather than suspicion about these arrangements, especially when applied to their government’s own credits. This would not require the type of complexity that appears to be the hallmark of much regulatory policy.

Central clearing of relatively standardized derivatives is another important focus under the Dodd-Frank Act.[24] This is leading to a fundamental redesign of the trading of derivative securities and swaps and the required use of central counter-parties (CCPs) for relatively standardized instruments. The re-engineering of these markets is proving to be tremendously complicated. While I am somewhat sympathetic to the use of the CCPs as a way to reduce contagion associated with counter-party risk and to make the risk structure more transparent, it is not clear that the use of clearinghouses will actually reduce systemic risk.[25] Risks are not eliminated when matched through a clearinghouse. Indeed, the incentives to trade with weak counter-parties would be heightened (because of more favorable pricing), and more generally, the clearinghouse would tend to attract transactions that it was mis-marking.[26] If market participants perceived the risk of trading through the clearinghouse were low (e.g., due to a potential federal guarantee) market participants would increase their risk exposures.[27] For these reasons, as well as the concentration of risk in the CCP, it is plausible that central clearing would raise systemic risk greatly when another crisis occurred and perhaps even raise the likelihood of a crisis.[28] While many observers have pointed to the lack of clearinghouse failures during the financial crisis a few years ago, in fact in recent decades there have been a number of clearinghouse failures, and the nature of the risks that would be assumed by a swap clearinghouse would be huge compared to that in traditional clearinghouses.[29] “Indeed, Federal Reserve Chairman Ben Bernanke attributed the [absence of such failures] during the financial crisis to ‘good luck’” and summarized the relevant takeaway as follows: “As Mark Twain’s character Pudd’nhead Wilson once opined, if you put all your eggs in one basket, you better watch that basket.”[30] To avoid the potential collapse of a major clearinghouse would require very strong risk management and backstops from Washington, D.C. The complexities associated with the operation and design of a swaps clearinghouse will be vast.

In trying to identify simple and robust perspectives to guide the financial regulatory process, it is helpful to focus briefly on cost-benefit analysis. This has been an especially visible issue in Washington, D.C., in the aftermath of last year’s decision by the District of Columbia Federal Circuit Court of Appeals, striking down the SEC’s proxy access rule due to an inadequate and inconsistent cost-benefit analysis.[31] The court’s ruling, following earlier decisions by the D.C. Circuit overturning the SEC’s independent mutual fund chair and director rule in 2005 and 2006,[32] highlights what should be central criteria for financial regulation under administrative law and economic principles. It is challenging to do cost-benefit analysis right, but until last year’s decision there was relatively little inclination by financial regulators to take the challenge seriously. In my view, the development of evidence in support of rule-making and to determine the direction of potential rule-makings is quite important. Among other tools, this emphasizes the importance of natural experiments—perhaps even randomized ones—as well as serious before-and-after analyses to assess the impact of regulations. Indeed, one way to give before-and-after analyses teeth would be to “sunset” (end) the rule adoption after a number of years, so that its merits would need to be reargued, in part using the data generated from the initial rule adoption.[33] More generally, excess complexity in the formulation of a regulation can be a serious impediment to the generation of meaningful evidence.

Adherence to economic principles is an important way to strive for simplicity in the regulatory process. While much of the focus of the Circuit Court’s proxy access decision addressed inconsistencies in the SEC’s cost-benefit analysis, at least some aspects of that rule also suggested conflict with economic principles.[34] I thought that a particularly striking aspect of the overturned proxy access rule was that the coalition of shareholders who would be permitted to nominate candidates to be placed on the corporation’s official proxy ballot needed to own at least 3% of the company’s shares for at least three prior years.[35] The latter restriction seems at variance with the traditional concept of the full transferability of ownership rights through a sale. Ownership of an asset is a claim to its future rather than something vested by virtue of history.[36]

A final theme that I would like to highlight in my discussion of simplicity vs. complexity in regulation is the importance of transparency and disclosure. This arises at many levels. First, I think that it is very important that the decision-making process of the regulators be exposed to sunlight with serious opportunity for diverse perspectives at the regulator to be articulated. Such conversations would reduce the effective complexity of regulation by contributing to the understanding of the public. Yet remarkably, a recent Wall Street Journal article highlights the almost total absence of public meetings by the Board of Governors of the Federal Reserve in the last two years and even errors by not properly recording dissents.[37] Transparency is important not only for statements about monetary actions, but also with respect to the rule-making (and along other lines for the detail underlying liquidity facilities).[38]

