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May 16, 2019 |
Impact of CFTC’s Proposed Amendments to Swap Data Reporting Requirements on Reporting and Non-Reporting Counterparties

Click for PDF On May 13, 2019, the Commodity Futures Trading Commission (the “Commission” or the “CFTC”) published a notice of proposed rulemaking titled Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (the “Proposal”).[1]  The Proposal seeks to modify existing swap data reporting requirements in Part 23 of the Commission’s regulations for swap dealers (“SDs”) and major swap participants (“MSPs”), Parts 43 and 45 of the Commission’s regulations for “reporting parties” and “reporting counterparties” (as such terms are defined in the Commission’s regulations),[2] and Part 49 of the Commission’s regulations for swap data repositories (“SDRs”).  The Proposal is the first rulemaking adopted by the CFTC following its Division of Market Oversight’s (the “Division”) July 2017 comprehensive analysis of the CFTC’s swap data reporting regulations, which was titled the Roadmap to Achieve High Quality Swaps Data (the “Roadmap”).[3]  In the Roadmap, the Division solicited public feedback on potential improvements to the CFTC’s swap data reporting regime in a manner that would achieve the CFTC’s regulatory goals of swap data transparency under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[4] without imposing unnecessary burdens on market participants. Consistent with the Roadmap’s goals, the CFTC’s expressed objectives in adopting the Proposal are to “improve the accuracy of data reported to, and maintained by, SDRs,” “require reporting counterparties to verify the accuracy of swap data pursuant to […] SDR procedures,” and “provide enhanced and streamlined oversight over SDRs and data reporting generally.”[5]  The CFTC notes that the Proposal is the first of three planned rulemakings as described in the Roadmap.[6]  While most of the Proposal’s amendments are intended to modify Part 49 of the Commission’s regulations, which covers SDR registration requirements, SDR operational duties, and the CFTC’s oversight over SDRs generally, the Proposal also would make certain substantive amendments to the swap data reporting requirements for SDs and MSPs under Part 23 and reporting counterparties (and non-reporting counterparties) under Parts 43 and 45 (the “Counterparty Reporting Rules”).[7]  This Client Alert focuses on the Proposal’s modifications to the Counterparty Reporting Rules.  With respect to the Counterparty Reporting Rules, the Proposal notes that current swap data that is available to the CFTC lacks accuracy.  This view has been specifically echoed by CFTC Chairman J. Christopher Giancarlo and several other past and current CFTC Commissioners.[8] To address these concerns regarding accuracy and data quality, the Proposal includes specific amendments to the Counterparty Reporting Rules.  In particular, the Proposal, if adopted, would establish:  (1) new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty (i.e., different requirements for SDs/MSPs versus non-SDs/MSPs); (2) revisions to existing swap data error and omission rules for reporting counterparties; and (3) enhanced requirements for SDs and MSPs in terms of their written policies and procedures for swap data reporting under Parts 43 and 45 of the Commission’s regulations.  In the sections below, we have summarized each of these three proposed amendments to the Counterparty Reporting Rules and its impact on the reporting counterparties. The Proposal’s comment period deadline is July 29, 2019.  Since the Proposal and two anticipated proposed rulemakings that are expected to follow will address interconnected issues, the CFTC plans to re-open the comment period for the Proposal at the same time it issues each anticipated rulemaking so that commenters can provide comments on the three rulemakings altogether. Please contact a member of Gibson Dunn’s Derivatives Team if you have any questions regarding the Proposal. 1.    Swap Data Verification The Proposal, if adopted, would establish new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty.  The Proposal’s amendments relating to data verification fall under Part 45 of the Commission’s regulations, which generally focuses on the duties of reporting counterparties to report swap data to SDRs for regulatory purposes.  The current Counterparty Reporting Rules do not explicitly require reporting counterparties to verify the data reported with the relevant SDR.  However, the Proposal would create a mandate that all reporting counterparties must verify their swap data for accuracy and completeness with reports provided by the SDR.[9]  Effectively, the Proposal would require a reporting counterparty to reconcile their internal books and records for each open swap against any and all open swaps reflected in an open swap report received from an SDR.[10]  Further, reporting counterparties would be required to conform to any swap data verification policies and procedures enacted by an SDR.[11] The Proposal includes specific timing requirements for reporting counterparty data verification as well as the timing of the frequency of the open swaps reports to be distributed by the SDR.  The open swaps reports must be distributed by the SDR to SD, MSP and DCO reporting counterparties on a weekly basis and to non-SD and non-MSP reporting counterparties on a monthly basis.[12]  Upon receipt and review of the open swaps report, reporting counterparties must submit either a (i) verification of data accuracy[13] or (ii) notice of discrepancy in response to every open swaps report received from an SDR within the following timeframes:  (a) 48 hours of the SDR’s providing the open swaps report if the reporting counterparty is a SD or MSP; or (b) 96 hours of the SDR’s providing the open swaps report for non-SD/MSP reporting counterparties.[14]  In the event that the reporting counterparty finds no discrepancies between its books and records and the data in the SDR’s open swap report, the reporting counterparty must nonetheless submit a verification of data accuracy indicating that the swap data is complete and accurate to the SDR in accordance with the aforementioned timing requirements.[15]  If, however, the reporting counterparty finds a discrepancy in the swap data (i.e., over-reporting or under-reporting), the reporting counterparty must submit a notice of discrepancy to the SDR in accordance with the timing outlined above.[16] The Commission explains that the Proposal’s swap data verification rules aim to improve swap data quality by facilitating the swift resolution of any discrepancies between the swap data maintained by an SDR and the information on record with a reporting counterparty.  However, the data verification requirements of the Proposal would impose new and notable obligations on all reporting counterparties (including smaller, non-SD/non-MSP reporting counterparties) that are not in existence under today’s reporting rules.  In particular, the Proposal would require reporting counterparties to review the SDR’s policies and procedures around the verification process, to build comprehensive systems to verify the swap data reported to the SDR by comparing its internal records against open swaps reports received from the SDR, and to send verification or discrepancy notices to the SDR within relatively short timeframes.  As reporting counterparties already report information to SDRs under the Counterparty Reporting Rules, the Commission expressed its belief that SDRs and reporting counterparties would coordinate with one another to implement a system which is efficient and convenient for both parties, with particular attention to not be unnecessarily burdensome to non-SD/MSP and non-derivatives clearing organization reporting counterparties.[17]  Further, many reporting counterparties report swap data to more than one SDR and given that each SDR will have its own unique policies and procedures, the verification process will differ between SDRs. 2.    Changes to Errors and Omissions Reporting If adopted, the Proposal would also revise the swap data error and omission correction requirements for reporting counterparties.[18]  Currently, the error and omission correction requirements under Part 43 and those under Part 45 have substantive differences from one another.  For example, Part 43 requires a reporting counterparty that “becomes aware of an error or omission in the swap transaction and pricing data” to “promptly notify the other party of the error and/or correction” while Part 45 does not have a similar notification requirement for the reporting counterparty to provide such notice.[19]  The Proposal would seek to fix the gaps between the two rules and would require reporting counterparties to correct any errors and omissions to which they may be aware, including, but not limited to, errors or omissions present in the swap data in the open swaps reports provided as part of the verification process specific in the Proposal.  For example, Proposed regulations 43.3(e)(1) and 45.14(b)(1) provide that to the extent that a reporting counterparty becomes aware of any error or omission in swap data previously reported to an SDR, the reporting counterparty must submit corrected swap data to the SDR.[20]  The error and omissions correction requirements would apply regardless of the state of the swap.  In other words, it would include the correction of live swaps and swaps that are no longer active (i.e., which are commonly referred to as “dead trades”). In addition, the Proposal would establish specific error and correction procedures for reporting counterparties.  In particular, the Proposal would retain the current error and correction procedure in the Counterparty Reporting Rules that requires reporting counterparties to correct swap data “as soon as technologically practicable” following discovery of the errors or omissions.[21]  The Proposal would modify the “as soon as technologically practicable” timing requirement by creating a backstop of three business days after the discovery of the error or omission.[22]  In the event that the reporting counterparty is unable to correct errors or omissions within three business days of discovery, the Proposal would require the reporting counterparty to immediately inform the Director of DMO, or such other CFTC employees whom the Director of DMO may designate, in writing, of the errors or omissions and provide an initial assessment of the scope of the errors or omissions and an initial remediation plan for correcting the errors or omissions.[23]  Proposed regulations 43.3(e)(1)(iii) and 45.14(b)(1)(iii) would require that a reporting counterparty conform to the SDR’s policies and procedures for correction of errors and omissions that the SDRs would be required to create under the Proposal.[24] The Proposal would also establish new requirements for non-reporting counterparties.  Proposed regulations 43.3(e)(2) and 45.14(b)(2) would require a non-reporting counterparty that “by any means becomes aware” of an error or omission in swap data previously reported to an SDR, or the omission of swap data for a swap that was not previously reported to an SDR as required, to notify its counterparty to the swap (i.e., the reporting counterparty) as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days following the discovery of the errors or omissions.[25]  This section of the Proposal also specifies that a non-reporting counterparty that does not know the identity of the reporting counterparty for a swap must notify the SEF or DCM where the swap was executed of the errors or omissions as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days after the discovery.[26]  In the Proposal, the Commission expressed its hope that the requirement to correct all swap data, regardless of status, would ensure that reporting counterparties establish and maintain properly functioning reporting systems to prevent the reporting of errors or omissions. The Proposal’s modifications to the errors and omissions correction requirements would notably make Parts 43 and 45 of the Commission’s regulations consistent in this regard.  In particular, the Proposal would remove the counterparty notification requirement set forth in current CFTC regulation 43.3(e)(1)(i).  However, the Proposal would create a more definitive timeframes in which reporting counterparties are required to correct errors and omissions and in which non-reporting counterparties are required to notify their counterparties of any such errors or omissions.  With respect to non-reporting counterparties, the current rules require that when a non-reporting counterparty “discovers” an error or omission it must “promptly notify” the reporting counterparty of such error or omission.  The Proposal would create more stringent requirements in this regard such that non-reporting counterparties that merely become “aware” of an error or omission by “any means” must notify the reporting counterparty “as soon as technologically practicable” but no later than three business days.  Further the Proposal clarifies that the non-reporting counterparty’s notification obligation with respect to omissions extends to data that was not reported to an SDR (but that presumably should have been reported). 3.    SD and MSP Requirements The Proposal would also establish enhanced requirements for SDs and MSPs with respect their written policies and procedures for swap data reporting under parts 23, 43, and 45 of the Commission’s regulations.  Under the current regime, SDs and MSPs are required to report all information and swap data required for swap transactions when they are reporting counterparties for purposes of regulatory and real-time public reporting.[27]  SDs and MSPs are also required to implement electronic systems and procedures necessary to transmit electronically all information and swap data required to be reported in accordance with Part 43 and Part 45.[28]  The Proposal would require each SD and MSP to establish, maintain and enforce written policies and procedures that are reasonably designed to ensure that the SD and MSP comply with all obligations to report swap data to an SDR, which would include any requirements under Part 43 and Part 45, as well as any rules established by the SDR.[29]  The preamble to the Proposal sets forth specific content that would be expected to be included in the SD or MSP’s policies and procedures.[30] The Proposal also would require SDs and MSPs to review their policies and procedures on an annual basis and to update them as needed to reflect the requirements in Part 43 and Part 45.[31]  The Commission believes that the annual review requirement in the Proposal would ensure that SDs’ and MSPs’ policies and procedures remain current and effective over time.  SDs and MSPs are currently expected to establish policies and procedures related to all of their swap market activities, including their swap data reporting obligations.[32]  The Proposal’s amendments to Part 23 would make the expectations around these policies and procedures explicit by creating new obligations and setting forth guidance around content regarding reporting policies and procedures, rather than merely cross-referencing Parts 43 and 45 as we see under the current regulations. [1]      Certain Swap Data Repository and Data Reporting Requirements, 84 Fed. Reg. 21044 (May 13, 2019). [2]      See 17 C.F.R. § 43.3(a)(3) (sets forth the determination of which counterparty to a swap transaction is the “reporting party” and has the obligation to report swap data to an SDR for purposes of real-time public reporting); 17 C.F.R. § 45.8 (sets forth the determination of which counterparty to a swap transaction is the “reporting counterparty” and has the obligation to report swap data to an SDR for purposes of regulatory reporting).  For purposes of this Client Alert, the term “reporting counterparty” will refer to both a “reporting party” under Part 43 and a “reporting counterparty” under Part 45. [3]      Division of Market Oversight, Roadmap to Achieve High Quality Swaps Data, U.S. Commodity Futures Trading Commission, July 10, 2017, available at http://www.cftc.gov/idc/groups/public /@newsroom/documents/file/dmo_swapdataplan071017.pdf. [4]      Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 Stat. 1376, Pub. Law 111-203 (July 21, 2010), as amended. [5]      Proposal at 21044. [6]      Proposal at 21045. [7]      The Proposal also includes proposed amendments to the reporting requirements for derivatives clearing organizations (“DCOs”), swap execution facilities (“SEFs”), and designated contract markets (“DCMs”) to the extent that these entities are also reporting counterparties.  This Client Alert is focused on the Proposal’s specific impact on the Counterparties and, for that reason, does not discuss the proposed amendments impacting DCOs, SEFs, and DCMs. [8]      Speech by Commissioner J. Christopher Giancarlo, Making Market Reform Work for America (Jan. 18, 2017), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-19 (“The CFTC has faced many challenges in optimizing swap data ranging from data field standardization and data validation to analysis automation and cross-border data aggregation and sharing.  Market participants vary significantly in how they report the same data field to SDRs.  Those same SDRs vary in how they report the data to the CFTC”). Statement by Commissioner Scott D. O’Malia, SIFMA Compliance and Legal Society Annual Seminar (Mar. 19, 2013), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-22 (“In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs.  In other words, the Commission told the industry what information to report, but didn’t specify which language to use.  This has become a serious problem. . . .  The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different.  In addition, data is being recorded inconsistently from one dealer to another.”). Speech by Commissioner Dan M. Berkovitz, Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (Apr. 25, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement042519 (“Accurate, complete, and timely information is therefore vital to any successful swap data reporting regime.  