August 2017 - Reverse-Merger.com

FINRA Issues New Guidance On Communications With The Public, Including Social Media

Posted by Securities Attorney Laura Anthony | August 22, 2017 Tags: Finra, FINRA Rule 2210, Regulatory Notice 17-18

In April 2017 FINRA issued Regulatory Notice 17-18 providing additional guidance on the use of social media and digital communications by member firms and persons associated with member firms. The guidance specifically relates to FINRA Rule 2210 – Communications with the Public, and supplements previously issued guidance in Regulatory Notices 10-06 and 11-39, published in 2011. The new guidance is in the form of FAQ’s and concentrates on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

I have previously written about the SEC’s guidance on social media use by companies, including as a method for communications with investors and the public. The most recent blog is HERE and includes hyperlinks to prior blogs, including a three-part summary of the SEC Guidance on Social Media and Websites for Company Announcements and Communications.

Brief Overview of Rule 2210

FINRA Rule 2210 governs communications by FINRA member firms and associated persons, including: (i) institutional communications – including any written or electronic communication, distributed or made available only to institutional investors such as banks, insurance companies and investment companies; (ii) retail communications – including any written or electronic communication distributed or made available to more than 25 retail investors within any 30-calendar-day period; and (iii) correspondence. The Rule also sets forth requirements related to approval, review and recordkeeping of communications; filing requirements and review procedures and content standards.

The Rule’s general content standards apply to all communications and are meant to ensure that communications are fair, balanced and not misleading. Communications to retail customers or potential customers have the highest standards. The communication rules focus on the recipient and not the type of product (IPO, private, debt, etc.) that might be being discussed.

Retail Communications

Subject to certain exemptions, an appropriately qualified registered principal of the member firm must approve each and every retail communication before the earlier of its first use, or its filing with FINRA’s Advertising Regulation Department. However, this requirement does not apply where another member firm has used the same communication and received approval from FINRA as to its content. In other words, member firms can piggyback on each other’s advertising and communication approvals.

The requirement also does not apply to: (i) certain communications excepted from the definition of a research report or debt research report unless the communication makes a financial or investment recommendation; (ii) any retail communication that is posted on an online interactive electronic forum; and (iii) retail communication that does not make any financial or investment recommendation or otherwise promote a product or service of the member firm.

Correspondence

All correspondence must be subject to general supervision and review requirements.

Institutional Communications

Members must establish written procedures that are appropriate to their business, size, structure, and customers for the review by an appropriately qualified registered principal of institutional communications used by the member and its associated persons. The procedures must be reasonably designed to ensure that institutional communications comply with applicable standards. When the procedures do not require review of all institutional communications prior to first use or distribution, they must include provisions for the education and training of associated persons as to the firm’s procedures, documentation of the education and training, and surveillance and follow-up to ensure that the procedures are implemented and adhered to.

Recordkeeping

As required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

Records must include: (i) a copy of the communication and the dates of first and last use; (ii) the name of any principal who approved the communication and the date of approval; (iii) if the communication was not approved, the name of the person who prepared or distributed it; (iv) information on the source of any statistical table, chart, graph or other illustration; (v) where the firm or representative is relying on another member’s approval, the name of the member and a copy of the review letter and approval from FINRA; and (vi) for any retail communication that includes or incorporates a performance ranking or performance comparison of a registered investment company, a copy of the ranking or performance used in the retail communication.

Filing Requirements and Review Procedures

For the first year as a licensed broker-dealer, a firm must file all retail communications with FINRA’s Advertising Regulation Department at least 10 days prior to its first use. If a communication is a free writing prospectus that has been filed with the SEC, it can be filed with FINRA within 10 days of its first use, instead of prior. FINRA can also impose a filing requirement on any firm at any time if it determines that the firm has departed from the standards in Rule 2210.

Retail communications concerning registered investment companies, which include or incorporate performance rankings or comparisons, must always be filed at least 10 business days prior to use. Likewise, retail communications recommending a specific registered investment company, concerning a direct participation program, concerning collateralized mortgages or concerning derivatives or indexes must all be filed with FINRA at least 10 business days prior to their first use.

If a member has filed a draft version or “storyboard” of a television or video retail communication pursuant to a filing requirement, then the member also must file the final filmed version within 10 business days of first use or broadcast.

Certain retail communications are excluded from the filing requirements, including: (i) communications based on a template that has previously been filed with FINRA and approved for use either without material change, or changes limited to updated statistical and other information; (ii) retail communications that do not make any financial or investment recommendation or otherwise promote a product or service of the member; (iii) retail communications that do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker; (iv) retail communications that do no more than identify the member or offer a specific security at a stated price; (v) offering documents, reports or free writing prospectus that have been filed with the SEC or a state or offering documents for exempt offerings; (vi) tombstone communications identifying a firm’s participation in an offering; (vii) press releases that are made available only to members of the media; (viii) republications of unaffiliated third-party articles or reports that the firm has neither adopted nor become entangled with; (ix) correspondence; (x) institutional communications; (xi) communications that refer to types of investments solely as part of a listing of products or services offered by the member; (xii) retail communications that are posted on an online interactive electronic forum; (xiii) press releases issued by closed-end investment companies that are listed on the New York Stock Exchange; (xiv) research reports on exchange traded securities.

FINRA may grant exemptions to the filing requirements for good cause. All filings must be approved by a registered principal within the firm prior to submitting to FINRA.

Content Standards

Rule 2210 focuses on antifraud issues. In particular, the Rule provides that “All member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” The next section continues: “No member may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication. No member may publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.”

Information may only be placed in a footnote if it is still clear. Members must ensure that statements are not misleading and that they provide balanced treatment of risks and potential benefits. FINRA requires that firms consider their audience in creating content, and such content must be audience-appropriate. Communications cannot exaggerate and may not predict or project performance.

There are specific requirements for content in communications. For example, a member firm must prominently include the name of the member firm, fictional names, and relationships between parties listed in the communication. There are specific requirements regarding communications related to tax-free or tax-exempt products and disclosures of fees and expenses for investment management companies and pooled funds.

Testimonials and Recommendations

Rule 2210 governs the use of testimonials about a member firm and the use of recommendations by a member firm. Each requires a reasonable basis and must be rendered by a person with the knowledge and experience to form a valid opinion. Retail communications involving recommendations about a product or service by a member firm have additional technical requirements.

BrokerCheck

All communications must contain a prominent reference and hyperlink to BrokerCheck.

New Guidance

FINRA Regulatory Notice 17-18 provides additional guidance on the use of social media and digital communications by member firms and associated persons through FAQ’s designed to supplement previously issued guidance on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

Recordkeeping

As noted above, and as required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

The new guidance confirms that the record retention requirements apply to communications made through text messaging or a chat service or app. Prior to allowing text or chat communications, a firm must ensure that it has the ability to retain the content of the communications.

Third-party Posts; Adoption or Entanglement

Generally speaking, posts by customers or other third parties on social media or any website established by a firm or its personnel do not constitute communications with the public by the firm or its associated persons under Rule 2210. Accordingly, these posts do not require pre-use approval by a principal in the firm, and as a practical matter, a firm could not require third parties to seek such approval. However, if the firm or associated person paid for the preparation of the content or otherwise caused it to be prepared and posted, the firm would be responsible for its content under FINRA’s “entanglement” theory. Moreover, if the firm or associated person explicitly or implicitly endorses or approves the third-party content, it would also be responsible for its content under FINRA’s theory of “adoption” of content. Where a firm or associated person is responsible for the content, it must comply with all the requirements of Rule 2210.

