About Steven Lofchie

Steven Lofchie is Senior Fellow of Legal Studies at the Center for Financial Stability and Co-chairman of the Financial Services Department at Cadwalader, Wickersham & Taft LLP.

CFTC Advisory Committee Recommends Regulatory Actions to Address Climate Risk

A subcommittee of the CFTC Market Risk Advisory Committee (“MRAC”) recommended that U.S. regulators take action to address the risks that climate change poses to the U.S. financial system.

The recommendations came in a report, titled Managing Climate Risk in the U.S. Financial System, issued by the MRAC Climate-Related Market Risk Subcommittee. CFTC Commissioner Rostin Behnam, the sponsor of the MRAC, suggested the report could be used by “policymakers, regulators, and stakeholders” to begin a process of “taking thoughtful and intentional steps toward building a climate-resilient financial system that prepares our country for the decades to come.”

The report presents 53 recommendations to mitigate risks to financial markets posed by climate change and concludes, among other things, that:

climate change poses a “major risk to the stability of the U.S. financial system and to its ability to sustain the American economy”;

regulators “must” recognize that climate changes poses “serious emerging risks” and should move “urgently and decisively to measure, understand, and address these risks”;

existing law provides U.S. financial regulators with significant authority that could be used to begin addressing financial climate-related risk;

regulators can help promote the role of financial markets as providers of solutions to climate-related risks; and

financial innovation is required to manage climate risk and to facilitate the flow of capital in order to help “accelerate net-zero transition and increase economic opportunity.”

The report was approved 34-0 by the subcommittee’s membership. The CFTC also posted statements from participants on the subcommittee: (1) Cargill, (2) Citi, JP Morgan and Morgan Stanley, (3) CME Group, (4) ConocoPhillips and (5) Vanguard.

LOFCHIE COMMENTARY

The job of the CFTC is to regulate markets in which market participants can agree to transfer risk between them. If there exists a sufficient number of market participants to create a liquid market in which they can buy and sell “climate risk,” such risk would be measured by these participants. Then the CFTC should do its best to regulate that market so that it operates efficiently and transparently. It is not the job of the CFTC, as a regulatory agency, to advocate as to carbon taxes (either for or against), or for that matter, local insurance markets, corporate disclosures, or corporate governance. That job is entrusted to other regulators. When regulators pursue these other objectives, they deviate from their mission and their real task.

With the NFL football season now upon us, it is appropriate for the CFTC to consider the words of the greatest football coach of all time: “Do Your Job.”

SEC Identifies Investment Risks Concerning Emerging Markets

The SEC identified risks to be considered by market participants recommending or making investments in emerging markets.

In a joint SEC statement, Chair Jay Clayton, Public Company Accounting Oversight Board (“PCAOB”) Chair William D. Duhnke III, Chief Accountant Sagar Teotia, Division of Corporation Finance Director William Hinman and Division of Investment Management Director Dalia Blass highlighted the limitations on the SEC’s ability to enforce high-quality disclosure standards in emerging markets.

According to the SEC, such emerging markets, including China, often present disclosures that are in “substantially” the same form as those of U.S. domestic companies. However, the SEC warned that the disclosure information may often be “incomplete or misleading.” The SEC identified the below risks and related considerations as to emerging markets.