These objectives were central to post-crisis reform efforts, and they must remain the primary considerations as the Commission moves to enhance its reporting rules”). [9]    Proposal at 21098.  Proposed § 45.14(a) addresses the verification of swap data accuracy against the SDR’s open swaps report. [10]   Proposal at 21098.  Proposed § 45.14(a)(1) addresses a reporting counterparty’s requirement to verify the accuracy and completeness against the open swap reports from the SDR. [11]   Proposal at 21103.  Proposed § 49.11 would set forth rules around such SDR policies and procedures relating to verification of swap data accuracy and would require the SDR to verify the accuracy of the data with reporting counterparties. [12]   Proposal at 21103.  Proposed §§ 49.11(b)(2) and (3) address the timing obligations for SDRs to distribute open swaps reports to reporting counterparties. [13]   For purposes of clarification, examples of unsatisfactory verification may include:  (i) failure to perform the verification in a timely manner and (ii) providing a verification of data accuracy indicating that the swap data was complete and accurate for swap that was not correct when verified. [14]   Proposal at 21098.  Proposed § 45.14(a)(2) addresses the timing in which such verification against the open swap reports from the SDR must occur.  This proposed requirement would also treat DCO reporting counterparties in the same way it does SD and MSP reporting counterparties. [15]   Proposal at 21098.  Proposed § 45.14(a)(3) addresses the requirement to submit a verification of data accuracy regardless of whether there are discrepancies identified.  Such verification would be required to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [16]   Proposal at 21098.  Proposed § 45.14(a)(4) addresses the requirement to submit a notice of discrepancy in the event of any inconsistencies.  Such notice of discrepancy would need to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [17]   Proposal at 21068. [18]   Proposal at 21097-21099.  Proposed §§ 43.3(e) and 45.14(b) address the error and omission correction requirements for Parts 43 and 45 of the CFTC’s regulations. [19]   17 C.F.R. § 43.3(e)(1)(i). [20]   Proposal at 21098-21099. [21]   17 C.F.R. §§ 43.3(e)(3), 43.3(e)(4), 45.14(a). [22]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(i) and 45.14(b)(1)(i) address the timing for errors and corrections. [23]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(ii) and 45.14(b)(1)(ii) address the requirement to notify the Director of the Division of Market Oversight if the error correction timing cannot be met. [24]   Proposal at 21098-21099. [25]   Proposal at 21098-21099.  The Proposal makes clear that the non-reporting counterparty is not only responsible for notifying the reporting counterparty of errors or omissions in the data that is reported, but also to notify the reporting counterparty of data that was not reported to an SDR. [26]   Proposal at 21099-21099.  Proposed §§ 43.3(e)(2) and 45.14(b)(2) would also require that if the reporting counterparty, SEF or DCM, as applicable, and the non-reporting counterparty agree that the swap data for a swap is incorrect or incomplete, the reporting counterparty, SEF or DCM, as applicable, must correct the swap data in accordance with proposed § 43.3(e)(1) or § 45.14(b)(1), as applicable. [27]   See 17 C.F.R. §§ 23.204(a), 23.205(a). [28]   See 17 C.F.R. §§ 23.204(b), 23.205(b). [29]   Proposal at 21097. [30]   With respect to Part 45, the Proposal explains that such policies and procedures would include, but not be limited to: (i) the reporting process and designation of responsibility for reporting swap data, (ii) reporting system outages or malfunctions (including the use of back-up systems), (iii) verification of all swap data reported to an SDR, (iv) training programs for employees responsible for reporting under Part 45, (v) control procedures relating to reporting under Part 45 and designation of personnel responsible for testing and verifying such policies and procedures; and (vi) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 45 on behalf of the SD or MSP as well as any rules established by the SDR.  With respect to Part 43, the Proposal explains that such policies and procedures would include, but not be limited to:  (i) the reporting process and designation of responsibility for reporting swap transaction and pricing data, (ii) reporting system outages or malfunctions (including use of back-up systems), (iii) training programs for employees responsible for reporting under Part 43, (iv) control procedures relating to reporting under Part 43 and designation of personnel responsible for testing and verifying such policies and procedures, (v) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 43 on behalf of the SD or MSP; and (vi) the determination of whether a new swap transaction or amendment, cancelation, novation, termination, or other lifecycle event of an existing swap, is subject to the real-time reporting requirements under Part 43.  Proposal at 21073. [31]   Proposal at 21097. [32]   See, e.g., 17 C.F.R. § 3.3(d)(1) (requiring a chief compliance officer to administer each of the registrant’s policies and procedures relating to its business as an SD/MSP that are required to be establish pursuant to the Act and the Commission’s regulations); 17 CFR § 3.2(c)(3)(ii) (requiring the National Futures Association to assess whether an entity’s SD/MSP documentation demonstrates compliance with the Section 4s Implementing Regulation to which it pertains which includes § 23.204 and § 23.205). The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner, Carl Kennedy and Erica Cushing. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions and Derivatives practice groups, or any of the following: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) Erica N. Cushing – Denver (+1 303-298-5711, ecushing@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

March 22, 2019 |
LSTA, LMA and APLMA Publish Sustainability Linked Loan Principles

Click for PDF Sustainability linked loans, a fast-growing loan product introduced in the United States last year, got a significant boost this week with the promulgation of the Sustainability Linked Loan Principles by the leading syndicated lending industry associations.  The SLLPs establish a voluntary framework for designing and negotiating sustainability linked loans, in order to assure the integrity of the asset class and promote its development. Sustainability Linked Loans – an Offshoot of Green Finance This week, the sustainable lending asset class took another step forward with the publication of the Sustainability Linked Loan Principles (the “SLLPs”) by the top three global syndicated lending industry associations.  The Loan Syndications and Trading Association (LSTA), the Loan Market Association (LMA), and the Asia Pacific Loan Market Association (APLMA) promulgated the SLLPs as a voluntary framework representing “the next step in collaboratively developing global standards for sustainable lending” (see LSTA’s Week in Review, March 22, 2019). A type of loan product that has taken root in Europe over the past few years, and arrived in 2018 in the United States, “sustainability linked loans” are loans that have certain of their terms, most typically the pricing, tied to sustainability performance targets – such as the borrower’s use of renewable energy, or its ESG (Environmental, Social and Governance) score as evaluated by a third party rating agency.  This is distinct from traditional “green finance”, in which the proceeds of the financing are earmarked for specific green projects; in most instances, sustainability linked loans are used for general corporate purposes. In order to meet their objective of facilitating and supporting environmentally and socially sustainable economic activity and growth – and to provide appropriate assurances to investors, regulators and other stakeholders – sustainability linked loans must tie their incentives (such as reduced pricing) to sustainability performance targets (1) that are “ambitious and meaningful to the borrower’s business”, and (2) that represent some improvement relative to the performance baseline.  The SLLPs’ goal is “to promote the development and preserve the integrity of the sustainability linked loan product” by setting out a framework of voluntary recommended guidelines, to be applied on a case-by-case basis by market participants, in order to secure these sustainability benefits. Core Components for Sustainability Linked Loans The SLLPs outline four core components for sustainability linked loans: 1. Relationship to Borrower’s Overall Corporate Social Responsibility (CSR) Strategy The borrower should align the loan’s sustainability performance targets with its overall sustainability objectives, as set forth in its CSR strategy, and communicate clearly to the lenders how the performance targets incentivized by the loan fit within those overall objectives. 2. Target Setting – Measuring the Sustainability of the Borrower Appropriate – and appropriately ambitious – performance targets need to be negotiated between the borrower and the lender group for each transaction.  The performance targets can be internal (tracking metrics such as energy efficiency, water consumption, sustainable sourcing and recycling, among others), or external – assessed by independent service providers against external rating criteria.  Appendix 1 of the SLLPs provides an indicative list of common categories of sustainability performance targets, but different, customized performance targets may be appropriate for specific transactions. In some cases, it may be helpful to seek an expert third party’s opinion in developing suitable metrics and performance targets.  It is important that the targets be meaningful and apply over the life of the loan, to incentivize ongoing positive change. 3. Reporting Borrowers should maintain up to date information relating to their performance targets, whether those targets are internally or externally scored.  The SLLPs recommend that such information be provided to the lender group at least once a year, and preferably also made publicly available. 4. Review Validation of the borrower’s performance is imperative.  However, the need for external review is to be negotiated on a case-by-case basis.  Where the information relating to the performance target is not made publicly available or otherwise accompanied by an audit statement, external review of the borrower’s performance is strongly recommended, and the SLLPs recommend that such review be performed on an annual basis at least.  By contrast, where the borrower is a public company that includes information on its sustainability performance metrics in its public disclosures, the need for additional third party validation is less pressing, though such validation may still be desirable. Conclusion Green finance, and sustainability linked loans, are on an upward trajectory.  LPC saw almost $60B globally in green and sustainability linked loans in 2018, quadrupling the volume recorded in 2017 (see LSTA’s Week in Review, February 1, 2019).  2018 was also the year that sustainability linked loans were first seen in the United States, with two loans that adopted internal sustainability performance metrics.  Earlier this month, Xylem Inc. became the first U.S. company to issue a sustainability linked loan with an external performance target – a comprehensive ESG score assessed by Sustainalytics, an expert third party provider of ESG ratings.  (Gibson Dunn represented Xylem in the transaction.) The publication of the SLLPs represents another milestone in the development of this loan product, providing market participants with an important framework to guide expectations, inform market practice, and enhance the integrity of the asset class. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. For further information, please contact the Gibson Dunn lawyer with whom you work or the following authors in New York: Aaron F. Adams (+1 212.351.2494, afadams@gibsondunn.com) Yair Y. Galil (+1 212.351.2313, ygalil@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 18, 2019 |
Developments in the Defense of Financial Institutions – Calculating the Financial Exposure

Click for PDF Our financial institution clients frequently inquire about how best to address their regulatory and financial exposure in inquiries by the U.S. Department of Justice (“DOJ”) and regulators in the United States.[1]  With corporate entities[2] being held criminally liable under the U.S. legal doctrine of respondeat superior for the actions of even non-executive relationship managers and other employees, it is essential for boards of directors and senior management to have a clear understanding of the ways in which U.S. enforcers determine penalties for organizations, particularly regulated financial institutions. This alert is part of a series of regular analyses of the unique impact of white collar issues on financial institutions.  In this edition, we examine the frameworks that DOJ and other U.S. enforcers have used in their corporate penalty calculations involving financial institutions.[3]  We begin in Section 1 by providing a general overview of the potential components of financial penalties imposed by DOJ and other U.S. enforcers.  Section 2 includes an analysis of DOJ resolutions involving financial institutions over a 10-year period and outliers within that same 10-year period.  Section 3 reviews the enforcement resolutions of certain other U.S. enforcers in order to highlight differences in the imposition of financial penalties (as discussed below) between those enforcers and DOJ.  Section 4 analyzes recent guidance and public statements for a preview of how corporate penalties may be calculated in the near future.  The alert concludes by presenting a series of key observations, which a financial institution should bear in mind if it finds itself forced to negotiate with DOJ or other U.S. enforcers in connection with a criminal or civil enforcement action. 1.      Potential Components of Financial Penalties Financial penalties generally consist of some combination of the following three potential components:  monetary fines; restitution; and disgorgement.[4]  In calculating financial exposure, it is useful to understand the policy objectives and legal underpinnings of each component.  This section discusses those objectives and legal underpinnings, and details how DOJ calculates the first component (i.e., monetary fines) as part of a criminal resolution. a.       Fines Many federal statutes contain their own fine provisions, including a maximum fine amount.  For example, the Bank Fraud statute provides for fines of up to $1 million per violation.[5]  Similarly, the mail and wire fraud statutes provide for a $1 million fine per occurrence.[6] It would be a mistake, however, to focus solely on the upper bounds contained in a specific federal statute in determining potential financial exposure, as those ranges often bear little resemblance to the penalty amount being sought in an enforcement action.  That is because federal law allows DOJ to calculate maximum fines as a multiple of the total amount of gross gain or loss attributable to an offense.[7]  Even relying on the statutory penalties, an aggressive U.S. enforcer may be able to augment a specific statutory range or cap by asserting that there are multiple discrete violations and aggregating those individual instances together to increase the potential penalty. The practical reality is that U.S. enforcers have broad discretion in assessing the ultimate fine amount.  That discretion is generally guided by a set of factors these enforcers consider when settling on a monetary penalty.  Each U.S. enforcer has its own set of factors, the application of which is sometimes difficult to discern in individual enforcement actions. DOJ’s determination of an appropriate fine or monetary penalty in a federal criminal investigation is driven by the concepts and principles codified in the U.S. Sentencing Guidelines (“Guidelines”), the most recent edition of which took effect on November 1, 2018.[8]  Chapter 8 of the Guidelines describes the principles used in calculating appropriate criminal fines for organizational or corporate defendants, which may be imposed instead of, or in addition to, restitution and/or disgorgement.  As described in further detail below, Chapter 8 of the Guidelines includes a number of aggravating or mitigating factors that can have a significant impact on the final fine amount. A number of U.S. enforcers also publish policies applicable to violations of particular statutory provisions.  These policies often offer reductions in the amount of a penalty if and when a corporate entity fulfills certain specific criteria. One recently promulgated policy is DOJ’s FCPA Corporate Enforcement Policy (the “FCPA Policy”), which was established as a pilot program in 2016 and formalized in DOJ’s Justice Manual in November 2017.[9]  The FCPA Policy incentivizes organizations to voluntarily self-disclose FCPA violations to DOJ.[10]  Under the FCPA Policy’s terms, a company’s voluntary self-disclosure, full cooperation, and timely efforts to remediate alleged misconduct are factors considered when determining whether the company qualifies for a mitigated penalty, which can range from a declination (i.e., a decision not to impose a fine at all), to a flat 50-percent reduction off the low end of the potential fines imposed where “aggravating factors” are present (e.g., the involvement of executive management).[11]  Not all factors need be present for a company to qualify for mitigation of the ultimate penalty.  For example, a company that fails to self-disclose, but which otherwise cooperates fully and makes remediation efforts, may still qualify to receive a fine reduction of up to 25 percent.  The FCPA Policy includes a set of detailed standards that specifically set forth what constitutes voluntary self-disclosure and full cooperation, and describe the basic requirements for a company to receive full credit for timely and appropriate remediation.  