The new guidance clarifies that a firm or registered representative can contact a third party to correct factual information, such as the spelling of a name, an incorrect address or website, where the firm was completely unaffiliated with the publisher and not involved in the publications content, without such correction resulting in entanglement or endorsement.

Hyperlinks to Third-party Sites

A firm is responsible for links to a third-party site if that firm has adopted or become entangled with the content. A firm would be deemed to have adopted content that it explicitly or implicitly endorses or approved and would be deemed to be entangled in content where it has participated in the development of such content. A member firm may not establish a link to any third-party site that the firm knows or has reason to know contains false or misleading content and may not include a link on its website if there are any red flags that indicate the linked site contains false or misleading content.

The new guidance clarifies that by sharing or linking to third-party content, the member firm has adopted that content and is responsible for its content to the same extent it is for firm-generated communications. Where the shared or linked content itself has additional links to other content, the firm must do a facts-and-circumstances analysis to determine if it would also be responsible for that additional content. The firm would not be deemed to have adopted the content in the links in the shared content, solely by sharing or linking.

In general, if a firm shares or links to content that in turn links to other content over which the firm has no influence or control, the firm would not have adopted the other content. On the other hand, if a firm shares or links to content that in turn links to other content over which the firm has influence or control, the firm would then have adopted that other content. In addition, if the firm shares or links to content that itself serves primarily as a vehicle for links, the firm would be responsible for the content in the links.

The new guidance also clarifies that whether a firm has adopted the content of an independent third-party website or any section of the website through the use of a link is fact dependent. Two factors are critical to the analysis: (i) whether the link is “ongoing” and (ii) whether the firm has influence or control over the content of the third-party site.

Where the link is “ongoing” the firm would not have adopted the content. “Ongoing” means that: (i) the link is continuously available to investors who visit the firm’s site; (ii) investors have access to the linked site whether or not it contains favorable material about the firm; and (iii) the linked site could be updated or changed by the independent third party and investors would still be able to use the link. As an example, some firms link to regulatory agencies such as FINRA or the SEC.

However, if the firm has influence or control over the third-party site, the firm would be entangled with its content and thus responsible under Rule 2210.

Personal Communications

Personal communications are not subject to Rule 2210. Moreover, if an associated person shares or links to content that the member firm made available, which is not related to its products or services, the communication is likewise not subject to Rule 2210. Examples given in the FINRA notice include information about the firm’s sponsorship of a charitable event, a human interest article, or an employment opportunity.

Native Advertising

Native advertising is defined as content that bears a similarity to the news feature articles, product reviews, entertainment and other material that surrounds it online. Native advertising can appear to be a genuine news article or product review at first glance. FINRA clarifies that native advertising is not inherently misleading and can be used as long as it complies with Rule 2210, including that the firm ensures that the communication is fair, balanced and not misleading. Native advertising must prominently disclose the firm’s name, accurately reflect any relationship with the firm and any other entity or individual named in the advertisement, and state whether mentioned products or services are offered by the firm.

Where a member firm arranges for or pays for third-party native advertising, such as content in a blog or posts by an influencer, the firm would be responsible for its content under the entanglement theory. As provided in an earlier Regulatory Notice, if a firm or representative has paid for the publication, production or distribution of any communication that appears to be a magazine, article or interview, then the communication must be clearly identified as an advertisement. Firms should clearly identify as advertisements any communications that take the form of comments or posts by influencers and include the broker-dealer’s name as well as any other information required for compliance with Rule 2210.

Testimonials and Endorsements

Many social networking sites, such as LinkedIn, allow individuals to post opinions or provide comments regarding a person’s professional capabilities. FINRA allows registered representatives and associated persons to utilize social networking platforms for business-related purposes as long as the account is supervised and retained by the member firm. FINRA does not include unsolicited third-party opinions or comments posted on a social network to be communications of the firm or representative for purposes of Rule 2210. However, if the firm or representative likes or shares content, they have adopted the content and become subject to the communication rules, including prohibitions on misleading or incomplete statements or claims, the testimonial requirements, and the supervision and recordkeeping rules.

Testimonials are governed by Rule 2210 and in particular:

(A) If any testimonial in a communication concerns a technical aspect of investing, the person making the testimonial must have the knowledge and experience to form a valid opinion.

(B) Retail communications or correspondence providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose the following: (i) the fact that the testimonial may not be representative of the experience of other customers; (ii) the fact that the testimonial is no guarantee of future performance or success; and (iii) if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial.

Testimonials are subject to the general Rule 2210 standards as well, including that they not be false, misleading, exaggerated or promissory. The disclosures that must be required can be included via a clearly marked and labeled hyperlink. Also, investment advisors are prohibited from directly or indirectly publishing, circulating or distributing testimonials.

BrokerCheck

Effective June 6, 2016, Rule 2210 requires each of a firm’s websites to include a readily apparent reference and hyperlink to BrokerCheck on (i) the initial web page that the firm intends to be viewed by retail investors, and (ii) any other web page that includes a professional profile of one or more registered persons who conduct business with retail investors. The reference and hyperlink are not required to be included in communications appearing on a third-party website, including social media sites, or in email or text messages.

The new guidance clarifies that the reference and hyperlink to BrokerCheck would not need to be included in an app created by a firm. However, if the app accesses and displays the firm’s website, the link must be readily apparent when the page is displayed through the app.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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« SEC Issues Report on Initial Coin Offerings (ICO’s) OTCQB Sets New Requirements For Change Of Control Events »

SEC Issues Report on Initial Coin Offerings (ICO’s)

Posted by Securities Attorney Laura Anthony | August 15, 2017 Tags: cryptocurrencies, cryptocurrency securities, Initial Coin Offerings, SEC, SEC Issues Report on Initial Coin Offerings (ICO's)

On July 25, 2017, the SEC issued a report on an investigation related to an initial coin offering (ICO) by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report (the “Report”). On the same day, the SEC issued an Investor Bulletin related to ICO’s. Offers and sales of digital coins, cryptocurrencies or tokens using distributed ledger technology (DLT) or blockchain have become widely known as ICO’s. For an introduction on DLT and blockchain, see HERE.

The basis of the report is that offers and sales of digital assets, including cryptocurrencies, are subject to the federal (and state) securities laws. From the highest level, the nature of a digital asset must be examined to determine if it meets the definition of a security using established principles (see HERE). In addition, all offers and sales of securities must either be registered with the SEC or there must be an available exemption from such registration. This statement applies to cryptocurrency securities in the same manner it applies to all other securities. In addition, participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements. Securities exchanges providing for trading must register unless an exemption applies.

Despite the SEC findings, it declined to pursue an enforcement action but rather used the opportunity to inform the public on its views and, in particular, that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In the press release announcing the investigative findings, SEC Chair Jay Clayton stated, “[T]he SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”

This is not the first time the SEC has addressed registration and exemption requirements associated with cryptocurrencies. There have been several other cases. For example, in December 2014 the SEC settled charges against BTC Virtual Stock Exchange and LTC Global Virtual Stock Exchange related to violations of both the broker-dealer registration requirements and the securities offer and sale registration requirements. For more information on that case, see HERE.