– Associated Risks and Disclosures. The SEC stated that companies operating in emerging markets experience greater risks, and therefore encouraged (i) issuers to disclose such matters to investors and (ii) funds investing in emerging markets to ensure that their material risk disclosures are in compliance with federal securities laws. The SEC emphasized that boilerplate disclosures are often insufficient in such circumstances.
– Variation in Quality of Financial Information, Requirements and Standards. The SEC recommended that (i) investors and financial professionals examine the nature and quality of financial information (e.g., financial reporting and audit requirements) when considering certain investments to make or recommend and (ii) issuers discuss related financial reporting matters with independent auditors or audit committees, if necessary.
– The Continual Inability of the PCAOB to Assess Audit Work Papers in China. The SEC urged investors to consider the PCAOB’s inability to inspect PCAOB-registered accounting firms in China.
– Limitations of U.S. Authorities to Bring Action. The SEC advised issuers to make clear the “substantial” difficulties experienced by U.S. authorities, including the SEC, in bringing enforcement actions against non-U.S. companies or non-U.S. persons.
– Shareholders’ Limitation of Rights. The SEC stated that shareholder claims, such as class action securities law and fraud claims, are generally “difficult or impossible” to pursue legally or logistically in many emerging markets. As a result, the SEC noted that issuers should explicitly state such risks to shareholders.
– Passive Investing Strategies. The SEC cautioned investors that index funds typically do not weight securities based on (i) investor protection limitations or (ii) variations in the quality of financial reporting and oversight mechanisms available.
– Considerations Overall. The SEC advised investment advisers, broker-dealers and market participants in general to consider the limitations and risks associated with emerging markets when recommending investments in such markets.

The SEC noted that these considerations, while not an exhaustive list, are often significant, and vary based on jurisdiction.

LOFCHIE COMMENTARY

Though the statement concerns emerging markets generally, a quick search turns up 29 references to China and none to Brazil, Russia, or India. Chinese issuers seeking to offer securities in the United States may expect to face closer scrutiny of their offering documents. Firms participating in such offerings must anticipate the risks of review of their diligence should an offering go badly. Likewise, funds that invest offshore should review their disclosures. Advisers and broker-dealers that recommend investments in Chinese issuers should take account of suitability considerations in light of the SEC’s statement.

SEC Adopts Amendments to Offering Process for BDCs and Closed-End Funds

The SEC adopted rule and form amendments to “modify the registration, communications, and offering processes” for business development companies (a type of closed-end investment company that is not registered, “BDCs”) and registered closed-end investment companies. The benefits of these rule changes were available to operating companies and are now being extended to funds, in accordance with a 2018 Congressional mandate expressed in the Small Business Credit Availability Act (the “BDC Act”) and the Economic Growth, Regulatory Relief and Consumer Protection Act (the “EGRRA Act”).

The new rule amendments include:

– expanding the definition of “well-known seasoned issuer” to capture eligible funds (generally, those having a public float of at least $700 million and meeting certain other regulatory conditions) to permit them to quickly sell securities “off the shelf” using short-form registration statements, provided that such funds include certain disclosures in their annual reports;

– making Securities Act Rule 486 (“Effective Date of Post-Effective Amendments and Registration Statements Filed by Certain Closed-End Management Investment Companies”) available to registered closed-end funds and BDCs that are involved in continuous offerings, so that they may immediately make effective changes to a registration statement;

– allowing certain funds to use communications rules designed to reduce regulatory costs and provide information to investors more quickly (e.g., permitting the use of the “free writing prospectus”);

– permitting closed-end funds that function as interval funds to register an indefinite number of shares and pay SEC fees only when the shares are actually sold;

– eliminating the requirement that funds provide new purchasers with copies of all previously filed materials, which may instead be made available on a website; and

– imposing certain tagging requirements concerning registration statement information.

Affected funds will also be required to tag certain data in their registration statement. BDCs will be required to submit financial information of the same type that operating companies submit.

Broker-Dealer Research Reports
The SEC made the Securities Act Rule 138 research safe harbor available for broker-dealers publishing research about certain categories of a seasoned fund’s securities when the fund is distributing certain other securities.

No Form 8-K Requirements
Closed-end funds will not be required to file periodic reports on Form 8-K. The SEC determined that this additional reporting burden, to which operating companies are subject, was not necessary in light of current funds’ practices.

Commissioner Statements
SEC Chair Jay Clayton said that the extension of the disclosure and regulatory framework to BDCs would improve investor protections.

SEC Commissioner Elad Roisman praised the final rule amendments for making the BDC offering rules consistent with those applicable to operating companies.