We discussed voluntary self-disclosure by financial institutions in greater detail in our July 2018 Defense of Financial Institutions Client Alert. b.      Restitution Restitution is an equitable remedy in criminal actions brought by U.S. enforcers.  Restitution is intended to compensate alleged victims based on the amount of their loss.[12]  In civil and administrative actions, restitution is available when a defendant is alleged to have violated a statute that provides for equitable remedies.  In these types of actions, a court looks to the statutory system under which a remedy is sought and determines its authority to order equitable relief.  Many state and federal statutes—such as the 1933 Securities Act and the 1934 Exchange Act—expressly confer equity jurisdiction on the courts.  Even when a statute is unclear regarding the scope of the grant of authority to issue equitable relief, courts have taken an expansive view of their implied powers to provide equitable relief.[13] As discussed in greater detail below, in the criminal context, DOJ will use the Guidelines to calculate restitution amounts.  The Guidelines mandate restitution for all federal offenses, except under certain circumstances. c.       Disgorgement Disgorgement is also an equitable remedy, but, unlike restitution, disgorgement focuses on the defendant (not the alleged victim) in an enforcement action.[14]  Specifically, disgorgement is intended to deprive the defendant of its profits or other gain associated with the alleged conduct that is the subject of the enforcement action. As with restitution, in the criminal context, the Guidelines expressly address disgorgement as a component of the sentencing process.[15]  Generally, however, restitution takes precedence over disgorgement, such that disgorgement may appropriately be viewed as a supplemental penalty imposed if and when a defendant retains any gains after restitution has been imposed.[16] Although disgorgement has traditionally been secondary to restitution in criminal proceedings, DOJ recently has sought disgorgement through its FCPA Policy as a primary remedy in FCPA enforcement actions.  In particular, DOJ has taken this novel approach by issuing resolutions involving declinations with disgorgement.[17] DOJ appears poised to extend this new approach in seeking declination-with-disgorgement resolutions beyond the FCPA context, potentially increasing the number of DOJ resolutions seeking disgorgement as the sole remedy.  In September 2018, DOJ reached a declination-with-disgorgement resolution with Barclays Bank PLC after an investigation involving fraud and market manipulation allegations.  In publicly discussing this resolution, the Principal Deputy Assistant Attorney General of the DOJ’s Criminal Division and the then Chief of DOJ’s Securities and Financial Fraud Unit stated that DOJ would consider declination-with-disgorgement resolutions in cases involving federal laws other than the FCPA, including the False Claims Act, the Dodd-Frank Act, and the Sarbanes-Oxley Act.[18] d.      Calculating the Fine under the Guidelines The Guidelines contain aggravating and mitigating factors that are used to determine a fine range.  These factors present opportunities for principled advocacy to explain why a particular enhancement is not warranted or, conversely, why a mitigating factor should be applied that would decrease the fine. In advocating for how specific factors contribute to a given fine calculation, financial institutions can rely on a number of sources, including: the text of the Guidelines themselves and the interpretive guidance contained in their application notes; case law, which is fairly limited given how infrequently organizations choose to litigate criminal cases; and the precedent established by prior criminal resolutions. Of these, prior resolutions can be very significant.  For that reason, financial institutions should seek to demonstrate that the application of relevant factors within the Guidelines is consistent with how similarly-situated organizations have been treated by DOJ.  Alternatively, financial institutions should seek to demonstrate that the result sought by the U.S. enforcer is inconsistent with prior cases, particularly when negotiating with government attorneys responsible for a wider range of enforcement matters, such as with one of the U.S. Attorney’s Offices most active in the corporate enforcement arena. We begin with an overview of the framework for calculating organizational fines under Chapter 8 of the Guidelines and then include a more detailed analysis of three of the most commonly used variables—prior history, the role of management, and placement within the resulting Guidelines range—that feed into the final fine calculation.  The overview and detailed analysis of each variable concludes with a discussion of potential advocacy points that financial institutions can utilize in negotiating DOJ resolutions.  i.      Overview of Criminal Fine Calculations under Chapter 8 of the Guidelines The determination of an appropriate criminal fine begins with the calculation of the base fine.  The base fine represents the greatest of: the amount correlating to the offense level calculated under the relevant section the Guidelines;[19] the pecuniary gain to the organization; or the pecuniary loss caused by the organization, to the extent it was caused intentionally, knowingly, or recklessly.[20] Section 8C2.4(d) contains a fine table with base fines ranging from $8,500 to $150,000,000 depending on the offense level calculated under the Chapter 2 of the Guidelines.  However, the pecuniary gain or loss involved in the alleged misconduct at hand often will exceed that number and will therefore serve as the base fine. To determine the applicable fine range, the base fine will be multiplied by a figure determined based on the “culpability score.”  The culpability score begins at a base level of five,[21] and can be increased or decreased based on certain “aggravating” or “mitigating” factors.[22]  The resulting culpability score determines the multiplier applicable to the base fine in order to determine the fine range, which can vary from as low as a multiplier of 0.05 for a culpability score of zero or below, to as high as a multiplier of 4.0 for a culpability score of 10 or above.[23] As the broad range of available multipliers suggests, even a modest change in culpability score can drastically affect the resulting penalty amount.  For example, in a matter with a $100 million base fine, a single point culpability score increase from five to six raises the top-end fine by $40 million, from $200 million to $240 million.  This fine amount is independent of the restitution, disgorgement, and any other financial components of the contemplated resolution.  Given the significant effect of the culpability score on the resulting penalty, financial institutions should arm themselves with principled arguments to explain why a particular culpability score factor should (or should not) be applied. There are three aspects of the fine calculation that often are relevant to financial institutions:  the organization’s prior history of allegedly similar misconduct; the extent to which a sentence can be enhanced or reduced based on the role of management; and the placement of the fine amount within the applicable fine range.     ii.      Prior History Enhancement Chapter 8 of the Guidelines provides a two-point enhancement in culpability score if “the organization (or a separately managed line of business) committed any part of the instant offense less than 5 years after (A) a criminal adjudication based on similar misconduct; or (B) civil or administrative adjudication(s) based on two or more separate instances of similar misconduct.”[24]  An organization can be subject to a one-point enhancement if either of these conditions occurred within the last 10 years prior to the alleged misconduct.[25] As financial institutions—particularly large, diversified organizations with several different business lines—may be subject to a wide range of regulatory or enforcement actions, it is important to understand the nuances of this enhancement to make arguments against its imposition.  The most salient aspects of this enhancement and the advocacy points most relevant for each are as follows: Policy Justification:  The organizational Guidelines do not specify the rationale for the prior history enhancement, but the guidance underlying analogous sections of the individual Guidelines roots this enhancement in the principles that recidivists are more culpable than first offenders and that stronger enforcement for repeat offenses acts as a general deterrent.[26]  Based on this yardstick, financial institutions can argue that recidivism concerns are misplaced if the government is relying on prior regulatory actions or findings—those regulatory actions serve different purposes than enforcement actions and should not properly be considered prior criminal history. “Adjudication:”  The Guidelines do not define what types of regulatory actions qualify as a prior “civil or administrative adjudication.”[27]  Other sources suggest the most salient characteristic of an adjudication is its adversarial nature.[28]  Based on this principle, financial institutions can potentially argue that administrative consent decrees (in which a party negotiates with the enforcer on how it will address a prior compliance deficiency or potential violation) and regulatory audits (which by their nature identify areas of improvement) should not serve as the basis of a sentencing enhancement, particularly where the organization has complied with the terms of the consent order or remediated the issues identified in the audit.  The specific and nuanced wording of individual consent decrees and audits can often aid with advancing this argument. Timing of Prior History:  Given the lengthy time span and multi-agency aspect of many enforcement inquiries involving financial institutions, any regulatory action involving similar misconduct must be issued prior to the instant alleged misconduct to justify the imposition of this enhancement.[29]  As such, the conduct underlying a prior regulatory adjudication should not both be part of the alleged misconduct forming the basis for the resolution and the basis for a prior history enhancement. Similar Misconduct:  For the prior history enhancement to be applied, the prior criminal, civil, and/or administrative adjudication(s) must be based on “similar misconduct” to the alleged misconduct in the instant case.[30]  The Guidelines define “similar misconduct” broadly to mean “prior conduct that is similar in nature to the conduct underlying the instant offense,” giving the example of Medicare fraud and another type of fraud,[31] and case law supports this broad interpretation.[32]  Nonetheless, organizations should be prepared to substantively distinguish the alleged misconduct from the conduct forming the basis of the alleged “prior adjudication(s).” “Separately Managed Lines of Business:”  The prior history enhancement applies if “an organization (or separately managed line of business)” was subject to a prior adjudication based on similar misconduct.[33]  The Guidelines indicate that a “separately managed line of business” may include a corporate subsidiary or division,[34] and that in determining the prior history of a separately managed line of business, the enforcer should only consider the history of that separately managed line of business.[35]  Thus, financial institutions could seek to demonstrate that a prior action involved a different subsidiary or unit than the component(s) involved in the current matter. In addition to the specific terms of this provision of the Guidelines, organizations may advocate against the application of the prior history enhancement based on its infrequent historical application in prior corporate criminal resolutions.  According to aggregate annual statistics published by the U.S. Sentencing Commission, the prior history enhancement has been applied in a mere 1.39 percent (12 of 865) cases involving detailed organizational sentencing calculations between 2006 and 2017.[36]  To go beyond data available at sentencing, we have reviewed 119 major corporate resolutions (including guilty pleas, deferred prosecution agreements (“DPAs”), and non-prosecution agreements (“NPAs”)) since the beginning of 2008,[37] and have identified only four resolutions in which a one- or two-point enhancement for prior history was applied.[38]  The circumstances of these resolutions suggest that DOJ will generally apply this enhancement only for cases involving clear instances of recidivism in breach of a prior resolution arising from the same type of misconduct. iii.      Sentencing Enhancements or Reductions Based on Management’s Role In recent years, U.S. enforcers have emphasized the importance of “corporate culture,” particularly as it relates to the “tone at the top” set by an organization’s senior management.  In the compliance context, the theory is that if an organization’s top management demonstrates a firm commitment to ensuring that the company complies with its legal and regulatory obligations—which must go beyond simply establishing written policies and procedures on paper—this emphasis will filter down to rank-and-file employees, ensuring a higher level of overall compliance.  Conversely, DOJ takes the view that if management fails to adequately invest in compliance and emphasizes profitability above all else, line employees throughout the organization will see compliance as an obstacle rather than as a point of emphasis. The alleged role of management is one of the largest drivers of an organization’s culpability score.  Organizations may be subject to a culpability score enhancement of up to five points if either “(i) high-level personnel of the organization [or unit] participated in, condoned, or was willfully ignorant of the offense; or (ii) tolerance of the offense by substantial authority personnel was pervasive throughout the organization [or organizational unit].”[39]  According to the Guidelines, the magnitude of the enhancement is based on the total headcount of the culpable organization (or unit) because the larger the organization, the more significant the consequences of management’s complicity or willful ignorance of misconduct, and the more substantial the risk that misconduct in one area will spread to the rest of the organization.[40]  Based on the significant impact that the role of management can play in the calculation of a monetary fine, financial institutions should consider the following advocacy points. Determining the Relevant Organization or Unit:  The biggest driver of the culpability score enhancement for management involvement is the size of the organization or unit implicated in the alleged misconduct.  Therefore, financial institutions should seek to precisely define what unit(s) or division(s) were implicated in the conduct at issue and which were not, and consequently should argue for an enhancement based on that more limited scope (if it is appropriate to impose one at all).  Recent corporate criminal resolutions involving only specific units or subsidiaries of large, multinational companies suggest that DOJ is receptive to these arguments and will resolve a matter with only the culpable unit(s) if doing so is warranted by the facts.[41] “Willful Ignorance:”  This enhancement may be applied if a high-level manager “participated in, condoned, or was willfully ignorant of the offense.”[42]  The Guidelines definition indicates that an individual is willfully ignorant if “the individual did not investigate the possible occurrence of unlawful conduct despite knowledge of circumstances that would lead a reasonable person to investigate whether unlawful conduct had occurred.”[43]  This fairly flexible definition—suggesting that mere failure to investigate the reasonable possibility of unlawful conduct will suffice—is in tension with recent Supreme Court precedent defining willful ignorance as characterized by employees’ efforts to “deliberately shield[] themselves from clear evidence of critical facts that are strongly suggested by the circumstances.”[44]  Given the non-mandatory nature of the Guidelines following the Supreme Court’s decision in United States v. Booker,[45] organizations should advocate that the Supreme Court’s more exacting standard be applied. Definition of an “Effective Compliance and Ethics Program:”  The Guidelines call for a three-point reduction in an organization’s culpability score if the organization had an “effective compliance and ethics program” in place at the time the offense occurred.[46]  This is a credit that is generally unavailable to organizations subject to the enhancement for management involvement.[47]  The Guidelines define this program by reference to seven “minimal” features needed to show that the organization “exercise[s] due diligence to prevent and detect criminal conduct” and “promote[s] an organizational culture that encourages ethical conduct and a commitment to compliance with the law.”[48]  The Guidelines further indicate that an ethics and compliance program must be “generally effective” at detecting and preventing criminal conduct, based on applicable industry and regulatory standards, the size and sophistication of the organization, and the organization’s history of prior misconduct.[49] Precedential Application of the Compliance and Ethics Program Reduction:  A review of all corporate sentencings between 2006 and 2017 indicates that a mere 5 of 860 (0.58 percent) of corporate defendants received this three-point credit.[50]  Given the emphasis over the last twenty years on corporate compliance, the paucity of companies qualifying for an effective compliance program is discouraging.  The infrequency with which organizations receive this credit at sentencing should not, however, prevent financial institutions from advocating for this credit in a pre-charge resolution, particularly since arguments about the state of a company’s compliance controls are relevant to placement in the fine range and may have implications for other civil or administrative proceedings.    