This blog will summarize the SEC Report of Investigation, statements by the Divisions of Corporation Finance and Enforcement and the Investor Bulletin on Initial Coin Offerings.

SEC Report of Investigation on an ICO

On July 25, 2017, the SEC issued its Report on an investigation into an ICO and related activities by the DAO, an unincorporated entity, Slock.it UG (“Slock.it”), a German corporation, and various principals and participants. As mentioned earlier, although the report provides a platform for which the SEC can educate the marketplace, it did not pursue enforcement actions against the targets of the investigation.

The “DAO” stands for a decentralized autonomous organization, or a virtual network embodied in computer code on a on a DLT or blockchain. The DAO was created by Slock.it to sell tokens to investors, which proceeds would be used to fund for-profit projects. The token holders would share in the profits and, as such, had an expectation of a return on investment. The DAO tokens were also transferable and available for secondary trading on different web-based platforms. After the ICO, but before projects were funded, the DAO was hacked and approximately one-third of its assets stolen. Fortunately the DAO was able to come up with a plan that caused the return of ETGH raised from the DAO back to their original Ethereum address and thus return investments to the original investors.

The SEC opened an investigation as to whether the offer and sale of the DAO Tokens invoked federal securities laws, whether the DAO Tokens were securities and whether the platforms for the secondary trading of the Tokens required registration as a securities exchange. The answer to each of these questions, under the facts and circumstances presented, was in the affirmative. Since the DAO had not yet commenced operations, the SEC did not review whether the DAO was acting as an “investment company” under the Investment Company Act of 1940, but noted that had they begun operations, such an analysis would have been appropriate.

The Report begins with the conclusion. Whether or not a particular transaction involves the offer and sale of a security depends on an analysis of the facts and circumstances, regardless of terminology or technology used or employed. All persons or entities that use a Decentralized Autonomous Organization (DAO Entity), DLT or other blockchain-based technology as a means to raise capital in the U.S. are subject to the U.S. federal securities laws. All securities offered and sold in the U.S. must be registered or must qualify for an exemption from registration. Moreover, any entities or platforms that allow for the secondary trading of securities must either be registered as a national securities exchange or operate pursuant to a registration exemption. The automation of functions, computer code, smart contracts, and decentralization does not change the obligations under the federal securities laws.

Background and Facts

In a one-month period from April 30, 2016, through May 28, 2016, the DAO offered and sold 1.15 billion DAO Tokens in exchange for 12 million Ether (“ETH”) valued at approximately $150 million USD. ETH is a virtual currency. The Financial Action Task Force defines a “virtual currency” as:

a digital representation of value that can be digitally traded and functions as: (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. It is not issued or guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency. Virtual currency is distinguished from fiat currency (a.k.a. “real currency,” “real money,” or “national currency”), which is the coin and paper money of a country that is designated as its legal tender; circulates; and is customarily used and accepted as a medium of exchange in the issuing country. It is distinct from e-money, which is a digital representation of fiat currency used to electronically transfer value denominated in fiat currency.

The DAO itself was created by the founders of Slock.it as a type of alternative corporation with all corporate functions and governance automated using blockchain and smart contracts. The DAO was the “first generation” of its kind. Participants sent in ETH in exchange for DAO Tokens. DAO Token holders could vote on projects to be used with the DAO assets (ETH, which could be exchanged for fiat currency and other physical or digital assets) and participate in rewards such as profit distributions and dividends. The entire DAO was intended to be autonomous such that project proposals were in the form of smart contracts and voting administered by computer code. The DAO code was launched on the Ethereum blockchain.

The DAO promoted itself through a website which described its purpose (“[T]o blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code”), how it operated, its source code, and a link to buy the DAO Tokens. The DAO was also promoted through media attention and numerous social media channels.

Anyone was eligible to purchase DAO Tokens as long as they paid in ETH and there were no limitations on the number of DAO Tokens offered for sale or the number that could be purchased by any purchaser. There were no parameters set on the accreditation or sophistication level of a purchaser. Anyone with ETH and an ETH blockchain address could participate. All ETH from DAO Token sales were aggregated in the DAO’s Ethereum blockchain address.

Only DAO Token holders could submit proposed projects in which the DAO might participate, and each proposal would have to involve a smart contract and comply with the preset DAO Token holders voting code. Projects would be approved by a majority vote of DAO Token holders. Before being submitted for a vote, projects were to be reviewed by human curators. Although beyond the scope of this blog, there appeared to be many issues with the system, including the programming for voting.

The DAO Tokens were unrestricted and there were several platforms that allowed for the immediate secondary trading of the DAO Tokens. The secondary market trading platforms were registered with the Federal Crimes Enforcement Network (FinCEN) as Money Services Businesses. For more on FinCEN, see HERE. The DAO Tokens were in fact actively traded on various platforms.

SEC Regulatory Analysis

Section 5 of the Securities Act of 1933, as amended (“Securities Act”) requires the registration of all offers and sales of securities unless there is an available exemption. The registration provisions are based on “full and fair disclosure” of all material information for an investor to make an informed investment decision, including detailed information about the issuer’s financial condition, identity and background of management and the price and amount of securities to be offered.

Section 5 of the Securities Act, like many provisions in the securities laws, is written in the inclusive, such that all offers and sales are covered unless an exemption is available pursuant to statute or case law. Section 5 states that “unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities in interstate commerce.” A violation of Section 5 does not require intent.

The SEC begins its analysis of the DAO Tokens by reference to the definitions of a security found in both Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Securities Exchange Act. Both definitions include the term “investment contract,” which has been famously defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. For an in-depth discussion on the definition of a security in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (the “Howey Test”), see HERE.

Under the Howey Test, whether an investment instrument is a security requires a substance-over-form analysis. The Howey Test defines an investment contract as follows:

“… an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party…. Such a definition… permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security…. It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

Applying the Howey Test, courts have interpreted a security to include such diverse items as citrus groves, warehouse receipts, chinchillas, minks, diamonds, bullion, pay phones, real estate and equipment, and condominium units, when they were offered or sold under circumstances involving the investment of money and an expectation of a return through the efforts of others.

Applying the Howey Test to the DAO Tokens, the SEC notes that “money” need not include cash, but rather can be anything of value. A contribution of ETH is an investment as considered by the Howey Test. Investors in the DAO were investing in a common enterprise with the expectation of profits, including dividends and increased value. The SEC also found that the profits were to be derived from the efforts of others, including Slock.it, its founders and the DAO curators.

In its analysis of whether the DAO was a security, the SEC spent the most discussion on the “from the efforts of others” factor. Presumably this is because the DAO was established as an autonomous organization with participants voting on all projects. However, the Slock.it team, through its curators, and management of the DAO website and participation in online forums, “led investors to believe that they could be relied on to provide the significant managerial efforts required to make the DAO a success.” Moreover, in fact, the curators and Slock.it team did exercise significant control over proposals and operations of the DAO and were responsible for stopping the hacking attack and coming up with a plan to rectify the situation.