SEC Commissioner Hester M. Peirce largely supported the relief provided by this rulemaking, but noted that the agency could have “offered additional relief without compromising investor protection.” Specifically, she stated that the SEC “unnecessarily restrict[s]” the amount of funds that will be able to benefit from the final rule amendments.

SEC Commissioner Allison Herren Lee criticized the final rule amendments for (i) “roll[ing] back investor protections”, (ii) failing to include the proposed Form 8-K reporting requirements, and (ii) allowing certain funds to make material changes in their registration statements that would become automatically effective without staff review. In addition, she objected to adopting a rulemaking during the COVID-19 pandemic.

The rule and form amendments will go into effect on August 1, 2020. The amendment regarding registration fee payments by interval funds and certain exchange-traded products will go into effect on August 1, 2021. Certain of the regulatory reporting requirements will not go into effect until 2022 or 2023.

LOFCHIE COMMENTARY

These rules are consistent with recent efforts to support the economy and small businesses. If the regulators are going to provide a means for retail investors to invest in small companies, supporting BDCs and closed-end investment funds seems one of the more promising paths; particularly as Regulation Best Interest and similar state suitability requirements may discourage broker-dealers from recommending individual investors buy securities issued by small issuers.

Notwithstanding Commissioner Lee’s objection that the rule amendments not be adopted during the pandemic seem, these rule amendments are not being rushed to market; they were proposed a year ago. When bad global events happen, the stock markets drop and investors lose money. SEC rule changes such as these would not provide protection against that.

FINRA Conducts Review of Firm’s “Zero Commissions”

In a targeted examination, FINRA is seeking information on the practices of firms that charge zero commission on client trades and “the impact that not charging commissions has or will have on the Firm’s order routing.”

In this latest targeted exam, also referred to as a “sweep,” FINRA’s Market Regulation Department’s Trading & Financial Compliance Examinations Department issued a sample exam letter of the information requested. The letter is intended to elicit information about the scope of the trades on which no commission is charged, as well as information concerning how the firm makes money, whether clients understand how the firm makes money, and whether the firm’s revenue practices may be detrimental to customers; e.g., whether the firm is less focused on obtaining best execution for customers because it is more dependent on obtaining revenue through trade rebates or payments for order flow arrangements.

LOFCHIE COMMENTARY

This is actually quite a significant targeted exam letter. It has relevance well beyond those firms that have a zero commission offering. FINRA is asking very detailed questions about how the firm makes money, and how the firm’s revenue stream affects the manner in which the firm does business and treats customers.

The type of information that the letter is intended to elicit includes information that would be relevant to the completion of Form CRS that is to be provided to clients.

In short, all firms, not only those that are potential recipients of the letter, should give careful consideration to how they would answer the questions raised, and as to how those answers would look to the regulators and their customers.

House Urges Supreme Court to Uphold Constitutionality of CFPB

The House of Representatives filed an amicus curiae brief urging the Supreme Court to reject a challenge to the constitutionality of the CFPB. The CFPB is an independent agency within the Federal Reserve System created by Title X of the Dodd-Frank Act. The Supreme Court scheduled the matter for oral argument on March 3, 2020.

The House brief argued that the Court should affirm the Ninth Circuit’s ruling in Seila Law LLC v. Consumer Financial Protection Bureau, 923 F.3d 680 (9th Cir. 2019), which upheld the CFPB’s constitutionality following the refusal of Seila Law LLC (“Seila”), a debt-collection firm, to comply with a civil investigative demand (“CID”) issued by that agency. In its petition to the Supreme Court, Seila argued that the CID is unlawful because the CFPB is unconstitutionally structured. In particular, Seila maintained that CFPB’s regulatory structure violates the Constitution’s separation of powers because it is an independent agency headed by a single Director who exercises substantial executive power but can be removed by the President only for cause.