iv.      Placement of the Penalty Within the Fine Range Even after DOJ calculates and establishes the key inputs of a financial penalty under the Guidelines (i.e., the base fine and culpability score), DOJ retains a potentially significant degree of discretion in situating a penalty within the resulting fine range. The Guidelines identify 11 factors that DOJ should consider in determining the appropriate placement of a penalty in the fine range.[51]  The Guidelines further indicate that DOJ may consider “the relative importance of any factor used to determine the range,” including the amount of pecuniary loss or gain, specific offense characteristics, or the aggravating or mitigating factors used to calculate the culpability score.[52]  Thus, DOJ has significant latitude in advocating for the placement of the fine relative to the range. Despite the seeming flexibility DOJ has in setting an appropriate fine relative to the applicable range, in practice, most fines are situated at or in some cases substantially below the lower end of the fine range.[53]  In some cases, companies were fined at or below the low end of the range as part of an articulated enforcement program that leads to different results than those suggested by Guidelines § 8C2.8. For one example, the DPA for the DOJ Tax Division’s recent Swiss Bank Program $98 million resolution with Zürcher Kantonalbank (“ZKB”), filed in August 2018, highlighted that the bank’s cooperation credit was reduced because it discouraged two indicted, separately represented bankers from cooperating with U.S. authorities, contributing to the employees’ decision to resist cooperating with the government’s investigation for about two years.[54]  Notwithstanding this seemingly imperfect cooperation, ZKB’s $35 million penalty represented a 50 percent discount below the bottom of the applicable fine range in recognition of its “substantial cooperation” with the investigation.[55]  For that reason, advocacy regarding the fine calculation should focus on the underlying basis for the base fine and the principles that feed into the culpability score, since those inputs will determine the range, and there will be ample precedent supporting a bottom-range or below-range fine. 2.      How DOJ Utilizes the Financial Penalty Components in Practice To understand how the three potential components—fine, restitution, and disgorgement—play out in practice, we analyzed 10-years’ worth of DOJ resolutions involving financial institutions.  In addition, we make reference to DOJ’s most notable resolutions in 2018 involving financial institutions.  Finally, to illuminate how DOJ can exercise complete discretion in calculating the penalties for a particular case in a manner that is either higher or lower than those penalties imposed in similar cases, we review DOJ resolutions where the financial penalties assessed were outliers in comparison to the majority of DOJ resolutions over the last 10 years. a.       10-Year Review of DOJ Resolutions Involving Financial Institutions We have identified 143 resolutions where DOJ assessed a penalty to a financial institution between 2008 to 2018.[56]  The findings below relate only to the penalties assessed by DOJ—not other U.S. enforcers.  It is not uncommon, however, particularly in larger resolutions, for financial institutions to enter into a global structure that includes resolutions with multiple U.S. agencies—both at the federal and state levels—and even foreign regulatory enforcement agencies.  The data and analysis in this subsection is limited to the penalty assessed by DOJ itself since that amount tends to be the largest single driver of financial exposure. Chart 1 below illustrates how frequently DOJ uses restitution, disgorgement/forfeiture, fines, or a mix of these penalties in resolutions with financial institutions. Chart 1 Chart 1 illustrates that approximately 68 percent of the resolutions that DOJ has entered into with financial institutions in the past decade have involved only a fine, without any disgorgement or restitution component.  Part of the explanation for this high percentage is that there were approximately 80 NPAs between DOJ and certain Swiss banks as part of a special DOJ program.  These resolutions only involved a fine.  However, fine-only resolutions are not limited to the Swiss bank context.  Resolutions between DOJ and financial institutions in matters resolving allegations of fraud or manipulation of the London Inter-bank Offered Rate (“LIBOR”), for instance, often involve only a fine component.  As such, resolutions involving only a fine are quite common. By contrast, resolutions involving only restitution are incredibly rare, occurring just 1.4 percent of the time.  Meanwhile, resolutions involving only disgorgement—which occur 14 percent of the time—are somewhat more common but still relatively rare.  The data also demonstrates that it is not uncommon for DOJ resolutions with financial institutions to involve multiple penalty components.  Approximately 16 percent of DOJ resolutions involve more than one penalty component.[57] If we analyze the amount of the penalties that DOJ assessed using each of these components, the importance of disgorgement and forfeiture as a penalty component becomes clearer.  Chart 2 illustrates the total amount of financial penalties DOJ has assessed to financial institutions using each penalty component between 2008 and 2018. Chart 2 As the data in Chart 2 shows, forfeiture and disgorgement account for nearly 61 percent of the dollars DOJ has assessed in penalties to financial institutions in the past decade, nearly twice as much as through fines alone.  A key factor that helps explain this data is that forfeiture has been the only, if not the predominant, penalty component in many of the largest resolutions between DOJ and financial institutions in the past decade.  Indeed, of the seven largest resolutions with DOJ in the past 10 years, disgorgement or forfeiture accounted for the majority of the financial penalty amounts.  For example, forfeiture comprised $8,833,600,000 of the $8,973,600,000 penalty in BNP Paribas’ 2014 sanctions resolution, and the entire penalty in HSBC’s $1.256 billion 2012 sanctions resolution, JP Morgan’s 2014 $1.7 billion BSA resolution, and Société Générale S.A.’s 2018 $717 million sanctions resolution. b.      Notable 2018 Resolutions In 2018, there were 13 resolutions between DOJ and financial institutions in which the overall financial penalty was more than $5 million.[58]  Five of the 13 involved penalties over $100 million, including the second largest penalty ever imposed on a financial institution for alleged violations of U.S. economic sanctions.  Gibson  Dunn’s 2018 Year-End NPA/DPA update offers a detailed analysis of these resolutions. c.       Outlier Resolutions When assessing how U.S. enforcers might assess penalties in a particular case, it is worth analyzing penalties that fall outside of the norm in order to understand whether the conduct at issue in a particular matter might carry significantly more or less financial exposure.  This subsection discusses two notable outliers, which illuminate how U.S. enforcers can exercise discretion in calculating the penalties for a particular case in a manner that is either higher or lower than those penalties imposed in similar cases.  At the high end, DOJ’s $8.9 billion resolution with BNP Paribas remains the largest criminal penalty assessed to date against a financial institution.  This DOJ resolution was notable not only in terms of the overall size of the penalty, but also in the way that it was calculated.  At the low end, DOJ resolutions with “Category Two” banks as part of DOJ’s Swiss Bank Program (as further discussed in the subsection below) were significantly less aggressive in terms of the way in which DOJ calculated financial penalties.     i.      On the High End – BNP Paribas In June 2014, BNP Paribas pled guilty to violating U.S. sanctions laws, agreeing to pay total financial penalties of $8.9 billion.[59]  This remains the largest criminal penalty that the United States has ever imposed on a financial institution or any other organization.  Of that $8.9 billion, BNP Paribas agreed to forfeit $8.8336 billion and pay a fine of $140 million.[60]  In addition to the sheer magnitude of the penalty, the way in which DOJ calculated the penalty was notable in two respects.  First, the forfeiture amount represented “the amount of proceeds traceable to the violations” set forth in the charging document.[61]  In other words, BNP Paribas was required to forfeit one dollar for every dollar that it cleared in a transaction violating U.S. sanctions laws, even though the bank only received a very small commission for clearing that dollar.  Second, the $140 million fine that DOJ assessed against BNP Paribas represented “twice the amount of pecuniary gain to [BNP Paribas] as a result of the offense conduct.”[62]  Thus, BNP Paribas’s fine was two times the amount of profits it received from this activity. It is quite rare for a penalty to include both a one-to-one forfeiture ratio (particularly in cases involving the violation of economic sanctions) and a two-to-one disgorgement ratio.  This extreme penalty may have reflected DOJ’s perception of the egregiousness of BNP Paribas’s alleged conduct and its level of cooperation.  Regarding its conduct, the bank cleared over $8.8 billion through the U.S. financial system that allegedly violated U.S. sanctions laws.[63]  It also continued to clear U.S. dollar transactions allegedly in violation of the Cuba embargo, according to DOJ, “long after it was clear that such business was illegal.”[64]  Moreover, the bank continued clearing transactions allegedly in violation of U.S. sanctions on Iran “nearly two years after the bank had commenced an internal investigation into its sanctions compliance and pledged to cooperate with the [g]overnment.”[65]  Ultimately, as the Assistant Attorney General for DOJ’s Criminal Division explained, “BNP Paribas flouted U.S. sanctions laws to an unprecedented extreme, concealed its tracks, and then chose not to fully cooperate with U.S. law enforcement, leading to a criminal guilty plea and nearly $9 billion penalty.”[66]     ii.      On the Low End – Swiss Bank Program In contrast to the BNP Paribas resolution, the total penalties that DOJ assessed in enforcement resolutions under its Swiss Bank Program with “Category Two” banks were on average less than five percent of the undeclared U.S. assets that these banks maintained. As noted above, DOJ’s Swiss Bank Program allowed Swiss banks to resolve potential criminal liabilities in the United States by voluntarily disclosing undeclared U.S. accounts held at their banks.[67]  There were four categories of banks covered under the Swiss Bank Program.  Category One banks were under active criminal investigation and thus ineligible for the program.[68]  Category Two banks were those that had “reason to believe” that they may have committed tax-related offenses under U.S. law.[69] Since the program began, DOJ has entered into 81 NPAs with Swiss banks.[70]  The vast majority of these NPAs were with Category Two banks.  In NPAs with Category Two banks, DOJ agreed to significantly more modest penalty calculations.  The NPAs generally disclose in the statement of facts the aggregate value of the U.S.-related accounts that the bank maintained and did not disclose.  The average penalty assessed in NPAs with Category Two banks was approximately three percent of the aggregate value of the undisclosed accounts. 3.      Other U.S. Enforcers In addition to DOJ, other U.S. enforcers impose monetary fines against financial institutions and other organizations for violations of relevant federal laws and regulations.  These other U.S. enforcers’ frameworks for calculating financial penalties, however, are not as well-defined as DOJ’s framework under the Guidelines.  In the subsections below, we highlight 2018 resolutions imposed by the OCC and the FRB.  What becomes most apparent in analyzing these resolutions is that certain U.S. enforcers only impose fines (and not restitution or disgorgement penalties). a.       2018 OCC Resolutions In 2018, the OCC entered into seven resolutions with financial institutions where involving a settlement amount of $10 million or greater.  In addition to the penalties that the OCC assessed to U.S. Bank (discussed in the 2018 DPA/NPA mid-year alert) and Rabobank NA, it also assessed two other notable penalties over $50 million in 2018.  First, Wells Fargo, National Association, entered into an order with the OCC, which included a $500 million in civil money penalties to resolve matters regarding the bank’s compliance risk management program and past practices.[71]  This penalty matched the largest penalty that the OCC has ever issued.  In addition, the bank submitted a plan for the management of remediation activities conducted by the bank.  Second, in October 2018, the OCC issued a consent order against Capital One Bank (U.S.A.), N.A., in which it assessed a $100 million civil penalty.[72]  This consent order was issued for BSA/AML violations, including violating a 2015 Consent Order.[73]  The fines in these OCC resolutions only included fines (i.e., the OCC did not include restitution or disgorgement). b.      2018 Federal Reserve Board Resolutions In 2018, the FRB issued five cease-and-desist orders, 12 civil monetary penalties, and three resolutions that included both a cease-and-desist order and a civil monetary penalty to financial institutions.  These three resolutions were the SocGen sanctions resolution, the U.S. Bank BSA/AML resolution (both referenced above), and a $54.75 million settlement with The Goldman Sachs Group, Inc. resolving allegations surrounding the bank’s foreign exchange trading business.[74]  All of these financial penalties were composed entirely of fines. 4.      Forward-Looking Guidance from Enforcers Recent guidance by U.S. enforcers provides helpful clues as to how they will approach financial penalties for corporations.  In particular, enforcers have been focused on enhancing inter-agency coordination in order to avoid imposing duplicative penalties. a.       Recent Guidance One example of a written policy is DOJ’s Justice Manual, which contains guidance with respect to the bringing of criminal actions against organizations and penalties associated with those actions.  The Justice Manual lists factors DOJ should consider in determining whether and how to charge a corporate entity, such as the nature of the offense, the “pervasiveness of the wrongdoing,” the “history of similar misconduct,” the “adequacy and effectiveness of the corporation’s compliance program,” among others.[75]  The Justice Manual also specifically outlines how voluntary self-disclosure and cooperation may affect the outcome of a criminal action against a legal entity, much like we discussed earlier in the context of the FCPA Policy.[76] In another example, the OCC issues written policies and guidance with respect to civil monetary penalties in its Policies and Procedures Manual (“PPM”), most recently updated on November 13, 2018.[77]  In the PPM, the OCC lays out the factors it considers in determining penalty amounts, including:  “(1) the size of financial resources and good faith of the institution . . .  charged; (2) the gravity of the violation; (3) the history of previous violations; and (4) such other matters as justice may require,” as well as 13 additional factors set forth in an Interagency Policy issued by the Federal Financial Institutions Examination Council (“FFIEC”) in 1998.[78]  The OCC includes matrices as appendices to the PPM, which apply “factor scores” to the different factors considered in determining an appropriate penalty.  Although these matrices “are only guidance” and “do not reduce the [penalty] process to a mathematical equation and are not a substitute for sound supervisory judgment,” they provide guidance and may give financial institutions a sense of how the factors are weighed when the OCC considers a monetary penalty.[79] The FDIC publishes a similar matrix and issues guidance on the factors it considers when imposing penalties.  These factors are essentially the same as those considered by the OCC, which is unsurprising due to the coordination of the federal banking regulators through the FFIEC.[80] Further guidance—although nonbinding—regularly comes in the form of speeches at conferences and events by DOJ and other officials.  Given the flexibility and judgment calls involved in each decision, however, any review or estimate of financial exposure must include a review of the enforcement actions brought by these agencies in order to glean which factors will be applied and how they will be weighted. b.      Recent Guidance Focused on Inter-Agency Coordination Although many different U.S. enforcers have the authority to impose financial penalties, there have been efforts to coordinate resolutions between these agencies and, in some cases, to attempt to avoid duplicative fines.  For example, in May 2018, Deputy Attorney General Rod Rosenstein announced a new DOJ Policy on Coordination of Corporate Resolution Penalties, which was then incorporated into the Justice Manual.[81]  This policy—commonly referred to as the “Anti-Piling On Policy”—seeks to avoid the unnecessary “piling on” of duplicative criminal and civil penalties and to encourage cooperation among enforcement agencies both within DOJ as well as between DOJ and other domestic and foreign enforcers.  The new Anti-Piling On Policy encourages DOJ to coordinate with other enforcers when considering appropriate penalties, listing specific factors that may lead to the imposition of multiple penalties, including:  (1) “the egregiousness of a company’s misconduct;” (2) “statutory mandates regarding penalties, fines, and/or forfeitures;” (3) “the risk of unwarranted delay in achieving a final resolution;” and (4) “the timeliness of a company’s disclosures and its cooperation” with DOJ.