The SEC also noted that the DAO Token holders voting rights were limited. The DAO Token holders could only vote within the rules (code) established by the Slock.it management team. The SEC points to case law related to multi-level marketing schemes which were securities despite the labor put forth by the investors because the promoter dictated the terms and controlled the scheme itself. The SEC stated that “[T]he voting rights afforded DAO Token holders did not provide them with meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote for contracts was a largely perfunctory one; and (2) DAO Token holders were widely dispersed and limited in their ability to communicate with one another.” Furthermore, the SEC questioned the level of disclosure on projects, believing that such disclosure was not “full and fair” such as to allow an informed investment decision.

Upon concluding that the DAO Tokens were securities, the SEC also concluded that the DAO needed to register their issuance, or satisfy a registration exemption, regardless of whether the DAO was incorporated or an unincorporated organization. Issuers, like securities, are broadly defined to include any sponsor or organization that is primarily responsible for the success or failure of the venture. Participants in an offering are also subject to Section 5 obligations and liability. Accordingly, this included the Slock.it founders and principals.

The secondary trading platforms also required registration, or the availability of an exemption, under the federal securities laws. Section 5 of the Exchange Act makes it unlawful for any broker, dealer or exchange to directly or indirectly affect any transaction in a security or report such transaction unless the exchange is registered as a national exchange or exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood …”

The functions of a stock exchange generally include: (i) bringing together orders for securities of multiple buyers and sellers; and (ii) using established, non-discretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. A frequent exemption to the definition of an exchange is an Alternative Trading System (ATS) that complies with Regulation ATS. Regulation ATS requires, among others, registration as a broker-dealer. The OTC Markets is an ATS, as is t0 Technologies. The platforms that traded the DAO Tokens fit within the definition of an exchange and did not satisfy any available registration exemptions.

Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on the DAO

On the same day that the SEC issued its investigative Report, the Divisions of Corporation Finance and Enforcement issued a statement on the Report. Off the top I notice that the SEC, under Chair Jay Clayton, Commissioner Michael Piwowar and the numerous new executive members, has a decidedly more positive attitude towards business and capital raising overall, than the prior regime. I also notice, through review of enforcement proceedings, that the new regime has not been deterred at all from its mission to detect and prosecute fraud, including micro-cap and penny-stock-related schemes.

To begin its statement, the Divisions noted that DLT, blockchain and other emerging technologies have the potential to influence and improve capital markets and the financial services industry. The Divisions “welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities,” and are “hopeful that innovation in this area will facilitate fair and efficient capital raisings for small businesses.” However, new technologies also offer new opportunities for misconduct and abuse.

The Divisions reiterate the SEC Report’s assertion that an offer and sale of securities must comply with the federal securities laws and that determining whether a particular investment opportunity involves a security involves a facts and circumstances analysis, including economic realities and underlying structure, regardless of the terminology or technology used.

Noting that the SEC Report had found that the DAO Tokens were securities, the Divisions caution sponsors and other participants in offerings of digital or other novel forms of value to consider whether they involve a security and thus their obligations under the federal securities laws, including registration or meeting the qualifications for a registration exemption. Market participants that operate a web or other platform that facilitates transactions in securities must also consider whether they need to be registered as a broker-dealer or an exchange, or if there is an available exemption.

Although the Divisions statement does not mention it, keeping in line with the fundamental view that basic securities laws apply, a web platform that meets the criteria set out in Section 4(b) of the Securities Act, as created by the JOBS Act, should qualify for a broker-dealer exemption when hosting digital coin or token offerings. See HERE for details on this exemption.

Furthermore, the Divisions caution that sponsors and other market participants should consider whether their business model results in an entity that needs to be registered as an investment company and whether anyone providing advice about an investment in the security could be an investment advisor.

The Divisions also caution against bad actors and fraud, again using the same principles and tenets that have always applied to economies. Investors should watch for red flags, including deals that sound too good to be true, promises of high returns with little or no risk, high-pressure sales tactics, and working with unregistered or unlicensed persons.

A fundamental message that I always try to deliver is that anyone engaging in any activity that could invoke the securities laws, should consult with competent securities counsel. The Divisions statement relays the same message, and in particular, that “market participants who are employing new technologies to form investment vehicles or distribute investment opportunities to consult with securities counsel to aid in their analysis of these issues.” The SEC staff also encourages direct communication with the SEC and has set up an email address for communications related to these matters.

Investor Bulletin on Initial Coin Offerings

In addition to its Report and statement of the Divisions of Corporation Finance and Enforcement, on July 25, 2017, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin on Initial Coin Offerings (ICO’s). The Investor Bulletin is written in a simple format and helps to inform the public on the basics of ICO’s.

As noted throughout this blog, virtual coins or tokens are created using DLT or blockchain and can be sold in exchange for other virtual coins (such as Bitcoin or Ethereum) or for fiat currency such as U.S. dollars. Generally tokens sold entitle the purchaser to some return on investment or participation in a project and also may be resold or traded on secondary markets, such as virtual currency exchanges. The Investor Bulletin informs the public that these virtual coin or token offerings can invoke the federal securities laws.

The Investor Bulletin provides some basic information on blockchain and virtual currencies. In particular, taken from the Investor Bulletin:

What is a blockchain?

A blockchain is an electronic distributed ledger or list of entries – much like a stock ledger – that is maintained by various participants in a network of computers. Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure. Some examples of blockchain are the Bitcoin and Ethereum blockchains, which are used to create and track transactions in Bitcoin and Ether, respectively.

What is a virtual currency or virtual token or coin?

A virtual currency is a digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value. Virtual tokens or coins may represent other rights, as well. Accordingly, in certain cases, the tokens or coins will be securities and may not be lawfully sold without registration with the SEC or pursuant to an exemption from registration.

What is a virtual currency exchange?

A virtual currency exchange is a person or entity that exchanges virtual currency for fiat currency, funds, or other forms of virtual currency. Virtual currency exchanges typically charge fees for these services. Secondary market trading of virtual tokens or coins may also occur on an exchange. These exchanges may not be registered securities exchanges or alternative trading systems regulated under the federal securities laws. Accordingly, in purchasing and selling virtual coins and tokens, you may not have the same protections that would apply in the case of stocks listed on an exchange.

Who issues virtual tokens or coins?

Virtual tokens or coins may be issued by a virtual organization or other capital-raising entity. A virtual organization is an organization embodied in computer code and executed on a distributed ledger or blockchain. The code, often called a “smart contract,” serves to automate certain functions of the organization, which may include the issuance of certain virtual coins or tokens. The DAO, which was a decentralized autonomous organization, is an example of a virtual organization.

The Investor Bulletin continues with warnings to potential investors, including to be aware that the federal securities laws require either registration or an exemption from registration for an offer and sale of securities. The Investor Bulletin points potential investors to the EDGAR database to find registration statements, and reminds investors that exemptions usually are limited to accredited investors.

Further, the Investor Bulletin discusses disclosure obligations and sets forth key information that an investor should be informed of, such as use of proceeds, management and business plans.

The Investor Bulletin points out that even if there has been a fraud or theft, their rights may be limited do to the nature of ICO’s in general, including that they can be autonomous, the inability to trace money, the international scope of offerings, that there is no central controlling authority and that there is no method to freeze or secure virtual currency. Finally, the Investor Bulletin points to the usual red flags, including “guaranteed” high returns or low risk, unsolicited offers, sounds too good to be true, buying pressure, no net worth or other investor requirements and unlicensed sellers.