The House brief addressed two questions: (i) whether the CFPB Director’s removal protection violates the separation of powers and (ii) whether a constitutional flaw in the CFPB Director’s removal protection entitles Seila to relief from the civil investigative demand, and requires invalidation of Title X of the Dodd-Frank Act, the statutory provision creating the CFPB.

In its brief, the House urged the Supreme Court to avoid ruling on the constitutionality of the CFPB Director’s removal protection, arguing that the Court should rule that the CID would be enforceable even if the removal protection is invalid. Second, the House contended that if the Court does reach the constitutional question, it should uphold the CFPB Director’s removal protection, arguing that such protection “is exactly the same as” that provided members of other independent agencies such as the FTC, and that the CFPB’s single-director structure enhances, rather than diminishes, the agency’s accountability to the President. Finally, the House argued that the constitutionality of the removal protection should not affect Title X and, therefore, the legal viability of the CFPB, pointing to the severability provision within the Dodd-Frank Act, which states that if “any provision” of the statute “is held to be unconstitutional, the remainder of th[e] Act . . . shall not be affected thereby.”

Amici curiae briefs from New York and 23 other state attorneys general, the National Consumer Law Center, and several other consumer-advocacy organizations echoed similar arguments in support of preserving the CFPB’s structure. Click here to see all amici briefs submitted on the constitutionality of the CFPB.

LOFCHIE COMMENTARY

Leaving aside the big picture question of the constitutionality of the CFPB structure, the CFPB structure makes for bad public policy. It represents an immense amount of power concentrated in the hands of a single individual, who does not report to any branch of Congress. There is simply no good reason why the CFPB should not be reorganized following the same basic structure as the other independent regulatory agencies, with representation from both political parties on the Commission, and the leader of the Commission being appointed by the current President, of whichever party that might be.

FRBNY Assesses Potential Impact of Cyberattacks on Payment Systems

The Federal Reserve Bank of New York (“FRBNY”) analyzed the potential impact of a cyberattack transmitted through a payment system against a (i) single large bank, (ii) group of smaller banks and (iii) common service provider.

In a report entitled “Cyber Risk and U.S. Financial System: A Pre-Mortem Analysis,” the FRBNY warned that an attack on a bank’s ability to send payments “would likely be amplified to affect the liquidity of many other banks in the system.” According to the FRBNY, the U.S. financial system would be impaired by such an attack on (i) any one of the five most active U.S. banks, (ii) several small to midsize banks that are associated through a shared vulnerability or (iii) a bank with a small number of total assets but a heavy payment flow.

Additionally, the FRBNY:

– compared cyber risk against the “broader theoretical literature on bank runs,” such as cyber and other shocks modeled in the theoretical literature;

– investigated the quantitative impact that a cyberattack can have on the financial system by studying the impairments of a cyberattack on a set of banks’ payment activities in Fedwire Funds Service;

– conducted a baseline scenario to highlight the high concentration of payments between large institutions within the wholesale payment network, and the great imbalance in liquidity that follows if a large institution does not remit payments to its counterparties; and

– considered scenarios involving multiple institutions that would be directly affected due to technological or other commonalities.

LOFCHIE COMMENTARY

Presumably, the bad guys know how to do this anyways, and the issues raised will focus the good guys on the risks.

FINRA Identifies 2020 Risk Monitoring and Examination Priorities

In its Risk Monitoring and Examination Priorities Letter (the “2020 Letter”), FINRA identified several areas of focus for 2020, including:

– Sales Practice and Supervision. FINRA will assess firms’ compliance with Regulation Best Interest (“Reg. BI”) and Form CRS. In addition, FINRA will focus on (i) communications to retail investors regarding private placements, (ii) use of different electronic communication channels (e.g., texting and social media), (iii) cash management and bank sweep programs, (iv) sales of IPO shares and (v) trading authorizations.