[82] In Rosenstein’s May 9, 2018 speech announcing the policy, he explicitly referred to coordination with the SEC, the CFTC, the FRB, the FDIC, the OCC, and OFAC, and stressed that “[b]y working with other agencies . . . our Department is better able to detect sophisticated financial fraud schemes and deploy adequate penalties and remedies to ensure market integrity.”[83]  In practice, the Anti-Piling On Policy does not reflect a major shift in DOJ’s approach, as DOJ had already been coordinating with other U.S. enforcers on many matters.  However, this new official policy does formalize and reduce to writing DOJ’s commitment to coordination. We have seen DOJ’s new Anti-Piling On Policy play out in a number of resolutions over the past year.  For example, in recent resolutions involving U.S. Bank and Rabobank NA (both referenced above), the various U.S. enforcers acknowledged and credited fines imposed by others.  While the Rabobank NA and U.S. Bank resolutions occurred before the official announcement of the Anti-Piling On Policy, they reflect the same coordination principles and appeared consistent with Rosenstein’s November 2017 remarks indicating that DOJ had intended to apply those principles going forward.  More recently, in the June 2018 SocGen FCPA and LIBOR DPA discussed above, DOJ credited the penalty paid to a foreign regulator—the Parquet National Financier—reducing its imposed fine by 50 percent on that basis.[84] Other U.S. enforcers have not yet officially announced parallel policies but many have demonstrated the same crediting of fines imposed by other agencies.  For example, the SEC in recent speeches has addressed its desire to work with other enforcers and to take into consideration other enforcement actions.  On May 11, 2018, just two days after the announcement of DOJ’s Anti-Piling On Policy, SEC Commissioner Hester Peirce remarked at a conference that “[a]nother way to conserve resources for matters most in need of our enforcement attention is to work with other regulators and the criminal authorities” and that “[i]n deciding whether to pursue a matter, the Enforcement Division . . . can take into consideration whether other regulatory or criminal authorities are looking at the same conduct.”[85]  This plays out in the amount of penalties imposed in addition to the decision to bring an action in the first place.  For example, in a July 2018 FCPA resolution with CSHK (discussed above), the SEC imposed disgorgement and accrued interest amounts totaling approximately $30 million, but did not require a separate fine, crediting the $47 million criminal penalty paid to DOJ.[86] Along the same lines, in June 2018, the FFIEC rescinded a previous policy statement from 1997 and replaced it with a new inter-agency policy reflecting coordination in enforcement actions against financial institutions by the OCC, the FRB, and the FDIC.[87]  This new policy reflects the same goal of coordinating actions and resolutions in order to avoid the piling on of duplicative monetary fines. Despite the efforts of agencies to coordinate and credit penalties imposed by others, the SocGen sanctions-related enforcement action discussed above does not appear to have involved credits by the settling agencies for fines paid to others.  In reaching the global resolution of $1.4 billion, DOJ did not credit payments to other U.S. enforcers and in fact referred to “separate agreements” under which SocGen “shall pay additional penalties.”[88]  Similarly, the OFAC Enforcement Information referred to the global settlement involving resolutions with DOJ, the FRB, the New York County District Attorney’s Office, the U.S. Attorney’s Office for the Southern District of New York, and the New York Department of Financial Services, but did not credit any of the other fines in assessing its penalty of nearly $54 million.[89]  OFAC has not publicly stated whether it is moving away from the crediting of payment to other enforcers or whether the SocGen resolution is an outlier.[90]  In any event, it is still too soon to know whether the trends toward cooperation and the avoiding of duplicative penalties will reduce the total penalty paid by an organization facing a multi-agency enforcement action. 5.      Conclusion Although most financial penalties in civil and criminal matters may contain the same potential components (i.e., fines, restitution, and/or disgorgement) as seen in the majority of DOJ corporate resolutions over a 10-year period, there can be significant variance in how these components are calculated. Additionally, although the determination of any base fine or penalty is driven by specific principles and elements for the sentencing of organizations in the Guidelines, these principles and elements will be informed by the facts that are the subject of any government investigation.  Often conduct can be viewed as implicating different statutes and violations.  For example, most alleged violations can be viewed according to the underlying problem (e.g., sanctions) as well as AML.  When negotiating with U.S. enforcers, financial institutions, and their counsel should consider how best to shape the narrative around the scope of the alleged misconduct and how those enforcers view different statutory violations.  By advocating effectively in this regard, a financial institution can position itself to reduce its potential financial penalty or even take advantage of a program designed to encourage cooperation (e.g., FCPA Policy). Financial institutions should also consider that fine calculations can be adjusted up or down based on culpability scores, prior history enhancements, and the role of management in the alleged misconduct.  Financial institutions should accordingly be prepared to make principled arguments rooted in the facts of the instant case and be familiar with the outcomes of other analogous cases in order to appeal to relevant organizational precedent.  Nonetheless, although the Guidelines’ principles are helpful in determining an organization’s exposure to a potential criminal penalty, financial institutions should be mindful of the significant discretion prosecutors wield in determining whether to apply a given enhancement or reduction and in situating the penalty amount within the applicable fine range. Finally, financial institutions should also keep in mind these criminal sentencing principles when negotiating civil or administrative resolutions.  For example, by negotiating for language explicitly disclaiming that a cease-and-desist order or consent decree should be regarded as a “civil or administrative adjudication,” a financial institution may limit its exposure to the prior history aggravating factor in potential future criminal actions. We believe that it is essential for our financial institution clients to understand their potential financial exposure when assessing matters involving DOJ or other U.S. enforcers.  We hope this publication serves as a helpful primer on this issue, and look forward to addressing other topics that raise unique issues for financial institutions in this rapidly-evolving area in future editions. [1]      Throughout this alert, we generally use the term “U.S. enforcers” to refer to U.S. regulatory agencies and departments, which bring criminal or civil enforcement against persons for violations of federal law. [2]      We use the terms “corporate entity” and “organization” to refer to non-individual persons subject to investigation by enforcers, regardless of the specific legal structure of a given organization.  Throughout this client alert, we use the two terms interchangeably.  For example, in several places, we refer to a penalty imposed against a financial institution or other organization simply as a “corporate penalty” for ease of reference. [3]      This alert also discusses other U.S. enforcers and regulatory agencies, including the U.S. Department of Treasury’s Office of Foreign Assets Control (“OFAC”), the U.S. Department of Treasury’s Financial Crimes Enforcement Network (“FinCEN”), the Office of the Comptroller of the Currency (“OCC”), the U.S. Securities and Exchange Commission (“SEC”), the U.S. Commodity Futures Trading Commission (“CFTC”), and the Board of Governors of the Federal Reserve System (“FRB”). [4]      For the purposes of this client alert, forfeiture is considered as a form of disgorgement.  As noted below, forfeiture is a unique driver of financial institution liability, and the complexities it presents will be the focus of a future Developments in the Defense of Financial Institutions client alert. [5]      18 U.S.C. § 1344. [6]      18 U.S.C. §§ 1341, 1343. [7]      See, e.g., 18 U.S.C. § 3571(d), which provides that a defendant may be fined up to twice the gross gain or gross loss attributable to an offense. [8]      This citation to the Guidelines in this client alert is drawn from the 2018 edition of the U.S. Sentencing Guidelines Manual, a publication of the United States Sentencing Commission, available at https://www.ussc.gov/sites/default/files/pdf/guidelines-manual/2018/GLMFull.pdf. [9]      U.S. Dep’t of Justice, Justice Manual §  9-47.120 (2017), available at https://www.justice.gov/jm/jm-9-47000-foreign-corrupt-practices-act-1977#9-47.120.  We discussed the FCPA Policy in greater detail in our 2017 Year-End FCPA Update. [10]    Id.; see also Rod J. Rosenstein, Deputy Att’y Gen., Deputy Attorney General Rosenstein Delivers Remarks at the 34th International Conference on the Foreign Corrupt Practices Act (Nov. 29, 2017), https://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-34th-international-conference-foreign/. [11]    U.S. Dep’t of Justice, Justice Manual §  9-47.120. [12]    See, e.g., United States v. Boccagna, 450 F.3d 107, 115 (2d Cir. 2006) (“[T]he purpose of restitution is essentially compensatory:  to restore a victim, to the extent money can do so, to the position he occupied before sustaining injury.”). [13]   See, e.g., FTC v. WV Universal Mgmt., LLC, 877 F.3d 1234, 1239 (11th Cir. 2017) (quoting FTC v. General Merch. Corp., 87 F.3d 466, 468 (11th Cir. 1996)) (noting that even though the Federal Trade Commission Act did not expressly provide for monetary equitable relief, Congress’s “unqualified grant of statutory authority to issue an injunction . . . carries with it the full range of equitable remedies”). [14]    See, e.g.,  SEC v. Contorinis, 743 F.3d 296, 301 (2d Cir. 2014); see also SEC v. Tome, 833 F.2d 1086, 1096 (2d Cir. 1987) (“The paramount purpose of enforcing the prohibition against insider trading by ordering disgorgement is to make sure that wrongdoers will not profit from their wrongdoing.”). [15]    See U.S. Sentencing Guidelines Manual [hereinafter, the “Guidelines”] §§  5E1.1, 8B1.1, 8C2.9. [16]    Guidelines § 8B1.1(c). [17]    DOJ’s resolutions with NCH Corporation, HMT LLC, CDM Smith Inc., and Linde North America Inc. are examples of this approach.  See Letter to Paul E. Coggins & Kiprian Mendrygal, Locke Lord LLP, Counsel for NCH Corporation (Sept. 29, 2016), available at https://www.justice.gov/criminal-fraud/file/899121/download; Letter to Steven A. Tyrell, Weil, Gotshal & Manges LLP, Counsel for HMT LLC (Sept. 29, 2016), available at https://www.justice.gov/criminal-fraud/file/899116/download; Letter to Nathaniel B. Edmonds, Paul Hastings LLP, Counsel for CDM Smith Inc. (June 21, 2017), available at https://www.justice.gov/criminal-fraud/page/file/976976/download; Letter  to Lucina Low & Thomas Best, Steptoe & Johnson LLP, Counsel for Linde North America Inc. (June 16, 2017), available at https://www.justice.gov/criminal-fraud/file/974516/download. [18]   See Jody Godoy, DOJ Expands Leniency Beyond FCPA, Lets Barclays Off, Law360 (Mar. 1, 2018), https://www.law360.com/articles/1017798/doj-expands-leniency-beyond-fcpa-lets-barclays-off. [19]     Common chapters of the Guidelines potentially applicable to financial institutions include 2B (fraud and embezzlement), 2C (bribery and gratuities), 2S (money laundering), and 2T (tax violations). [20]    Guidelines § 8C2.4(a).  “Pecuniary gain” and “pecuniary loss” are defined with reference to the definitions at § 8A1.2 cmt. n.3(H), and (I), respectively.  “Pecuniary gain” refers to “the additional before-tax profit to the defendant resulting from the relevant conduct of the offense,” and “pecuniary loss” refers to the greater of the reasonably foreseeable actual loss or intended loss from the offense conduct, as defined at § 2B1.1 cmt. n.3(A). [21]    Id. § 8C2.5(a). [22]     Aggravating factors, which increase the culpability score, include the size of the organization, involvement of high-level management, history of prior enforcement resolutions for similar misconduct, violations of an existing judicial or administrative order and conduct alleged to be indicative of obstruction of justice.  Id. § 8C2.5(b)-(e). Mitigating factors, which decrease the culpability score, include the existence of an effective compliance and ethics program at the time of the alleged misconduct, prompt, voluntary self-disclosure of the conduct, full cooperation in the government’s investigation, and clearly demonstrated acceptance of responsibility for the conduct at issue.  Id. § 8C2.5(f)-(g). [23]    Id. § 8C2.6. [24]   Id. § 8C2.5(c)(2). [25]   Id. § 8C2.5(c)(1). [26]   See id. Ch. 4, pt. A, Introductory Commentary (“A defendant with a record of prior criminal behavior is more culpable than a first offender and thus deserving of greater punishment. General deterrence of criminal conduct dictates that a clear message be sent to society that repeated criminal behavior will aggravate the need for punishment with each recurrence.”). [27]   Id. § 8A1.2 cmt. n.3(G) (defining “prior criminal adjudication” as “conviction by trial, plea of guilty . . . or plea of nolo contendere“). [28]   See, e.g., Black’s Law Dictionary (10th ed. 2014) (defining “adjudication” as “[t]he legal process of resolving a dispute” or “the process of judicially deciding a case,” and “administrative adjudication” as “[t]he process used by an administrative agency to issue regulations through an adversary proceeding”).  In the context of administrative adjudications, the Administrative Procedures Act sets forth a series of basic requirements for so-called “formal” agency adjudications, including the presentation of evidence before a presiding official, the opportunity to present rebuttal evidence or cross-examine witnesses, and a written decision on the record.  See 5 U.S.C. § 554 et seq. [29]   Guidelines § 8C2.5(c) indicates that the prior adjudication(s) must occur within five to ten years before the organization committed any part of the “instant offense.”  Chapter 8 of the Guidelines defines “instant,” when applied to modify the term “offense,” as used “to distinguish the violation for which the defendant is being sentenced from a prior or subsequent offense.”  Guidelines § 8A1.2 cmt. n.3(A). [30]   § 8C2.5(c). [31]   § 8A1.2 cmt. n.3(F). [32]   See, e.g., United States v. Hernandez, 160 F.3d 661, 669–70 (11th Cir. 1998) (failure to pay employees minimum wage is similar to committing bankruptcy fraud); United States v. Starr, 971 F.2d 357, 361–62 (9th Cir. 1992) (possession of stolen property and embezzlement are similar to bank robbery); United States v. Cota-Guerrero, 907 F.2d 87, 89 (9th Cir. 1990) (illegal possession of firearm is similar to assault with a deadly weapon). [33]   Guidelines § 8C2.5(c) (emphasis added). [34]   Id. cmt. n.5 (defining “separately managed line of business” as “a subpart of a for-profit organization that has its own management, has a high degree of autonomy from higher managerial authority, and maintains its own separate books of account”). [35]   Id. [36]   This figure was calculated using the statistics contained in Table 54 of the U.S. Sentencing Commission’s Annual Sourcebooks of Federal Sentencing Statistics for the years 2006 to 2017, which are available at https://www.ussc.gov/research/sourcebook/archive/. [37]   For this analysis, we reviewed all corporate criminal resolutions based on alleged violations relating to the FCPA, AML statutes, LIBOR, and foreign exchange issues, sanctions, and tax fraud, as identified by running searches using the Corporate Prosecution Registry available at http://lib.law.virginia.edu/Garrett/corporate-prosecution-registry/browse/browse.html. [38]   See Plea Agreement, United States v. Rabobank, Nat’l Ass’n, No. 18-cr-00614 (S.D. Cal. Feb. 7, 2018), available at https://www.justice.gov/opa/press-release/file/1032101/download; Deferred Prosecution Agreement, United States v. Zimmer Biomet Holdings, No. 12-cr-00080 (D.D.C. Jan. 12, 2017), available at https://www.justice.gov/opa/press-release/file/925171/download; Plea Agreement, United States v. ABB Inc., No. 4:10-cr-00664 (S.D. Tex. Sept. 29, 2010), available at https://www.justice.gov/sites/default/files/criminal-fraud/legacy/2015/03/05/09-29-10abbinc-plea.pdf; Deferred Prosecution Agreement, United States v. ABB Ltd., No. 4:10-cr-00665 (S.D. Tex. Sept. 29, 2010), available at https://www.justice.gov/sites/default/files/criminal-fraud/legacy/2011/02/16/09-29-10abbjordan-dpa.pdf. [39]   Guidelines § 8C2.5(b). “High-level personnel” are defined as those who have substantial control or policy-making responsibility within the organization or unit (such as directors, executives officers, or the heads of significant units or divisions).  Guidelines § 8A1.2 cmt. n.3(B).  “Substantial authority personnel” are those who “exercise a substantial measure of discretion,” which encompasses “high-level personnel,” individuals who exercise substantial supervisory authority, or non-managerial personnel with a significant degree of discretionary authority, such as those who can negotiate prices or approve significant contracts.  Id. § 8A1.2 cmt. n.3(C).  “Pervasiveness” is described as a sliding scale based on “the number, and degree of responsibility of individuals within substantial authority personnel who participated in, condoned, or were willfully ignorant of the offense.”  