The Author

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« An Introduction To Distributed Ledger Technology (Blockchain Technology) FINRA Issues New Guidance On Communications With The Public, Including Social Media »

An Introduction To Distributed Ledger Technology (Blockchain Technology)

Posted by Securities Attorney Laura Anthony | August 8, 2017 Tags: An Introduction To Distributed Ledger Technology (Blockchain Technology), Blockchain Technology, Distributed Ledger Technology, FINRA Report on Distributed Ledger Technology, FINRA Report on Distributed Ledger Technology and Implications of Blockchain for the Securities Industry

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, including the maintenance of shareholder and corporate records. DLT is commonly referred to as blockchain. The symposium included participation by the Office of the Comptroller of Currency, the US Commodity Futures Trading Commission (CFTC), the Federal Reserve Board and the SEC.

FINRA also published a report earlier in the year discussing the implications of DLT for the securities industry. Delaware, Nevada and Arizona have already passed statutes allowing for the use of DLT for corporate and shareholder records. This is the first in many blogs that will discuss DLT as this exciting new era of technology continues to unfold and impact the securities markets. In this blog I will discuss FINRA’s report published in January 2017 and in the next in the series, I will summarize the recent SEC investigative report on initial coin offerings and conclusion that cryptocurrencies and tokens are securities. In a follow-on blog, I will summarize the state blockchain legislation to date, including Delaware’s groundbreaking statute.

Blockchain is an openly distributed database which is used to continuously maintain a list of records, called blocks. Each new block is linked to prior blocks in such a way that data cannot be retroactively changed in a prior block without changing all blocks, which is virtually impossible. A DLT ledger is shared among a network of participants, instead of relying on a single central ledger.

Ultimately the blockchain technology could be used to maintain shareholder records in a secure immediate form as well as to process capital markets trades instantaneously. It is thought that stock ledgers and any transfers would be updated instantaneously, effectively allowing for T+0 settlement of trades without the need for intermediaries. A change of this magnitude is many years away as effective regulation and consideration on market impacts will take time. For more on trade settlements, see HERE.

The technology is already being utilized, most notably by the cryptocurrency industry. At least one industry leader, Overstock CEO Patrick Byrne’s t0 Technologies, has created a system that could form the basis for widely used blockchain technology which disrupts the capital market trading systems. I don’t expect quick changes to trading systems and settlement. Blockchain remains widely unregulated and without consensus from top financial regulators, any change to capital market structures will face roadblocks. However, I expect that the ability for public companies to maintain stock ledgers using DLT technology will be forthcoming very soon.

FINRA Report on Distributed Ledger Technology and Implications of Blockchain for the Securities Industry

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry. The symposium followed FINRA’s January 2017 report on DLT and its implications for the securities industry. In recent years, over $1 billion has been invested by various market participants to explore the use of DLT in the financial services industry. Although the level and speed of disruption to current systems remains debated, it is universally agreed that DLT will be utilized in the securities industry. DLT has the potential to completely change business models and practices and as such, regulators realize the necessity to be actively engaged to prepare for the new regime. On a positive note, FINRA views DLT as having the potential to provide investors with greater access to services and transparency and to provide firms with increased operational efficiencies and enhanced risk management.

Many aspects of FINRA’s rules and areas of responsibilities can be impacted by DLT, including, for example, clearing arrangements (it is thought that DLT can eliminate middle-market participants involved in the clearing process), recordkeeping requirements, and trade and order reporting and processing. In addition, FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT is already being used in the securities markets in the form of initial cryptocurrency offerings (ICO’s) and in states that have passed corporate statutes allowing for the use of the technology to maintain corporate and shareholder records. On July 25, 2017, the SEC issued a report on an investigation related to an ICO by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report. Although I will write an in-depth blog on the report and statements in the coming weeks, the SEC concluded that the fundamental tenets related to the definition of a security apply and that cryptocurrencies and tokens that fall within that definition are securities, subject to SEC regulations, regardless of the title or form they may take. For more on decoding what is a security, see HERE.

FINRA’s report on DLT is broken down into three sections including: (i) overview of distributed ledger technology; (ii) DLT securities industry applications and potential impact; and (iii) factors to consider when implementing DLT. FINRA also discussed regulatory requirements and potential changes related to DLT. I will summarize each section with my usual commentary and input.

Overview of Distributed Ledger Technology

DLT involves a distributed database maintained over a network of computers where information can be added by the network participants. Each added layer of information or data is referred to as a block. The network participants can share and retain identical cryptographically secured information and records.

DLT uses either a public or private network. A public network is open and accessible to anyone that joins, without restrictions. All data stored on a public network is visible to anyone on the network, although it is encrypted. A public network has no central authority and relies solely on the network participants to verify transactions and record data on the network. Algorithm and computational technology is used to protect the integrity of the data.

A private network is limited to individuals and entities that are granted access by a network operator. Access can be tiered with different entities being allowed differing levels of authority to transact and view data. In the financial services industry, it is likely that networks will be private.

The transactions and data on the network usually represent an underlying asset that may be digital assets, such as cryptosecurities and cryptocurrencies, or a representation of a hard asset stored offline (a token representing an interest in a gold bar, for example). Assets on a DLT network are cryptographically secured using public and private key combinations. The public key combination allows access to the network itself, and the private key is for access to the asset itself and is held by the asset holder or its agent.

A transaction may be initiated by any party on the network that holds assets on that network. When a transaction is initiated, it is verified using a predetermined process that can be either consensus-based or proof-of-work based, although new verification processes are being explored. In layman’s terms, the verification process is based on computer computations. The settlement of the transaction is occurs when verification is completed. Currently this can occur immediately or take a few hours.

Once verified, a transaction is “cryptographically hashed” and forms a permanent record on the DLT network. Records are time-stamped and displayed sequentially to all parties with network access. Currently, historical records cannot be edited or changed, though technology is being developed to change that.

DLT Securities Industry Applications and Potential Impact

Currently, market participants are experimenting with several uses of DLT within the market infrastructure and ecosystem. DLT can be used in specific markets, such as debt, equity and derivatives, and in specific market functions, such as clearing. Many discrete applications exist for the use of DLT, including, for example, clearing arrangements, recordkeeping requirements, and trade and order reporting and processing. In addition, DLT can impact financial condition recordkeeping and reporting, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans.

The most common current use of DLT is related to private company equities. DLT can be used to track transfers, maintain shareholder records and for capitalization tables. Nasdaq has utilized DLT technology to complete and record a private securities transaction using its Nasdaq Linq blockchain ledger technology. The Nasdaq platform allows private companies to use DLT to record and track trading of private securities.

DLT will eventually be used for public company equities, but the regulatory aspects are behind the technology. However, Overstock’s Patrick Byrne has created and launched a private platform to allow for public trading of securities using blockchain, called t0 Technologies. The platform only currently trades Overstock’s digital shares, but as an SEC licensed alternative trading system (ATS), the foundation is in place for utilizing the platform to launch and trade public offerings of third-party securities.