Disclosure also is an important substantive value in the regulatory process for regulators to take seriously. Yet in some situations regulators appear to have discouraged disclosures. An interesting example along these lines is the limited disclosures by Bank of America during its acquisition of Merrill Lynch, with the apparent strong encouragement of the Federal Reserve and Treasury.[39] Indeed, more extensive and informative disclosures to shareholders would likely have led to the rejection of the acquisition, heightening concerns about the possible collapse of Merrill Lynch. The example of stress tests also is an interesting one in which the concerns of systemic risk regulators and banking supervisors would not have emphasized disclosure and indeed, the absence of any disclosure until the latter stages of the 2009 stress tests was striking.[40] Yet disclosure is a fundamental principle in America’s capital markets, and indeed to the extent that banks plan to address stress test results with a capital raising, it is crucial that investors be apprised of the planned uses of the funds (including providing a capital cushion) rather than being misled. Full disclosure also is very simple (especially compared to incomplete disclosure)—the structure of information that is available to market participants would be transparent and recognized by all.

Financial regulation benefits from an emphasis on simple rather than complicated rules that avoid creating needless distortions, undertake serious cost-benefit analyses, use transparent rule-making processes, and emphasize disclosure and incentives.

I appreciate your listening and reflecting upon my remarks and would welcome any questions that you might have. Thanks very much.

 

Preferred citation: Chester S. Spatt, Complexity of Regulation, 3 Harv. Bus. L. Rev. Online 1 (2012), https://journals.law.harvard.edu/hblr//?p=2299.

† Chester S. Spatt is the Pamela R. and Kenneth B. Dunn Professor of Finance at the Tepper School of Business at Carnegie Mellon University, where he has been a faculty member since 1979. Professor Spatt also served as the Chief Economist of the U.S. Securities and Exchange Commission in Washington, D.C. from July 2004 until July 2007.  He gratefully acknowledges financial support from the Sloan Foundation.

[1] See Anat R. Admati et al., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Capital is Not Expensive 11–19 (Rock Ctr. for Corp. Governance at Stanford Univ., Working Paper No. 86, 2011) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669704.

[2] Id. at 17–18.

[3] See id. at 1.

[4] Anat R. Admati and Martin Hellwig, Good Banking Regulation Needs Clear Focus, Sensible Tools, and Political Will, Int’l Centre for Fin. Reg. 5 (Dec. 2011) http://www.icffr.org/assets/pdfs/February-2012/ICFR—Financial-Times-Research-Prize-2011/A-Admati-and-M-Hellwig—Good-Banking-Regulation-N.aspx, in advocating high capital standards, also emphasize that “regulation should focus on measures that are cost effective and that do not require that supervisors know more than is feasible.”  Allan H. Meltzer, Banks Need More Capital, Not More Rules, Wall St. J., May 16, 2012, http://online.wsj.com/article/SB10001424052702304192704577405821765336832.html, also calls for high capital standards and points to the difficulty designing and implementing regulation (using the example of the ambiguity as to whether the recent losing trades of JP Morgan Chase would have been covered by the Volcker Rule, if it had been in effect) and advocates outright repeal of Dodd-Frank.

[5] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 165(d)(1) 124 Stat. 1376, 1426 (2010) [hereinafter Dodd-Frank Act].

[6] Id. § 204.

[7] See id. sec. 619 § 13.

[8] See, e.g., Nelson D. Schwartz, Bank of America Cuts Back Its Prop Trading Desk, N.Y. Times, Sept. 29, 2010, http://dealbook.nytimes.com/2010/09/29/bank-of-america-cuts-back-its-prop-trading-desk/.

[9] See, e.g., Craig Torres & Cheyenne Hopkins, Bernanke Says Dodd-Frank’s Volcker Rule Won’t Be Ready by July 21 Deadline, Bloomberg, Feb. 29 2012, http://www.bloomberg.com/news/2012-02-29/bernanke-says-dodd-frank-s-volcker-rule-won-t-be-ready-by-july-21-deadline.html.

[10] Ben Protess, Barney Frank Wants Simpler Volcker Rule by Labor Day, N.Y. Times, Mar. 22, 2012, http://dealbook.nytimes.com/2012/03/22/barney-frank-wants-simpler-volcker-rule-by-labor-day/.

[11] Dodd-Frank Act sec. 619 § 13.

[12] Cheyenne Hopkins, U.S. Regulators Exploring Volcker Exemption for Foreign Sovereign Debt, Bloomberg, Feb. 1, 2012, http://www.bloomberg.com/news/2012-02-01/u-s-regulators-weigh-volcker-exemption-for-sovereign-debt.html.