Id. § 8C2.5 cmt. n.4. [40]   Id. § 8C2.5, Background note. [41]   See, e.g., Plea Agreement at 8, United States v. Tyco Valves & Controls Middle East, Inc., No. 1:12-cr-00418 (E.D. Va. Sept. 24, 2012), available at https://www.justice.gov/sites/default/files/criminal-fraud/legacy/2012/09/27/2012-09-24-plea-agreement.pdf (one-point enhancement applied for the regional subsidiary of organization, which had only a fraction of the entire organization’s approximate 70,000 employees according to 2012 annual report, available at http://www.tyco.com/uploads/files/tyco_annual-report_2012.pdf); Deferred Prosecution Agreement at 8, United States v. Shell Nigeria Exploration and Prod. Co., No. 4:10-cr-00767 (S.D. Tex. Nov. 4, 2010), ), available at https://www.justice.gov/sites/default/files/criminal-fraud/legacy/2011/02/16/11-04-10snepco-dpa.pdf (three-point enhancement applied for the Nigerian subsidiary of organization, which had only a fraction of the entire organization’s approximate 90,000 employees according to 2011 annual report, available at https://reports.shell.com/annual-report/2011/servicepages/filelibrary/files/collection.php). [42]   Guidelines § 8C2.5(b) (emphasis added). [43]   Guidelines § 8A1.2 cmt. n.3(J). [44]   Global-Tech Appliances, Inc. v. SEB S.A., 563 U.S. 754, 766 & 767 n.7 (2011) (approving “willful ignorance” jury instruction). [45]   543 U.S. 220, 245 (2005) (Breyer, J.) (modifying the federal sentencing statutes so as to render the Guidelines “effectively advisory,” by requiring a sentencing court to consider sentencing ranges, while permitting it to tailor a given sentence in light of other statutory considerations). [46]   Guidelines § 8C2.5(f)(1). [47]   An organization is not eligible for this mitigating factor if it was subject to an enhancement under § 8C2.5(b) based on the involvement, condonation, or willful ignorance of high-level personnel within a unit of 200 or more employees, id. § 8C2.5(f)(3)(A), and is presumptively ineligible if the relevant unit(s) had less than 200 employees or if only substantial authority personnel were implicated, id. § 8C2.5(f)(3)(B).  However, a limited exception is available if non-culpable compliance and ethics personnel identified the problem before it was discovered by outside parties and promptly reported it to the appropriate governmental authorities.  See id. § 8C2.5(f)(3)(C)(iii). [48]   Id. § 8B2.1(a), (b).  These factors are:  (1) established standards and procedures to prevent and detect criminal conduct; (2) the organization’s governing authority must be knowledgeable about the content and function of the program and exercise reasonable oversight, and specific high-level individuals must be assigned responsibility for oversight; (3) reasonable efforts not to give substantial authority to personnel the organization knew or should have known has engaged in illegal or non-compliant activities; (4) reasonable steps to periodically communicate compliance and ethics standards to all staff through training and other forms of dissemination; (5) reasonable monitoring and auditing programs to ensure the compliance and ethics program is followed; (6) consistent promotion and enforcement at all levels of the organization through appropriate incentives and disciplinary measures; and (7) reasonable steps to respond to identified criminal conduct and prevent further such conduct, including by modifying the compliance and ethics program as necessary. [49]   Id. § 8B2.1(a) cmt. n.2. [50]   See note 36 supra. [51]   These factors are: (1) policy considerations, such as the severity of the offense, need to promote respect for the rule of law, deterrence, and the protection of the public from future crimes; (2) the organization’s role in the offense; (3) the potential collateral consequences of a conviction; (4) non-pecuniary losses caused or threatened by the offense; (5) whether the offense involved a vulnerable victim; (6) the prior criminal records of individuals within the high-level personnel of the organization or applicable unit who were involved in the criminal conduct; (7) prior civil or criminal conduct not covered by the prior history enhancement under § 8C2.5(c); (8) if the culpability score is higher than 10 or lower than 0 (meaning the minimum or maximum multiplier is applicable); (9) partial but incomplete satisfaction of the aggravating or mitigating factors under § 8C2.5 which feed into the culpability score; (10) the factors listed at 18 U.S.C. § 3572(a) (which include the defendant’s income and capacity to pay, the burden of the fine on the defendant, the degree of pecuniary loss inflicted on others, the need for restitution or the deprivation of ill-gotten gains, the extent to which the cost of the fine can or will be passed onto consumers or other persons, or the steps taken to discipline culpable employees); and (11) if the organization lacked an effective compliance program at the time of the offense conduct.  Guidelines § 8C2.8(a). [52]   Id. § 8C2.8(b). [53]   As discussed in section 2 below, our review of 119 corporate resolutions involving bribery, AML, sanctions, criminal tax, and currency violations in the past 10 years has determined that of the 82 DPAs and guilty pleas explicitly referencing the placement of the penalty relative to the applicable fine range, 16 (19.5 percent) were placed near or at the bottom of the fine range, and 60 (73.2 percent) received a discount below the low end of the fine range.  Thus, based on our analysis, for nearly 93 percent of all resolutions involving these types of violations, the fine was placed near, or even below, the bottom of the fine range. [54]   Deferred Prosecution Agreement ¶ 9, Ex. C at 7–8, Zürcher Kantonalbank (S.D.N.Y. Aug. 7, 2018), available at https://www.justice.gov/usao-sdny/press-release/file/1086876/download. [55]   Id. at ¶ 9. [56]   This number does not include resolutions where DOJ did not assess a penalty but instead deemed the financial institution’s payment to other regulators sufficient to satisfy any monetary penalty.  This was the structure, for instance of the resolutions in 2011 between DOJ and a number of financial institutions regarding alleged antitrust violations in the municipal reinvestment industry. [57]   It is important to note that other U.S. regulators may order disgorgement or restitution as part of a global settlement even if DOJ does not. [58]   DOJ also entered into NPAs with Red Cedar Services, Inc. and Santee Financial Services for $2,000,000 and $1,000,000, respectively.  See Non-Prosecution Agreement with Red Cedar Services at 2, April 25, 2018, available at https://www.gibsondunn.com/wp-content/uploads/2018/07/Red-Cedar-Services-NPA-2018.pdf; Non-Prosecution Agreement with Santee Financial Services at 2, April 13, 2018, available at  https://www.gibsondunn.com/wp-content/uploads/2018/07/Santee-Financial-Services-NPA-2018.pdf. [59]    Press Release, U.S. Dep’t of Justice, BNP Paribas Agrees to Plead Guilty and to Pay $8.9 Billion for Illegally Processing Financial Transactions for Countries Subject to U.S. Economic Sanctions (June 30, 2014), https://www.justice.gov/opa/pr/bnp-paribas-agrees-plead-guilty-and-pay-89-billion-illegally-processing-financial. [60]    Id. [61]    Plea Agreement at 1, United States v. BNP Paribas S.A., No. 14-cr-00460 (S.D.N.Y. June 27, 2014), BNP Paribas Plea Agreement at 1, June 27, 2014, available at  https://www.justice.gov/sites/default/files/opa/legacy/2014/06/30/plea-agreement.pdf (“BNP Paribas Plea Agreement”). [62]    Id. at 4. [63]     BNP Paribas Agrees to Plead Guilty and to Pay $8.9 Billion for Illegally Processing Financial Transactions for Countries Subject to U.S. Economic Sanctions, U.S. Dep’t of Justice (June 30, 2014), available at https://www.justice.gov/opa/pr/bnp-paribas-agrees-plead-guilty-and-pay-89-billion-illegally-processing-financial. [64]     Id. [65]     Id. [66]     Press Release, U.S. Dep’t of Justice, BNP Paribas Sentenced for Conspiring to Violate the International Emergency Economic Powers Act and the Trading with the Enemy Act (May 1, 2015), https://www.justice.gov/opa/pr/bnp-paribas-sentenced-conspiring-violate-international-emergency-economic-powers-act-and. [67]    Swiss Bank Program, U.S. Dep’t of Justice, available at https://www.justice.gov/tax/swiss-bank-program  (last visited Jan. 8, 2019). [68]   U.S. Dep’t of Justice, Program for Non-Prosecution Agreements or Non-Target Letters for Swiss Banks, available at https://www.justice.gov/iso/opa/resources/7532013829164644664074.pdf. [69] Id. The Program also included two additional categories.  Categories Three and Four, however, are not relevant for the purposes of this discussion. [70]   Swiss Bank Program, U.S. Dep’t of Justice, available at https://www.justice.gov/tax/swiss-bank-program (last visited Jan. 8, 2019). [71]    Consent Order for a Civil Monetary Penalty, OCC, In re Wells Fargo Bank, N.A. (Apr. 20, 2018), available at https://www.occ.gov/static/enforcement-actions/ea2018-026.pdf. [72]   Consent Order, OCC, In re Capital One, N.A. and Capital One Bank (U.S.A.), N.A. (Oct. 23, 2018), available at https://www.occ.gov/static/enforcement-actions/ea2018-080.pdf. [73]   Id. [74]     Press Release, FRB, Federal Reserve Board Fines Goldman Sachs Group, Inc., $54.75 Million for Unsafe and Unsound Practices in Firm’s Foreign Exchange (FX) Trading Business, (May 8, 2018), https://www.federalreserve.gov/newsevents/pressreleases/enforcement20180501b.htm. [75]   U.S. Dep’t of Justice, Justice Manual §§ 9-28.200, 9-28.300, available at https://www.justice.gov/jm/jm-9-28000-principles-federal-prosecution-business-organizations#9-28.200. [76]   Id. §§ 9-28.700, 9-28.900, available at https://www.justice.gov/jm/jm-9-28000-principles-federal-prosecution-business-organizations#9-28.700. [77]   OCC, Policies and Procedures Manual 5000-7 (Nov. 13, 2018), https://www.occ.gov/publications/publications-by-type/other-publications-reports/ppms/ppm-5000-7.pdf. [78]   Id. at 4. [79]   Id. at 5.   [80]   FDIC, DSC Risk Management Manual of Examination Policies § 14.1, Civil Money Penalties, available at https://www.fdic.gov/regulations/safety/manual/section14-1.pdf. [81]   Justice Manual § 1-12.100, available at https://www.justice.gov/jm/jm-1-12000-coordination-parallel-criminal-civil-regulatory-and-administrative-proceedings#1-12.100.  Although this policy was officially implemented in May 2018, Rosenstein had also already announced DOJ’s efforts to improve coordination in a November 2017 speech.  Rod Rosenstein, Deputy Att’y Gen., Deputy Attorney General Rosenstein Delivers Remarks at the Clearing House’s 2017 Annual Conference (Nov. 8, 2017), https://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-clearing-house-s-2017-annual (announcing DOJ’s efforts to “consider[] proposals to improve coordination” and “help avoid duplicative and unwarranted payments”). [82]   Justice Manual § 1-12.100, available at https://www.justice.gov/jm/jm-1-12000-coordination-parallel-criminal-civil-regulatory-and-administrative-proceedings#1-12.100. [83]   Rod Rosenstein, Deputy Att’y Gen., Deputy Attorney General Rod Rosenstein Delivers Remarks to the New York City Bar White Collar Crime Institute (May 9, 2018), https://www.justice.gov/opa/speech/deputy-attorney-general-rod-rosenstein-delivers-remarks-new-york-city-bar-white-collar. [84]   Press Release, U.S. Dep’t of Justice, Société Générale S.A. Agrees to Pay $860 Million in Criminal Penalties for Bribing Gaddafi-Era Libyan Officials and Manipulating LIBOR Rate (June 4, 2018), https://www.justice.gov/opa/pr/soci-t-g-n-rale-sa-agrees-pay-860-million-criminal-penalties-bribing-gaddafi-era-libyan. [85]   Commissioner Hester M. Peirce, The Why Behind the No: Remarks at the 50th Annual Rocky Mountain Securities Conference (May 11, 2018), https://www.sec.gov/news/speech/peirce-why-behind-no-051118. [86]   Press Release, SEC, SEC Charges Credit Suisse With FCPA Violations (Jul. 5, 2018), https://www.sec.gov/news/press-release/2018-128. [87]   Interagency Coordination of Formal Corrective Action by the Federal Bank Regulatory Agencies, 83 Fed. Reg. 113, 27329 (June 12, 2018), https://www.govinfo.gov/content/pkg/FR-2018-06-12/pdf/2018-12557.pdf. [88]   Press Release, U.S. Dep’t of Justice, Manhattan U.S. Attorney Announces Criminal Charges Against Société Générale S.A. For Violations Of The Trading With The Enemy Act (Nov. 19, 2018), https://www.justice.gov/usao-sdny/pr/manhattan-us-attorney-announces-criminal-charges-against-soci-t-g-n-rale-sa-violations. [89]   OFAC Enforcement Information, Société Générale S.A. Settles Potential Civil Liability for Apparent Violations of Multiple Sanctions Programs (Nov. 19, 2018), https://www.treasury.gov/resource-center/sanctions/CivPen/Documents/20181119_socgen_web.pdf. [90]   In previous OFAC resolutions involving other enforcers, OFAC resolution documents had explicitly noted that penalties (or portions of penalties) were deemed “satisfied” by payments or conditions in agreements with other agencies.  See, e.g.,  OFAC Enforcement Information, National Oilwell Varco, Inc. Settles Potential Civil Liability for Apparent Violations of the Cuban Assets Control Regulations, the Iranian Transactions and Sanctions Regulations, and the Sudanese Sanctions Regulations (Nov. 14, 2016), https://www.treasury.gov/resource-center/sanctions/CivPen/Documents/20161114_varco.pdf.OFAC Enforcement Information, Alcon Laboratories, Inc., Alcon Pharmaceuticals Ltd., and Alcon Management, SA, Settle Potential Civil Liability for Apparent Violations of the Iranian Transactions and Sanctions Regulations and the Sudanese Sanctions Regulations (Jul. 5, 2016),  https://www.treasury.gov/resource-center/sanctions/CivPen/Documents/20160705_alcon.pdf. The following Gibson Dunn attorneys assisted in preparing this client update:  M. Kendall Day, Stephanie L. Brooker, F. Joseph Warin, Carl Kennedy, Chris Jones, Jaclyn Neely, Chantalle Carles Schropp, and Alexander Moss. Gibson Dunn has deep experience with issues relating to the defense of financial institutions, and we have recently increased our financial institutions defense and AML capabilities with the addition to our partnership of M. Kendall Day. Kendall joined Gibson Dunn in May 2018, having spent 15 years as a white collar prosecutor, most recently as an Acting Deputy Assistant Attorney General, the highest level of career official in DOJ’s Criminal Division. For his last three years at DOJ, Kendall exercised nationwide supervisory authority over every BSA and money-laundering charge, DPA and NPA involving every type of financial institution. Kendall joined Stephanie Brooker, a former Director of the Enforcement Division at FinCEN and a former federal prosecutor and Chief of the Asset Forfeiture and Money Laundering Section for the U.S. Attorney’s Office for the District of Columbia, who serves as Co-Chair of the Financial Institutions Practice Group and a member of White Collar Defense and Investigations Practice Group. Kendall and Stephanie practice with a Gibson Dunn network of more than 50 former federal prosecutors in domestic and international offices around the globe. For assistance navigating white collar or regulatory enforcement issues involving financial institutions, please contact any Gibson Dunn attorney with whom you work, or any of the following leaders and members of the firm’s White Collar Defense and Investigations and Financial Institutions practice groups: Washington, D.C. F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) Richard W. Grime (+1 202-955-8219, rgrime@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) Judith A. Lee (+1 202-887-3591, jalee@gibsondunn.com) Stephanie Brooker (+1 202-887-3502, sbrooker@gibsondunn.com) John W.F. Chesley (+1 202-887-3788, jchesley@gibsondunn.com) Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com) M. Kendall Day (+1 202-955-8220, kday@gibsondunn.com) David Debold (+1 202-955-8551, ddebold@gibsondunn.com) Stuart F. Delery (+1 202-887-3650, sdelery@gibsondunn.com) Michael S. Diamant (+1 202-887-3604, mdiamant@gibsondunn.com) Adam M. Smith (+1 202-887-3547, asmith@gibsondunn.com) Linda Noonan (+1 202-887-3595, lnoonan@gibsondunn.com) Oleh Vretsona (+1 202-887-3779, ovretsona@gibsondunn.com) Christopher W.H. Sullivan (+1 202-887-3625, csullivan@gibsondunn.com) Courtney M. Brown (+1 202-955-8685, cmbrown@gibsondunn.com) Jason H. Smith (+1 202-887-3576, jsmith@gibsondunn.com) Ella Alves Capone (+1 202-887-3511, ecapone@gibsondunn.com) Pedro G. 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Welch (+852 2214 3716, owelch@gibsondunn.com) São Paulo Lisa A. Alfaro (+55 (11) 3521-7160, lalfaro@gibsondunn.com) Fernando Almeida (+55 (11) 3521-7095, falmeida@gibsondunn.com)   © 2019 Gibson, Dunn & Crutcher LLP, 333 South Grand Avenue, Los Angeles, CA 90071 Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 21, 2018 |
Gibson Dunn Ranked in the 2019 UK Legal 500

The UK Legal 500 2019 ranked Gibson Dunn in 13 practice areas and named six partners as Leading Lawyers. The firm was recognized in the following categories: Corporate and Commercial: Equity Capital Markets Corporate and Commercial: M&A – Upper Mid-Market and Premium Deals, £250m+ Corporate and Commercial: Private Equity – High-value Deals Dispute Resolution: Commercial Litigation Dispute Resolution: International Arbitration Finance: Acquisition Finance Finance: Bank Lending: Investment Grade Debt and Syndicated Loans Human Resources: Employment – Employers Public Sector: Administrative and Public Law Real Estate: Commercial Property – Hotels and Leisure Real Estate: Commercial Property – Investment Real Estate: Property Finance Risk Advisory: Regulatory Investigations and Corporate Crime The partners named as Leading Lawyers are Sandy Bhogal – Corporate and Commercial: Corporate Tax; Steve Thierbach – Corporate and Commercial: Equity Capital Markets; Philip Rocher – Dispute Resolution: Commercial Litigation; Cyrus Benson – Dispute Resolution: International Arbitration; Jeffrey Sullivan – Dispute Resolution: International Arbitration; and Alan Samson – Real Estate: Commercial Property and Real Estate: Property Finance. Claibourne Harrison has also been named as a Next Generation Lawyer for Real Estate: Commercial Property.