The debt market also sees the benefit of DLT. The current average settlement time for the secondary trading of syndicated loans is approximately a month. The repurchase agreement marketplace is filled with inefficiencies, as is the trading market for corporate bonds. DLT could be used in all aspects of these markets. It is thought that DLT can also be used to automate the derivative marketplace and create greater transparency.

DLT technology is being worked on to create operational processes with the securities industry itself as well, including by creating central repositories of standardized reference data for various securities products, creating efficiencies for all participants. DLT can also centralize identity management functions, on a global scale.

In addition to the centralization of data, DLT can be used to process transactions by using overlaid software. For example, “smart contracts” can be created that would automatically execute agreed-upon terms in a contract based on certain triggering events. Smart contracts can be used for escrow arrangements, collateral management and corporate actions such as dividends and splits.

In addition to discrete areas, DLT can have market-wide impacts as well. One area that is gaining traction is the clearing process. Overstock’s platform is called t0 as a play on the widely used T+2 (formerly T+3) time for settlement. t0 references the immediate clearing and settlement of trades using DLT technology. However, despite the technological abilities, FINRA notes that it is unclear what the ideal settlement time would be for various segments of the securities market. Some market participants advocate for a netting and end-of-day settlement rather than a real-time contemporaneous process.

Real-time settlements would also impact short trading and other hedging transactions, including by market makers. On the positive side, it is thought that real-time settlement will reduce market risk, free up collateral and create overall efficiencies. As FINRA notes, it is likely that considerations related to settlement times will differ based on asset type, volume of transactions, liquidity requirements, impact on market makers and current market efficiencies.

Clearly DLT will increase market transparency. The basis of the technology is a series of blocks with a complete history available for view by network participants. Market participants and the investing public could be provided with access to relevant information on the network without the need to create a new reporting infrastructure. FINRA notes that regulators need to consider the benefits of such total transparency and the counter need to protect privacy, personally identifiable information and trading strategies. Also, consideration must be given to the need to ensure that material information available to a private network does not disadvantage the rest of the public.

DLT has the ability to alter or even eliminate the roles of intermediaries in the securities industry. The process of executing a trade as well as the subsequent settlement and clearing of such trade could be done directly between the issuing company and purchaser or third-party buyers and sellers. In addition, the need for market participants that effectuate transaction netting and maintenance of margin requirements could be reduced or eliminated.

The operational risks associated with the securities markets can be changed including sharing information over a network of multiple entities, the use of private and public keys to obtain access to assets, the use of smart contracts and other automated operations. The very nature of DLT as a shared network creates cybersecurity risks and the need for robust countermeasures.

Factors to Consider When Implementing DLT

As discussed, DLT applications have already impacted the securities industry. Many financial institutions have already established in-house or third-party research teams to build and test DLT networks and applications. FINRA’s report provides a good high-level summary of the obvious factors to consider with implementing DLT technology in capital markets, including governance, operational structure and network security.

Governance

A basis of DLT technology is that it is an open network with no centralized governing power or operator. FINRA notes that although there are benefits to this system, there are also issues, such as how to handle a large volume of transactions effectively. As a result, closed networks have started where participants are pre-vetted trusted parties. In the capital markets, questions will need to be answered related to the operation of the network and who has responsibility for what aspects—for example, who would decide governance and internal controls and procedures, who would enforce these governance rules, who would be responsible for day-to-day operations including addressing system failures or technical issues, how errors would be rectified and conflicts of interests addressed.

Operational Structure

Any DLT Network will need to consider its operational structure including a framework for: (i) network participant access and related onboarding and offboarding procedures; (ii) transaction validation; (iii) asset representation (such as shares of stock); and (iv) data and transparency requirements.

A network will need to establish criteria and procedures for establishing and maintaining participating members and determining their level of access. Controls and procedures will need to address: (i) criteria for participants to gain access to the network; (ii) a vetting and onboarding process including identity verification and user agreements; (iii) an offboarding process for both involuntary offboarding as a result of noncompliance and voluntary offboarding; (iv) monitoring and enforcement procedures for compliance with rules of conduct; (v) establishing various levels of access; and (vi) access for regulators.

Networks will need to determine a method for transaction validation. In the short history of blockchain, there have already been different methodologies. Validation could be consensus-based, single-node verifier or multiple-node verifier. Each method has pros and cons, and the specific algorithms and processes would need to be ferreted out.

On the topic of asset representation, networks will need to determine if the actual asset will be directly issued digitally (which only works for certain assets such as intangibles, stock or agreements representing ownership interests) or issued traditionally and be tokenized on the network. If tokenized, further thought must be given to security, handling loss or theft of the underlying asset, fractionalization issues, handling changes such as reverse or forward stock splits or conversions, and new issuances as some examples.

Likewise, thought must be given to the handling of cash on the network, including the settlement of transactions. In that regard, could tokens become a form of cash and if so, how would they ultimately be converted into established government currencies? Ownership in almost any asset could also be tokenized (such as diamonds, gold, precious metals, art, etc.), creating issues of custodianship and security for the underlying asset. Intangible assets would be relatively easy to tokenize. Fungible assets would be easier than non-fungible assets, with unique assets being the most difficult.

A network will need controls and processes related to data transparency including public or shared information versus private information.

Network Security

In addition to the security of the underlying asset, there are security concerns with the network itself. The issue is more complex due to the decentralized nature of, and global access and participants to, the network. A DLT Network must have security for external and internal risks while maintaining the privacy of personal information for network participants.

Network participants will need to consider: (i) how DLT fits within their current recordkeeping framework including maintenance and backup systems; (ii) cybersecurity issues, including hacking, phishing, malware and other forms of threats and program and testing requirements; (iii) updating written supervisory procedures and policy procedures; and (iv) business controls for identity and transaction verification and fraud prevention.

Regulatory Considerations

Broker-dealers are currently exploring issuing and trading securities, facilitating automated actions such as dividend payments and maintaining transaction records on a DLT network. These areas are regulated by both the SEC and FINRA. The FINRA report points out the potential for a “paradigm shift for several traditional processes in the securities industry through the development of new business models and new practices incorporating DLT” that requires regulatory attention.

I personally believe this shift will occur in a shorter period of time than some others predict. I can see a time in the not-too-distant future where the role of transfer agents is minimalized or completely changed to a reviewer of opinion letters for legend removals; the DTC will be drastically changed and much less powerful; there will no longer be a separation between clearing firms and introducing brokers and all trades will clear instantaneously (t+0).

The FINRA report specifically discusses some major areas of consideration including: (i) customer funds and securities; (ii)

Customer Funds and Securities

DLT will create new ways to hold customer funds and securities and thus custodial changes. Broker-dealers that hold funds and securities must generally comply with Exchange Act Rule 15c3-3, which generally requires the broker to maintain physical possession or control over the customer’s fully paid and excess margin securities. Where funds and securities are purely digital, such as cryptosecurities, consideration will need to be made over how they are accounted for and who has the obligation. In addition, certain activities and access levels could amount to “receiving, delivering, holding or controlling customer assets” such as having access to a private key code for a customer.

Also potentially implicated in this area are Exchange Act Rule 15c3-1 related to net capital requirements, FINRA Rule 4160 on verification of assets and Exchange Act Rule 17a-13 related to quarterly security accounts.