– Market Integrity. FINRA will monitor firms for compliance with current Order Audit Trail System (“OATS”) requirements, and implementation of Consolidated Audit Trail (“CAT”) reporting requirements. In addition, FINRA will address firms’ compliance with (i) direct market access requirements under Exchange Act Rule 15c3-5, (ii) best execution requirements under FINRA Rule 5310, and (iii) the requirements of Rule 603 (the “Vendor Display Rule”) and Rule 606 (“Disclosure of order routing information”) of Regulation NMS.

– Financial Management. FINRA will focus on (i) clearance and custody of digital asset transactions, (ii) liquidity management, (iii) compliance with net capital requirements in connection with underwriting commitments and (iv) the steps firms are taking to transition away from LIBOR.

– Firm Operations. FINRA will focus on (i) cybersecurity, (ii) technology governance programs and (iii) supervisory controls relating to customer confirmation and AML requirements.

Lofchie Commentary

Several of the financial management areas of focus are as to issues where there is not actually a rule in place; e.g., liquidity management and transition from LIBOR. That does not make them any less significant. Firms may want to consider how they institute operational procedures to deal with regulatory expectations where there is not a specific rule that drives the firm’s conduct.

SEC Commissioner Hester Peirce Questions Current Data Collection Practices

SEC Commissioner Hester M. Peirce questioned the agency’s current data collection process and analysis.

In a speech before the National Economists Club, Ms. Peirce expressed concern that regulators’ data collection requirements are too far-reaching. According to Ms. Peirce, regulators are increasingly expanding data requirements without adequately considering (i) the underlying costs to regulators, market participants and investors, (ii) the usefulness of the information, and (iii) the potential cybersecurity risks. She:

  • questioned whether the information collected by Form PF is useful enough to outweigh the burden of compliance on hedge funds and other private funds; and
  • expressed concern that the Consolidated Audit Trail (or “CAT”) – which will collect data from broker-dealers across the county – is costly and a significant cybersecurity liability.

Ms. Peirce urged the SEC to invite academics and market participants to analyze the data collected, raise questions and suggest regulatory solutions. She stated that oftentimes market participants are better at “identifying problems and generating solutions” than the regulators. To encourage independent assistance, Ms. Peirce advised the SEC to make it easier for market participants to access the available data.

Ms. Peirce also addressed recent feedback calling on regulators to foster “sustainable finance,” (a/k/a “building a financial system that fosters a better, more sustainable society”). She stated that such a system should be formed by the free market, and should not be “dictated by a few powerful financial regulators.”

LOFCHIE COMMENTARY

In a world where every website is under potential attack from hostile nation states and from criminal organizations, why would one take the risk of gathering so much financial information in one place? The U.S. government has been successfully hacked; very sophisticated data companies have been successfully hacked; large financial institutions have been successfully hacked. There appears no obvious justification for accumulating so much financial information in a single location, as there can be no assurance that it can be kept safe for all time. Put another way, if the regulators cannot attest that, even if the site is hacked, the benefit of collecting and aggregating the financial information will nonetheless outweigh the harm, then it seems imprudent to proceed.

Form PF, as previously described, is “fundamentally useless.” See, e.g.SEC Requests Comments on Form PF. Anyone with knowledge of the relevant subject areas can look at the questions and see that they will not generate meaningful data; it’s not even necessary to look at the responses to see that the entire data collection effort has been a 99% waste.

Facebook CEO Mark Zuckerberg Defends Libra

In testimony before the House Financial Services Committee, Facebook CEO Mark Zuckerberg defended his company’s proposed virtual currency, “Libra.” The Committee also considered several bills related to technology and the financial services industry.

Mr. Zuckerberg emphasized that Facebook would not launch the Libra payment system until it has the support of U.S. regulators. He warned that, while these issues are being “debate[d],” China and other countries are working to launch similar payment systems. He argued that since Libra would be backed by U.S. dollars, it would “extend” U.S. financial leadership. He also addressed several concerns, assuring the legislators that:

– a recent white paper co-authored by Facebook (see previous coverage) was intended to start a dialogue with financial experts and regulators, rather than serve as the “final word”;

– Facebook does not intend to “circumvent” regulators; and

– the intended purpose of Libra is to provide for the transfer of money through an online payment system, not to be a replacement for sovereign currency.