November 19, 2018 |
Brexit – The Draft Divorce Deal and Its Fall-Out

Click for PDF 1. Negotiators for the European Union and the United Kingdom have agreed a 585-page draft withdrawal agreement (the “Withdrawal Agreement”).  A copy of the Withdrawal Agreement can be found here. 2. The draft Withdrawal Agreement sets out how and when the UK will leave the EU and will be legally binding.  A separate, non-binding draft declaration (available here) sets out the aspirations for the future trading relationship between the UK and EU (this draft declaration is still being negotiated, with the UK and EU expected to agree a final draft this week). 3. This long-awaited “divorce deal” has been agreed by the UK Government’s senior ministers (the Cabinet) but it now needs to be approved by MPs in the UK House of Commons and by the 27 other EU member states and the European Parliament. Next steps 4. An EU summit is currently due to be held on 25 November 2018, where EU 27 leaders are expected to sign off on the Withdrawal Agreement and the future relationship declaration. 5. Following the EU meeting the deal will be put to the House of Commons in the UK Parliament for a “meaningful vote”. It is not yet clear what the motion will be nor what amendments will be permitted.  But, for all practical purposes, it is a critical vote to approve the deal. 6. The House of Commons vote is expected around 7 December 2018 and at present it looks unlikely that the vote will be passed.  That could change if amendments are agreed to the Withdrawal Agreement or future relationship declaration. 7. If the House of Commons votes the deal down, the Government will have up to 21 days to put forward a new plan.  Any new agreement would need to be agreed with the EU. 8. Two of the key issues relate to (i) the circumstances in which the UK can withdraw from the transition arrangements and whether it can do so without an EU veto and (ii) whether Northern Ireland will have a different regulatory regime to the rest of the UK, creating a border down the Irish Sea.  “Backstop” arrangements are in place to prevent that happening but there is a lack of consensus over whether those arrangements are good enough.  The political debate in the UK is focused on whether improvements can be made to the provisions relating to these two issues in particular.  The EU position is that no changes of substance will be allowed but “some tweaking” of the language in the political declaration may be possible. Some of the EU 27 countries are also thought to be considering comments. 9. The UK Cabinet backed the divorce deal.  However, two cabinet ministers and two junior ministers subsequently resigned, including the Brexit secretary Dominic Raab.  New cabinet appointments have been made, including one Brexit supporter and one Remain supporter. 10. A number of leading backbench Conservative Party MPs have called for the Prime Minister to stand down, and are seeking to move for a vote of no confidence in her leadership of the Conservative Party.  A challenge is triggered if 15% of Conservative MPs (48 in total) write letters to the Party’s Chief Whip demanding a confidence vote.  As of today, at least 24 MPs have publicly confirmed they have submitted letters.  If a confidence vote is called, then it is passed if a simple majority of Conservative MPs vote in favour.  It is not clear that this will happen and, if Theresa May wins, the rules then prevent another vote of confidence for twelve months.  If she lost, there would be a separate process to elect a new leader but Theresa May, or a caretaker, would remain as Prime Minister until a new leader was elected. Content of Withdrawal Agreement 11. The UK is due to leave the EU at 11 pm on Friday 29 March 2019 (midnight CET on 30 March 2019).  The Withdrawal Agreement sets out the terms of the UK’s departure from the EU: Transition period: The Withdrawal Agreement proposes a 21-month transition period after the UK’s departure at the end of March 2019.  That end date can be extended once if more time is needed for a trade deal to be secured and to avoid the UK entering into the backstop (see below).  The draft Withdrawal Agreement does not yet give a specific end-date for this extension, stating only that it will end by “20xx”. Governance: During the transition period, and if the transition period is extended into a backstop, the UK will have to follow all EU rules and abide by Court of Justice of the European Union (CJEU) rulings.  Opponents argue this leaves the UK as a rule taker and no longer a rule maker. Financial arrangement: The Withdrawal Agreement does not specify the “divorce bill” but additional notes provided by the Government estimate a “fair financial settlement” of around £39 billion from the UK.  This covers financial liabilities accrued but not yet paid during the UK’s membership of the EU and payments to be made to the EU Budget during the transition period. Future trading relations: The Withdrawal Agreement does not include a trade deal, which will be hammered out in the transition period.  Under the Withdrawal Agreement, there will be a “single customs territory” until the end of the transition period on 31 December 2020.  The UK will then remain indefinitely in a customs union with the EU if a new trade agreement is not reached in that time.  This arrangement is intended to avoid a “hard border” between Northern Ireland and the Republic of Ireland – see below.  Among the political difficulties with this proposed arrangement is that a customs union is, along with the single market, essentially one of the key structures of the EU, and remaining in such a customs union is likely to be characterised as hollowing out the whole purpose of Brexit. Northern Ireland backstop: The management of the flow of goods and people across the Irish land border, and between Northern Ireland and the UK, have become critical issues in the Brexit debate and negotiations.  Both sides want to avoid a “hard border” (physical checks or infrastructure between Northern Ireland and Ireland), and a key part of the negotiations for the Withdrawal Agreement has been agreeing the position of last resort in the event that the UK leaves the EU without securing an all-encompassing deal (the so-called “backstop”).  The agreed backstop would involve Northern Ireland being in the same customs territory as the rest of the UK and the EU.  It would, however, mean different (EU) regulations for Northern Ireland in agriculture, the environment, state aid and other areas.  There would also be checks on goods traded from Northern Ireland to the rest of the UK.  The agreement states that the EU and the UK will use their “best endeavours” to come to a future trade agreement to avoid the backstop, and notes the transition period can also be extended.  While this arrangement can likely command the support of the other 27 EU member states, including, critically, the Republic of Ireland, the fact that it creates trade barriers, however technical, between Northern Ireland and Great Britain is likely to render it unacceptable to a large minority of Conservative MPs and to the DUP. Exiting the backstop: There will be no unilateral right of withdrawal from any backstop arrangement and Britain will not be able to implement free trade deals during this time.  It can request to pull out, but the final decision will rest with an independent arbitration panel with members nominated by both sides: two from the UK-side, two from the EU-side and one chairperson agreed by both parties. Immigration: EU nationals who have lived in the UK continually for five years, and UK citizens who have lived in EU countries, will have the right to stay permanently in the UK (or the EU, as the case may be), along with their family members.  Free movement of workers between the EU and UK will come to an end, although there will be visa-free travel to EU countries. Conclusion 12. Some UK business leaders and senior City figures have backed the deal as a significant breakthrough in Brexit negotiations.  If Brexit is to happen, many businesses will be pleased that the Withdrawal Agreement offers at least a foundation for moving forward.  Other commentators are critical of the “half-way house” set out in the Withdrawal Agreement and doubt whether Theresa May’s strategy can hold.  EU negotiations typically go right to the wire but the political state in the UK remains volatile while this plays out and there can be no certainty of outcome. This client alert was prepared by London partners Nicholas Aleksander, Patrick Doris and Charlie Geffen and of counsel Anne MacPherson. We have a working group in London (led by Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) addressing Brexit related issues.  Please feel free to contact any member of the working group or any of the other lawyers mentioned below. Ali Nikpay – Antitrust ANikpay@gibsondunn.com Tel: 020 7071 4273 Charlie Geffen – Corporate CGeffen@gibsondunn.com Tel: 020 7071 4225 Nicholas Aleksander – Tax NAleksander@gibsondunn.com Tel: 020 7071 4232 Philip Rocher – Litigation PRocher@gibsondunn.com Tel: 020 7071 4202 Jeffrey M. Trinklein – Tax JTrinklein@gibsondunn.com Tel: 020 7071 4224 Patrick Doris – Litigation; Data Protection PDoris@gibsondunn.com Tel:  020 7071 4276 Alan Samson – Real Estate ASamson@gibsondunn.com Tel:  020 7071 4222 Penny Madden QC – Arbitration PMadden@gibsondunn.com Tel:  020 7071 4226 Selina Sagayam – Corporate SSagayam@gibsondunn.com Tel:  020 7071 4263 Thomas M. Budd – Finance TBudd@gibsondunn.com Tel:  020 7071 4234 James A. Cox – Employment; Data Protection JCox@gibsondunn.com Tel: 020 7071 4250 Gregory A. Campbell – Restructuring GCampbell@gibsondunn.com Tel:  020 7071 4236 © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 15, 2018 |
SEC Announces First Enforcement Action Against Digital Token Platform as Unregistered Securities Exchange

Click for PDF On November 8, 2018, the U.S. Securities and Exchange Commission (SEC) announced that it had taken its first enforcement action against a digital “token” trading platform on the basis that the platform operated as an unregistered national securities exchange.  This action follows on a number of recent enforcement actions relating to unregistered broker-dealers and unregistered initial coin offerings (ICOs) and demonstrates that the SEC continues to be vigilant in the area of digital tokens. In its Order accepting an offer of settlement,[1] the SEC found that EtherDelta founder, Zachary Coburn, caused the EtherDelta platform to operate as an unregistered national securities exchange in violation of Section 5 of the Securities Exchange Act of 1934 (Exchange Act).  EtherDelta is an online platform that allows buyers and sellers to trade digital assets issued and distributed on the Ethereum Blockchain that use the standard coding protocol (ERC20) used by the majority of issuers in ICOs.  Coburn launched the website in July 2016; it made limited token pairs available for trading (particular tokens for Ether only) and displayed current top 500 firm bids and offers by symbol, price, and size.  Users could therefore enter orders to buy or sell specified quantities of a particular token at a specified Ether price and with a specified time-in-force. The SEC noted that in July 2017, it had issued its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 on The DAO (DAO Report).  The DAO Report had advised that if a platform offered the trading of digital assets that are securities and operates as an “exchange” under the federal securities laws, then it must register as an exchange or be able to claim an exemption from registration.  It further noted that 3.3  million buy and sell orders in ERC20 tokens were processed on EtherDelta between the issuance of the DAO Report and December 15, 2017.[2]  The EtherDelta platform was available to anyone, including U.S. persons, and had no limits on its hours of operation.  Certain of the tokens traded were securities within the meaning of the federal securities laws. The SEC further asserted that Coburn was responsible for performing due diligence on the tokens traded before those tokens were added to EtherDelta’s list of official token listings – a list that included approximately 500 tokens. Under Exchange Act Rule 3b-16(a), a platform will be considered to be an exchange if the platform “(1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.”[3]  If a platform is an exchange, it must register with the SEC or have an exemption, such as for an alternative trading system (ATS). The SEC stated that EtherDelta satisfied the Rule 3b-16(a) criteria in that it “receiv[ed] and stor[ed] orders in tokens in [its] order book and display[ed] the top 500 orders (including token symbol, size, and price) as bids and offers” on its website.  The platform was the means “for these orders to interact and execute through the combined use of the EtherDelta website, order book, and pre-programmed trading protocols” defined in the platform’s smart contract – which were “established, non-discretionary methods” within the meaning of Rule 3b-16(a).  In addition, certain of the tokens were securities under the Howey test:  purchasers invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others. Because EtherDelta did not register as a national securities exchange or operate pursuant to an exemption, it violated Section 5 of the Exchange Act.  Coburn, as the founder of EtherDelta, should have known that his actions would contribute to EtherDelta’s violations, and thus he caused EtherDelta’s violations within the meaning of Section 21C(a) of the Exchange Act. In settling the action, Coburn agreed to pay disgorgement of $300,000 plus prejudgment interest.  In addition, the SEC imposed a $75,000 civil money penalty.  The order notes that Coburn cooperated in the investigation and agreed to testify in any related enforcement action, suggesting that the civil money penalty would have been higher absent this co-operation. Conclusion The EtherDelta action demonstrates that the SEC continues to keep a watchful eye on ICO and token offerings, and that it believes that it put participants in these markets on notice when it issued the DAO Report in July 2017.  In addition, just as the order does not indicate precisely how many of the EtherDelta tokens were securities under the Howey test, it also does not contain any mention of the extent or quality of Coburn’s diligence under Howey – his civil money penalty appears to have been low due to his cooperation with the SEC alone.  The action is the first unregistered securities exchange action taken by the SEC, but it may well not be the last.  Given the continued vigilance of the SEC, it is to be expected that more and more firms will seek to buy or establish ATSs for token trading, because this exemption from registration as a national securities exchange is clearly available for tokens that are securities under Howey.    [1]   In the Matter of Zachary Coburn, Respondent (November 8, 2018), available at https://www.sec.gov/news/press-release/2018-258.    [2]   Coburn entered into an agreement to sell EtherDelta to non-U.S. buyers in November 2017.    [3]   17 C.F.R. § 240.3b-16(a) (emphasis added). The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Alan Bannister, Nicolas Dumont, Michael Mencher, and Jordan Garside. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions, Capital Markets or Securities Enforcement practice groups, or the following: Financial Institutions and Capital Markets Groups: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) J. Alan Bannister – New York (+1 212-351-2310, abannister@gibsondunn.com) Nicolas H.R. Dumont – New York (+1 212-351-3837, ndumont@gibsondunn.com) Stewart L. McDowell – San Francisco (+1 415-393-8322, smcdowell@gibsondunn.com) Michael A. Mencher – New York (+1 212-351-5309, mmencher@gibsondunn.com) Securities Enforcement Group: Marc J. Fagel – San Francisco (+1 415-393-8332, mfagel@gibsondunn.com) Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 30, 2018 |
Webcast: Spinning Out and Splitting Off – Navigating Complex Challenges in Corporate Separations

In the current strong market environment, spin-off deals have become a regular feature of the M&A landscape as strategic companies look for ways to maximize the value of various assets. Although the announcements have become routine, planning for and completing these transactions is a significant and multi-disciplinary undertaking. By its nature, a spin-off is at least a 3-in-1 transaction starting with the reorganization and carveout of the assets to be separated, followed by the negotiation of separation-related documents and finally the offering of the securities—and that does not even account for the significant tax, corporate governance, finance, IP and employee benefits aspects of the transaction. In this program, a panel of lawyers from a number of these key practice areas provided insights based on their recent experience structuring and executing spin-off transactions. They walked through the hot topics, common issues and potential work-arounds. View Slides (PDF) PANELISTS: Daniel Angel is a partner in Gibson Dunn’s New York office, Co-Chair of the firm’s Technology Transactions Practice Group and a member of its Strategic Sourcing and Commercial Transactions Practice Group. He is a transactional attorney who has represented clients on technology-related transactions since 2003. Mr. Angel has worked with a broad variety of clients ranging from market leaders to start-ups in a wide range of industries including financial services, private equity funds, life sciences, specialty chemicals, insurance, energy and telecommunications. Michael J. Collins is a partner in Gibson Dunn’s Washington, D.C. office and Co-Chair of the Executive Compensation and Employee Benefits Practice Group. His practice focuses on all aspects of employee benefits and executive compensation. He represents buyers and sellers in corporate transactions and companies in drafting and negotiating employment and equity compensation arrangements. Andrew L. Fabens is a partner in Gibson Dunn’s New York office, Co-Chair of the firm’s Capital Markets Practice Group and a member of the firm’s Securities Regulation and Corporate Governance Practice Group. Mr. Fabens advises companies on long-term and strategic capital planning, disclosure and reporting obligations under U.S. federal securities laws, corporate governance issues and stock exchange listing obligations. He represents issuers and underwriters in public and private corporate finance transactions, both in the United States and internationally. Stephen I. Glover is a partner in Gibson Dunn’s Washington, D.C. office and Co-Chair of the firm’s Mergers and Acquisitions Practice Group. Mr. Glover has an extensive practice representing public and private companies in complex mergers and acquisitions, including spin-offs and related transactions, as well as other corporate matters. Mr. Glover’s clients include large public corporations, emerging growth companies and middle market companies in a wide range of industries. He also advises private equity firms, individual investors and others. Elizabeth A. Ising is a partner in Gibson Dunn’s Washington, D.C. office, Co-Chair of the firm’s Securities Regulation and Corporate Governance Practice Group and a member of the firm’s Hostile M&A and Shareholder Activism team and Financial Institutions Practice Group. She advises clients, including public companies and their boards of directors, on corporate governance, securities law and regulatory matters and executive compensation best practices and disclosures. Saee Muzumdar is a partner in Gibson Dunn’s New York office and a member of the firm’s Mergers and Acquisitions Practice Group. Ms. Muzumdar is a corporate transactional lawyer whose practice includes representing both strategic companies and private equity clients (including their portfolio companies) in connection with all aspects of their domestic and cross-border M&A activities and general corporate counseling. Daniel A. Zygielbaum is an associate in Gibson Dunn’s Washington, D.C. office and a member of the firm’s Tax and Real Estate Investment Trust (REIT) Practice Groups. Mr. Zygielbaum’s practice focuses on international and domestic taxation of corporations, partnerships (including private equity funds), limited liability companies, REITs and their debt and equity investors. He advises clients on tax planning for fund formations and corporate and real estate acquisitions, dispositions, reorganizations and joint ventures. MCLE CREDIT INFORMATION: This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.50 credit hours, of which 1.50 credit hours may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit. Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact Jeanine McKeown (National Training Administrator), at 213-229-7140 or jmckeown@gibsondunn.com to request the MCLE form. This program has been approved for credit in accordance with the requirements of the Texas State Bar for a maximum of 1.50 credit hours, of which 1.50 credit hour may be applied toward the area of accredited general requirement. Attorneys seeking Texas credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact Jeanine McKeown (National Training Administrator), at 213-229-7140 or jmckeown@gibsondunn.com to request the MCLE form. Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.50 hours. California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