Broker-Dealer Net Capital

Exchange Act Rule 15c3-1 requires a firm to maintain a minimum level of net capital at all times. The FINRA Rule 4100 series sets forth the rules and requirements for complying with net capital requirements including calculations and which assets are allowable or non-allowable within those calculations. Regulations need to address how cryptosecurities, digital currency, and tokens in general will be accounted for, for purposes of net capital calculations.

Books and Records Requirements

Exchange Act Rule 17a-3 and 17a-4 and FINRA Rule 4511 regulate book and record requirements for broker-dealers. DLT allows books and records to be maintained on the network itself, though consideration must be made as to how this will comply with regulations, and what changes need to be made with the regulations to update for the new technology.

Clearance and Settlement

It is my view that DLT could have the biggest impact on clearance and settlement from a pure industry disruption viewpoint. FINRA notes, “Depending on how trade execution and settlement is ultimately structured, broker-dealers and other market participants may wish to consider whether any of their activities in the DLT environment meet the definition of a clearing agency and whether corresponding clearing agency registration requirements under Section 17A of the Exchange Act would be applicable.”

In addition, as mentioned, DLT could eliminate the distinction between introducing and clearing brokers and the corresponding carrying agreement rules.

Anti-Money Laundering and Customer Identification Programs

DLT allows for global and anonymous participation, and accordingly practices and regulations will need to address anti-money laundering (AML) and customer identification obligations (CIP). The Bank Secrecy Act of 1970 requires controls and procedures to detect and prevent money laundering. FINRA Rule 3310 addresses AML obligations. For more on this topic, see HERE.

In addition, FINRA Rule 2090, the Know Your Customer (KYC) rule, requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” Technology is already being explored to centralize identity management functions such that once a customer identity is verified, the information can be shared with all network participants. Obviously this would greatly streamline processes for broker-dealers and customers alike.

It is likely that DLT technology will surpass regulatory changes in the AML/CIP/KYC sectors. The FINRA report notes that the current rules allow a firm to outsource functions to third parties, but not overall responsibility. Accordingly, a firm could utilize DLT technology for these functions now if they can fashion internal controls and procedures that comply with the ultimate rule responsibilities.

Customer Data Privacy

Broker-dealers have an obligation to protect personal customer information (Regulation S-P). The rules also require that a firm provide an annual notice to customers related to the protection, and sharing, of their personal information. DLT by nature will include customer information and transaction histories that will be available to network participants. Regulations, as well as internal controls and procedures, will need to adapt for DLT technology.

Trade and Order Reporting Requirements

FINRA regulates the trading and order reporting requirements for the over-the-counter (OTC Markets) and requires certain reports to a centralized Securities Information Processor for listed securities. DLT may be soon be used for the facilitation of OTC Markets equity transactions. This may involve tokenizing existing securities and trading on a different network. FINRA Rule 6100 Series (Quoting and Trading in NMS Stock), Rule 6400 Series (Quoting and Trading on OTC Equity Securities), Rule 4550 Series (Alternative Trading Systems) and Rule 5000 Series governing offering and trading standards and practices would all be implicated. I note that t0 Technologies has registered as an ATS.

Supervision and Surveillance

DLT networks will present new and unique challenges related to maintaining supervisory rules and procedures as well as surveillance systems themselves. This area includes the ability to review customer accounts and correct order errors. Like other areas of DLT technology, centralized systems available to all network participants are being developed that can perform some of these functions.

Fees and Commissions

Certain additional fees may be necessary for a DLT network, such as wallet management, key management and on-boarding, whereby other areas may reduce fees as centralization brings economies. In addition, consideration must be given to the payment of fees to third parties that are not registered broker-dealers but that provide DLT outsource functions.

Customer Confirmations and Account Statements

Exchange Act Rule 10b-10 requires firms to provide customers with certain records including trade confirmations and account statements. DLT technology will change the flow and availability of information.

Material Impact on Business Operations

NASD Rule 1017(a)(5) requires broker-dealers that undergo a material change in business operations to file a Continuing Membership Application (CMA) prior to implementing the material change. Many of the aspects of DLT technology may result in a material change and broker-dealers need to consider the need to file 1017 applications.

Business Continuity Plans

FINRA Rule 4370 requires broker-dealers to maintain business continuity plans. Firms must consider the impact of DLT technology on their plans and update accordingly.

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SEC Chair Jay Clayton Discusses Direction Of SEC

Posted by Securities Attorney Laura Anthony | August 1, 2017 Tags: Chair Jay Clayton, Finra, SEC, SEC Chair Jay Clayton, SEC Chair Jay Clayton Discusses Direction Of SEC

In a much talked about speech to the Economic Club of New York on July 12, 2017, SEC Chairman Jay Clayton set forth his thoughts on SEC policy, including a list of guiding principles for his tenure. Chair Clayton’s underlying theme is the furtherance of opportunities and protection of Main Street investors, a welcome viewpoint from the securities markets’ top regulator. This was Chair Clayton’s first public speech in his new role and follows Commissioner Michael Piwowar’s recent remarks to the SEC-NYU Dialogue on Securities Market Regulation largely related to the U.S. IPO market. For a summary of Commissioner Piwowar’s speech, read HERE.

Guiding Principles

Chair Clayton outlined a list of eight guiding principles for the SEC.

#1: The SEC’s Mission is its touchstone

As described by Chair Clayton, the SEC has a three part mission: (i) to protect investors; (ii) to maintain fair, orderly and efficient markets, and (iii) to facilitate capital formation. Chair Clayton stresses that it is important to give each part of the three-part mission equal priority. For more information on the role and purpose of the SEC, see HERE.

#2: SEC Analysis Starts and ends with the long-term interests of the Main Street investor

According to Clayton, an assessment of whether the SEC is being true to its three-part mission requires an analysis of the long-term interests of the Main Street investors, including individual retirement accounts. This involves reviewing actions in light of the impact on investment opportunities, benefits and disclosure information for “Mr. and Mrs. 401(k).”

#3: The SEC’s historic approach to regulation is sound

As I’ve written about many times, disclosure and materiality have been at the center of the SEC’s historic regulatory approach. Chair Clayton reiterates that point. The SEC does not conduct merit reviews of filings and registration statements but rather focuses on whether the disclosures provided by a company provide potential investors and the marketplace with the information necessary to make an informed investment decision. For more information on disclosure requirements and recent initiatives, see HERE and HERE.

In addition to disclosure rules, the SEC places heightened responsibility on the individuals and people that actively participate in the securities markets. The SEC has made it a priority to review and pursue enforcement actions, where appropriate, against securities exchanges, clearing agencies, broker-dealers and investment advisors. In that regard, the SEC has historically and will continue to enforce antifraud provisions. Clayton states that “wholesale changes to the Commissions’ fundamental regulatory approach would not make sense.”

#4: Regulatory actions drive change, and change can have lasting effects

Under the fourth principle, Clayton continues to speak of the benefits of the disclosure-based system for public company capital markets. However, he does note that over time, new disclosure rules have been added on to the old, based on determinations beyond materiality, and that the SEC now needs to conduct a cumulative and not just incremental view of the disclosure rules and regulations.

Clayton specifically points to the much talked about decline in the number of IPO’s over the last two decades. He also points out that the median word count for SEC filings has more than doubled in over the same period, and that reports lack readability. Clayton points out, and I agree, that fewer small and medium-sized public companies affects the liquidity and trading for all public companies in that size range. A reduction of U.S. listed public companies is a serious issue for the U.S. economy and an improvement in this regard is a clear priority to the SEC.