[13] Sarah N. Lynch & Dave Clarke, Volcker Rule May Disadvantage U.S. Banks: OCC’s Walsh, Reuters, Jan. 17, 2012, available at http://www.reuters.com/article/2012/01/17/us-financial-regulation-volcker-idUSTRE80B1QB20120117.

[14] Dodd-Frank Act § 939.

[15] See Dodd-Frank Act sec. 932 § 15E.

[16] See Statement No. 320, Chester S. Spatt & Peter J. Wallison, Shadow Fin. Regulatory Comm., A Regulatory Blueprint for Mismanaging the Sovereign Debt Crisis 1 (Dec. 5, 2011), http://www.aei.org/paper/economics/financial-services/a-regulatory-blueprint-for-mismanaging-the-soverign-debt-crisis/.

[17] Id.

[18] Id.

[19] Id. at 1–2.

[20] Id. at 2.

[21] Id.

[22] Id.

[23] Id.

[24] See Dodd-Frank Act § 723.

[25] Chester S. Spatt, Statement for Senate Subcommittee on Securities, Insurance, and Investment Hearing on Derivatives Clearinghouses: Opportunities and Challenges 2 (May 25, 2011) [hereinafter Spatt, Opportunities and Challenges]; see also Chester S. Spatt, Designing Reliable Clearing and Settlement Systems for Enhancing the Transparency and Stability of Derivatives Markets, Presentation at the Wharton School Financial Institutions Center Conference on Strengthening the Liquidity of the Financial System (June 28, 2011) (on file with author).

[26] See Spatt, Opportunities and Challenges, supra note 25, at 2–3.

[27] See id. at 2; see also Mark J. Roe, Derivatives Clearinghouses Are No Magic Bullet, Wall St. J., May 6, 2010, http://online.wsj.com/article/SB10001424052748703871904575216251915383146.html.

[28] Spatt, Opportunities and Challenges, supra note 25.

[29] Id. at 3–4.

[30] Id. at 4 (quoting Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Remarks at the 2011 Financial Markets Conference: Clearinghouses, Financial Stability, and Financial Reform 8–9 (Apr. 4, 2011)); see also Editorial, Pudd’nhead Wilson in Washington, Wall St. J., Apr. 23, 2011, http://online.wsj.com/article/SB10001424052748704658704576274870104134358.html.

[31] Bus. Roundtable v. Sec. & Exch. Comm’n, 647 F.3d 1144, 1148–51 (D.C. Cir. 2011).

[32] See Chamber of Commerce of U.S. v. Sec. & Exch. Comm’n (Chamber I), 412 F.3d 133 (D.C. Cir 2005) (overturning the SEC’s independent and mutual fund chair and director rule because the SEC failed to consider the cost of compliance and alternative rules); see also Chamber of Commerce of U.S. v. Sec. & Exch. Comm’n, 443 F.3d 890 (D.C. Cir. 2006) (holding that the SEC did not follow adequate procedures in its response to Chamber I).

[33] Chester S. Spatt, Measurement and Policy Formulation, Speech at the Meeting of the Society for Financial Econometrics at the University of Chicago, 5–6 (June 2011).

[34] See Bus. Roundtable, 647 F.3d at 1148–50.

[35] Id. at 1147.

[36] Cf. Statement No. 297, Marshall Blume et al., Shadow Fin. Regulatory Comm., Proxy Access and the Market for Corporate Control 2 (Sept. 13, 2010), http://www.aei.org/files/2010/09/13/Statement%20No.%20297.pdf.

[37] Victoria McGrane & Jon Hilsenrath, Fed Writes Sweeping Rules from Behind Closed Doors, Wall St. J., Feb. 21, 2012, http://online.wsj.com/article/SB10001424052970204059804577225122892450312.html

[38] With respect to the transparency of liquidity facilities, see, for example, Bob Ivry & Craig Torres, Fed’s Court-Ordered Transparency Shows Americans Have Right to Know, Bloomberg, Mar. 22, 2011, http://www.bloomberg.com/news/2011-03-22/fed-s-court-ordered-transparency-shows-americans-have-a-right-to-know-.html.

[39] See Chester S. Spatt, Regulatory Conflict: Market Integrity vs. Financial Stability, 71 U. Pitt. L. Rev. 625, 630–32 (2010) [hereinafter Spatt, Regulatory Conflict]; see also Chester S. Spatt, Economic Principles, Government Policy and the Market Crisis, Keynote Address at the Western Finance Association 17 (June 19, 2009).

[40] Spatt, Regulatory Conflict, supra note 39, at 629.