Mr. Zuckerberg also affirmed Facebook’s commitment to preventing discrimination among Facebook’s advertisers. To “combat[]” discrimination, he stated, Facebook has made specific changes to policies in order to prevent discriminatory advertisement targeting. For example, Facebook banned the use of age, gender or zip codes in housing and credit advertisements.

Committee members at the hearing discussed several bills concerning technology and finance related to issues raised by the testimony. These included:

H.R. Draft “Keep Big Tech Out of Finance Act” would prohibit large platform utilities (i.e., Facebook) from (i) being authorized as, or affiliating with, a U.S. financial institution or (ii) operating a digital asset that is intended to be “widely used” as a method for exchange, pursuant to the Federal Reserve.

H.R. Draft “Stablecoins Are Securities Act of 2019” would make clear that a managed stablecoin is subject to the same securities laws’ requirements as other securities that are meant to protect investors, such as disclosure, antifraud and conflicts of interest.

H.R. Draft “Bill to Prohibit the Listing of Certain Securities” would limit issuers of stablecoins access to capital markets prohibiting certain trading on U.S. national securities exchanges.

H.R. Draft “Designing Accounting Safeguards to Help Broaden Oversight and Regulations on Data” would create more “transparency” on how consumer data is collected by requiring commercial data operators to disclose (i) the type of user data collected, (ii) an examination of how valuable the user data is and (iii) third-party contracts involving the collection of the data.

H.R. Draft “Diverse Asset Managers Act” would require SEC registrants to (i) consider at least one “diverse” asset manager when seeking asset management services and (ii) report to the SEC the extent to which diverse asset managers are used.

LOFCHIE COMMENTARY

Facebook’s attempted entry into the digital currency market accelerated the inevitable: Congress and the financial regulators are more closely scrutinizing the entry of technology firms into the financial markets. What was not inevitable was Congressional overreaction. While it now seems universal practice to refer to Libra as a Stablecoin, it is not: it is an asset-backed coin (try “ABCoin”). Because the managers of Libra would have had the ability to shift the assets supporting Libra, Libra is not stable. Because of the management of the underlying assets backing the product, Libra almost certainly would have been a “security,” at least in the absence of an exemption, and therefore, it is not necessary to amend the securities laws to that end.

A true Stablecoin, whether backed by the dollar or another currency (or even a pool of currencies) may be issued as a custodial receipt that is not a security, and need not be regulated as a security. It would thus be a shame if such Stablecoins, which may very well provide an attractive alternative to other payment methods, were made impossible because of an overbroad reaction to Libra.

Mr. Zuckerberg is absolutely correct that the United States benefits if a global stablecoin backed by the dollar were to emerge. Facebook’s principal mistake, which arguably reflects a certain lack of sophisticated understanding of financial regulation, was to go forward with a managed ABCoin, rather than a true Stablecoin.

IRS to Ask Taxpayers about Virtual Currency Transactions

The IRS proposed an amended draft of the 2019 Form 1040 that includes a question about taxpayer virtual currency transactions.

As previously covered, the IRS provided updated guidance in the form of a revenue ruling and an FAQ on the tax treatment of virtual currency transactions. The FAQ addressed (i) when a cryptocurrency on a distributed ledger undergoes a protocol change that permanently divides the legacy from the existing distributed ledger (i.e., a “hard fork”) and (ii) when units of a cryptocurrency are delivered to the distributed ledger addresses of multiple taxpayers (i.e., an “airdrop”), typically following a hard fork.

The IRS proposed adding the following question to the 2019 Form 1040: “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

Comments on the revised draft must be submitted to the IRS within 30 days after October 11, 2019.