For more on the SEC’s ongoing Disclosure Effectiveness program, see the further reading section at the end of this blog.

#5: As markets evolve, so must the SEC

Technology and innovation are constantly disrupting the way in which markets work and investors transact. Chair Clayton is well aware that the SEC must keep up with these changes and “strive to ensure that our rules and operations reflect the realities of our capital markets.” Clayton sees this as an opportunity to make improvements and efficiencies.

The SEC itself has utilized technology to improve its own systems, including through the use of algorithms and analytics to detect companies and individuals engaged in suspicious behavior. The SEC is adapting machine learning and artificial intelligence to new functions, including analyzing regulatory filings. On the other side, the SEC has to be aware of the costs involved with implementing these changes, versus the benefits derived.

#6: Effective rulemaking does not end with rule adoption

The SEC has developed robust processes for obtaining public input (comments) and performing economic analysis related to its rulemaking. Clayton is committed to ensuring that the SEC perform rigorous economic analysis in both the proposed and adoption stages of new rules. Clayton is aware of the principle of unintended consequences in rulemaking and is committed to ensuring that rules be reviewed retrospectively as well. Clayton states, “[W]e should listen to investors and others about where rules are, or are not, functioning as intended.”

Although Clayton does not get into specifics, certainly changes are necessary in the disclosure requirements, fiduciary rule, Dodd-Frank rollbacks (see HERE on the Financial Choice Act 2.0); finders’ fees (see HERE for more), eligibility for Regulation A+ (see HERE for more), and small business-venture capital marketplace.

#7: The costs of a rule now often include the cost of demonstrating compliance

Clayton states, “[R]ules are meant to be followed, and the public depends on regulators to make sure that happens. It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.” Vaguely worded rules end up with subpar compliance and enforcement. Clayton refers to the officer and director certifications required by the Sarbanes-Oxley Act and the need to create a system of internal controls to support the ultimate words on the paper – which system can be hugely expensive.

I note that understanding rules and their application is one of the biggest hurdles in the small-cap industry, including where responsibility lies vis-à-vis different participants in the marketplace. For example, the responsibility of a company, transfer agent, introducing broker, and clearing broker in the chain of the issuance and ultimate trading of a security, continues to provide challenges for all participants. Often participants are left with an education and interpretation by enforcement process, rather than what would be a much more efficient system providing participants with the knowledge and tools to create compliance systems that prevent fraud and related issues and reduce the need for retrospective enforcement.

#8: Coordination is key

Clayton notes that “the SEC shares the financial services space with many other regulatory players charged with overseeing related or overlapping industries and market participants.” There are more than 15 U.S. federal regulatory bodies and over 50 state and territory regulators, plus the Department of Justice, state attorneys general, self-regulatory organizations (SRO – such as FINRA) and non-SRO standard-setting entities (for example, DTC) in the financial services sector. In addition, the SEC works with international regulators and markets cooperating with over 115 foreign jurisdictions.

Clayton specifically points to the regulations of over-the-counter derivatives – including security-based swaps for which the SEC shares regulatory functions with the CFTC (for more on this, see HERE). Clayton is committed to working with the CFTC to improve this particular area of financial regulation and reduce unnecessary complexity and costs.

In addition, cybersecurity is an important area requiring regulatory coordination. Information sharing is essential to address potential and respond to actual cyber threats.

Putting Principles into Practice

After laying out his eight principles for the SEC, Chair Clayton addressed some specific areas of SEC policy.

Enforcement and Examinations

Clayton is committed to deploying significant resources to enforcement against fraud and shady practices in areas where Main Street investors are most exposed, including affinity and micro-cap fraud. He indicates that the SEC is taking further steps to find and eliminate pump-and-dump scammers, those that victimize retirees, and cyber criminals. As a practitioner in the small- and micro-cap market space, I welcome and look forward to initiatives that work to reduce fraud, while still supporting the honest participants and the necessary small-business ecosystem.

Clayton also recognizes that the markets also have more sophisticated issues requiring enforcement attention related to market participants. The SEC is “committed to making our markets s fair, orderly, and efficient – and as liquid – as possible.” Although prior Commissioners and Chairs have made similar statements, the addition of “and as liquid” by this regime continues to illustrate a commitment to supporting business growth and not just enforcement.

Finally on this topic, Clayton stresses the importance of cybersecurity in today’s marketplace. Public companies have an obligation to disclose material information about cyber risks and cyber events (see HERE for more on this topic). However, cyber criminals, including entire nations, can have resources far beyond a single company, and companies should not be punished for being a victim where they are being responsible in face of cyber threats. To bring proportionality to the topic, Clayton points out that cyber threats go beyond capital markets but affect national security as well.

Capital Formation

Consistent with his pro-business attitude, Jay Clayton advocates enhancing the ability of “every American to participate in investment opportunities, including through public markets.” Of course, the flip side is the ability for businesses to raise money to grow and create jobs. Clayton is also consistent with the message that he and other Commissioners have been relaying that the U.S. public markets need to grow and become more attractive to businesses (without damaging the private marketplace).

As a first step, the SEC recently expanded the ability to file confidential registration statements for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting, to all companies. Previously only emerging growth companies (EGC’s) were allowed to file registration statements confidentially. For more on this, see my blog HERE. Clayton believes that allowing companies to submit sensitive information on a non-public basis for initial staff review, will make the going public process more attractive to earlier-stage entities.

As a last point on capital formation, Chair Clayton encourages companies to request waivers or modifications to the financial reporting requirements under Regulation S-X, where the particular disclosure or reporting is overly burdensome and not material to the total mix of information presented to investors.

Market Structure

Clayton suggests shifting the focus of the conversation on market structure to actions. He recommends proceeding with a pilot program to test how adjustments to the access fee cap under Rule 610 of the Securities Exchange Act of 1934 would affect equities trading. The pilot would provide the SEC with more data to assess the effects of access fees and rebates on market makers, pricing and liquidity. Clayton is open to that and further suggestions from the SEC’s Equity Market Structure Advisory Committee.

Clayton believes the SEC should broaden its review of market structure to also include the fixed-income markets, to provide stable investment options for retirees. In that regard the SEC is creating a Fixed Income Market Structure Advisory Committee.

Investment Advice and Disclosure to Investors

Chair Clayton addresses both the fiduciary rule and improving disclosures to investors. Related to the fiduciary rule, Clayton states that it is important for the SEC to bring clarity and consistency to the area. In that regard, in June the SEC issued a statement seeking public input and comment on standards of conduct for investment advisers and broker-dealers.

Related to disclosures, as with all other areas of disclosure, investment advisors must provide potential investors with easily accessible and meaningful information. Clayton refers to the SEC’s ongoing Disclosure Effectiveness initiative, the progress in which is summarized at the end of this blog.

Resources to Educate Investors

A priority for the SEC is to provide more information to investors through technology and other means.

Further Reading on Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC’s ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I note that we have not seen any regulatory changes since the election and new regime at the SEC, but certainly significant changes are expected in light of Chair Clayton’s, and the Commissioners’, publicly disclosed priorities.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

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