October 22, 2018 |
IRS Provides Much Needed Guidance on Opportunity Zones through Issuance of Proposed Regulations

Click for PDF On October 19, 2018, the Internal Revenue Service (the “IRS“) and the Treasury Department issued proposed regulations (the “Proposed Regulations“) providing rules regarding the establishment and operation of “qualified opportunity funds” and their investment in “opportunity zones.”[1]  The Proposed Regulations address many open questions with respect to qualified opportunity funds, while expressly providing in the preamble that additional guidance will be forthcoming to address issues not resolved by the Proposed Regulations.  The Proposed Regulations should provide investors, sponsors and developers with the answers needed to move forward with projects in opportunity zones. Opportunity Zones Qualified opportunity funds were created as part of the tax law signed into law in December 2017 (commonly known as the Tax Cuts and Jobs Act (“TCJA“)) to incentivize private investment in economically underperforming areas by providing tax benefits for investments through qualified opportunity funds in opportunity zones.  Opportunity zones are low-income communities that were designated by each of the States as qualified opportunity zones – as of this writing, all opportunity zones have been designated, and each designation remains in effect from the date of designation until the end of the tenth year after such designation. Investments in qualified opportunity funds can qualify for three principal tax benefits: (i) a temporary deferral of capital gains that are reinvested in a qualified opportunity fund, (ii) a partial exclusion of those reinvested capital gains on a sliding scale and (iii) a permanent exclusion of all gains realized on an investment in a qualified opportunity fund that is held for a ten-year period. In general, all capital gains realized by a person that are reinvested within 180 days of the recognition of such gain in a qualified opportunity fund for which an election is made are deferred for U.S. federal income tax purposes until the earlier of (i) the date on which such investment is sold or exchanged and (ii) December 31, 2026. In addition, an investor’s tax basis in a qualified opportunity fund for purposes of determining gain or loss, is increased by 10 percent of the amount of gain deferred if the investment is held for five years prior to December 31, 2026 and is increased by an additional 5 percent (for a total increase of 15 percent) of the amount of gain deferred if the investment is held for seven years prior to December 31, 2026. Finally, for investments in a qualified opportunity fund that are attributable to reinvested capital gains and held for at least 10 years, the basis of such investment is increased to the fair market value of the investment on the date of the sale or exchange of such investment, effectively eliminating any gain (other than the deferred gain that was reinvested in the qualified opportunity fund and taxable or excluded as described above) in the investment for U.S. federal income tax purposes (such benefit, the “Ten Year Benefit“). A qualified opportunity fund, in general terms, is a corporation or partnership that invests at least 90 percent of its assets in “qualified opportunity zone property,” which is defined under the TCJA as “qualified opportunity zone business property,” “qualified opportunity zone stock” and “qualified opportunity zone partnership interests.”  Qualified opportunity zone business property is tangible property used in a trade or business within an opportunity zone if, among other requirements, (i) the property is acquired by the qualified opportunity fund by purchase, after December 31, 2017, from an unrelated person, (ii) either the original use of the property in the opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund “substantially improves” the property by doubling the basis of the property over any 30 month period after the property is acquired and (iii) substantially all of the use of the property is within an opportunity zone.  Essentially, qualified opportunity zone stock and qualified opportunity zone partnership interests are stock or interests in a corporation or partnership acquired in a primary issuance for cash after December 31, 2017 and where “substantially all” of the tangible property, whether leased or owned, of the corporation or partnership is qualified opportunity zone business property. The Proposed Regulations – Summary and Observations The powerful tax incentives provided by opportunity zones attracted substantial interest from investors and the real estate community, but many unresolved questions have prevented some taxpayers from availing themselves of the benefits of the law.  A few highlights from the Proposed Regulations, as well as certain issues that were not resolved, are outlined below. Capital Gains The language of the TCJA left open the possibility that both capital gains and ordinary gains (e.g., dealer income) could qualify for deferral if invested in a qualified opportunity fund.  The Proposed Regulations provide that only capital gains, whether short-term or long-term, qualify for deferral if invested in a qualified opportunity fund and further provide that when recognized, any deferred gain will retain its original character as short-term or long-term. Taxpayer Entitled to Deferral The Proposed Regulations make clear that if a partnership recognizes capital gains, then the partnership, and if the partnership does not so elect, the partners, may elect to defer such capital gains.  In addition, the Proposed Regulations provide that in measuring the 180-day period by which capital gains need to be invested in a qualified opportunity fund, the 180-day period for a partner begins on the last day of the partnership’s taxable year in which the gain is recognized, or if a partner elects, the date the partnership recognized the gain.  The Proposed Regulations also state that rules analogous to the partnership rules apply to other pass-through entities, such as S corporations. Ten Year Benefit The Ten Year Benefit attributable to investments in qualified opportunity funds will be realized only if the investment is held for 10 years.  Because all designations of qualified opportunity zones under the TCJA automatically expire no later than December 31, 2028, there was some uncertainly as to whether the Ten Year Benefit applied to investments disposed of after that date.  The Proposed Regulations expressly provide that the Ten Year Benefit rule applies to investments disposed of prior to January 1, 2048. Qualified Opportunity Funds The Proposed Regulations generally provide that a qualified opportunity fund is required to be classified as a corporation or partnership for U.S. federal income tax purposes, must be created or organized in one of the 50 States, the District of Columbia, or, in certain cases a U.S. possession, and will be entitled to self-certify its qualification to be a qualified opportunity fund on an IRS Form 8996, a draft form of which was issued contemporaneously with the issuance of the Proposed Regulations. Substantial Improvements Existing buildings in qualified opportunity zones generally will qualify as qualified opportunity zone business property only if the building is substantially improved, which requires the tax basis of the building to be doubled in any 30-month period after the property is acquired.  In very helpful rule for the real estate community, the Proposed Regulations provide that, in determining whether a building has been substantially improved, any basis attributable to land will not be taken into account.  This rule will allow major renovation projects to qualify for qualified opportunity zone tax benefits, rather than just ground up development.  This rule will also place a premium on taxpayers’ ability to sustain a challenge to an allocation of purchase price to land versus improvements. Ownership of Qualified Opportunity Zone Business Property In order for a fund to qualify as a qualified opportunity fund, at least 90 percent of the fund’s assets must be invested in qualified opportunity zone property, which includes qualified opportunity zone business property.  For shares or interests in a corporation or partnership to qualify as qualified opportunity zone stock or a qualified opportunity zone partnership interest, “substantially all” of the corporation’s or partnership’s assets must be comprised of qualified opportunity zone business property. In a very helpful rule, the Proposed Regulations provide that cash and other working capital assets held for up to 31 months will count as qualified opportunity zone business property, so long as (i) the cash and other working capital assets are held for the acquisition, construction and/or or substantial improvement of tangible property in an opportunity zone, (ii) there is a written plan that identifies the cash and other working capital as held for such purposes, and (iii) the cash and other working capital assets are expended in a manner substantially consistent with that plan. In addition, the Proposed Regulations provide that for purposes of determining whether “substantially all” of a corporation’s or partnership’s tangible property is qualified opportunity zone business property, only 70 percent of the tangible property owned or leased by the corporation or partnership in its trade or business must be qualified opportunity zone business property. Qualified Opportunity Funds Organized as Tax Partnerships Under general partnership tax principles, when a partnership borrows money, the partners are treated as contributing money to the partnership for purposes of determining their tax basis in their partnership interest.  As a result of this rule, there was uncertainty regarding whether investments by a qualified opportunity fund that were funded with debt would result in a partner being treated, in respect of the deemed contribution of money attributable to such debt, as making a contribution to the partnership that was not in respect of reinvested capital gains and, thus, resulting in a portion of such partner’s investment in the qualified opportunity fund failing to qualify for the Ten Year Benefit.  The Proposed Regulations expressly provide that debt incurred by a qualified opportunity fund will not impact the portion of a partner’s investment in the qualified opportunity fund that qualifies for the Ten Year Benefit. The Proposed Regulations did not address many of the other open issues with respect to qualified opportunity funds organized as partnerships, including whether investors are treated as having sold a portion of their interest in a qualified opportunity fund and thus can enjoy the Ten Year Benefit if a qualified opportunity fund treated as a partnership and holding multiple investments disposes of one or more (but not all) of its investments.  Accordingly, until further guidance is issued, we expect to see most qualified opportunity funds organized as single asset corporations or partnerships. Effective Date In general, taxpayers are permitted to rely upon the Proposed Regulations so long as they apply the Proposed Regulations in their entirety and in a consistent manner.    [1]   Prop. Treas. Reg. §1.1400Z-2 (REG-115420-18). Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or the following authors: Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com) Paul S. Issler – Los Angeles (+1 213-229-7763, pissler@gibsondunn.com) Daniel A. Zygielbaum – New York (+1 202-887-3768, dzygielbaum@gibsondunn.com) Please also feel free to contact any of the following leaders and members of the Tax practice group: Jeffrey M. Trinklein – Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com) David Sinak – Co-Chair, Dallas (+1 214-698-3107, dsinak@gibsondunn.com) David B. Rosenauer – New York (+1 212-351-3853, drosenauer@gibsondunn.com) Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com) Romina Weiss – New York (+1 212-351-3929, rweiss@gibsondunn.com) Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com) Hatef Behnia – Los Angeles (+1 213-229-7534, hbehnia@gibsondunn.com) Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com) Scott Knutson – Orange County (+1 949-451-3961, sknutson@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 17, 2018 |
SEC Warns Public Companies on Cyber-Fraud Controls

Click for PDF On October 16, 2018, the Securities and Exchange Commission issued a report warning public companies about the importance of internal controls to prevent cyber fraud.  The report described the SEC Division of Enforcement’s investigation of multiple public companies which had collectively lost nearly $100 million in a range of cyber-scams typically involving phony emails requesting payments to vendors or corporate executives.[1] Although these types of cyber-crimes are common, the Enforcement Division notably investigated whether the failure of the companies’ internal accounting controls to prevent unauthorized payments violated the federal securities laws.  The SEC ultimately declined to pursue enforcement actions, but nonetheless issued a report cautioning public companies about the importance of devising and maintaining a system of internal accounting controls sufficient to protect company assets. While the SEC has previously addressed the need for public companies to promptly disclose cybersecurity incidents, the new report sees the agency wading into corporate controls designed to mitigate such risks.  The report encourages companies to calibrate existing internal controls, and related personnel training, to ensure they are responsive to emerging cyber threats.  The report (issued to coincide with National Cybersecurity Awareness Month) clearly intends to warn public companies that future investigations may result in enforcement action. The Report of Investigation Section 21(a) of the Securities Exchange Act of 1934 empowers the SEC to issue a public Report of Investigation where deemed appropriate.  While SEC investigations are confidential unless and until the SEC files an enforcement action alleging that an individual or entity has violated the federal securities laws, Section 21(a) reports provide a vehicle to publicize investigative findings even where no enforcement action is pursued.  Such reports are used sparingly, perhaps every few years, typically to address emerging issues where the interpretation of the federal securities laws may be uncertain.  (For instance, recent Section 21(a) reports have addressed the treatment of digital tokens as securities and the use of social media to disseminate material corporate information.) The October 16 report details the Enforcement Division’s investigations into the internal accounting controls of nine issuers, across multiple industries, that were victims of cyber-scams. The Division identified two specific types of cyber-fraud – typically referred to as business email compromises or “BECs” – that had been perpetrated.  The first involved emails from persons claiming to be unaffiliated corporate executives, typically sent to finance personnel directing them to wire large sums of money to a foreign bank account for time-sensitive deals. These were often unsophisticated operations, textbook fakes that included urgent, secret requests, unusual foreign transactions, and spelling and grammatical errors. The second type of business email compromises were harder to detect. Perpetrators hacked real vendors’ accounts and sent invoices and requests for payments that appeared to be for otherwise legitimate transactions. As a result, issuers made payments on outstanding invoices to foreign accounts controlled by impersonators rather than their real vendors, often learning of the scam only when the legitimate vendor inquired into delinquent bills. According to the SEC, both types of frauds often succeeded, at least in part, because responsible personnel failed to understand their company’s existing cybersecurity controls or to appropriately question the veracity of the emails.  The SEC explained that the frauds themselves were not sophisticated in design or in their use of technology; rather, they relied on “weaknesses in policies and procedures and human vulnerabilities that rendered the control environment ineffective.” SEC Cyber-Fraud Guidance Cybersecurity has been a high priority for the SEC dating back several years. The SEC has pursued a number of enforcement actions against registered securities firms arising out of data breaches or deficient controls.  For example, just last month the SEC brought a settled action against a broker-dealer/investment-adviser which suffered a cyber-intrusion that had allegedly compromised the personal information of thousands of customers.  The SEC alleged that the firm had failed to comply with securities regulations governing the safeguarding of customer information, including the Identity Theft Red Flags Rule.[2] The SEC has been less aggressive in pursuing cybersecurity-related actions against public companies.  However, earlier this year, the SEC brought its first enforcement action against a public company for alleged delays in its disclosure of a large-scale data breach.[3] But such enforcement actions put the SEC in the difficult position of weighing charges against companies which are themselves victims of a crime.  The SEC has thus tried to be measured in its approach to such actions, turning to speeches and public guidance rather than a large number of enforcement actions.  (Indeed, the SEC has had to make the embarrassing disclosure that its own EDGAR online filing system had been hacked and sensitive information compromised.[4]) Hence, in February 2018, the SEC issued interpretive guidance for public companies regarding the disclosure of cybersecurity risks and incidents.[5]  Among other things, the guidance counseled the timely public disclosure of material data breaches, recognizing that such disclosures need not compromise the company’s cybersecurity efforts.  The guidance further discussed the need to maintain effective disclosure controls and procedures.  However, the February guidance did not address specific controls to prevent cyber incidents in the first place. The new Report of Investigation takes the additional step of addressing not just corporate disclosures of cyber incidents, but the procedures companies are expected to maintain in order to prevent these breaches from occurring.  The SEC noted that the internal controls provisions of the federal securities laws are not new, and based its report largely on the controls set forth in Section 13(b)(2)(B) of the Exchange Act.  But the SEC emphasized that such controls must be “attuned to this kind of cyber-related fraud, as well as the critical role training plays in implementing controls that serve their purpose and protect assets in compliance with the federal securities laws.”  The report noted that the issuers under investigation had procedures in place to authorize and process payment requests, yet were still victimized, at least in part “because the responsible personnel did not sufficiently understand the company’s existing controls or did not recognize indications in the emailed instructions that those communications lacked reliability.” The SEC concluded that public companies’ “internal accounting controls may need to be reassessed in light of emerging risks, including risks arising from cyber-related frauds” and “must calibrate their internal accounting controls to the current risk environment.” Unfortunately, the vagueness of such guidance leaves the burden on companies to determine how best to address emerging risks.  Whether a company’s controls are adequate may be judged in hindsight by the Enforcement Division; not surprisingly, companies and individuals under investigation often find the staff asserting that, if the controls did not prevent the misconduct, they were by definition inadequate.  Here, the SEC took a cautious approach in issuing a Section 21(a) report highlighting the risk rather than publicly identifying and penalizing the companies which had already been victimized by these scams. However, companies and their advisors should assume that, with this warning shot across the bow, the next investigation of a similar incident may result in more serious action.  Persons responsible for designing and maintaining the company’s internal controls should consider whether improvements (such as enhanced trainings) are warranted; having now spoken on the issue, the Enforcement Division is likely to view corporate inaction as a factor in how it assesses the company’s liability for future data breaches and cyber-frauds.    [1]   SEC Press Release (Oct. 16, 2018), available at www.sec.gov/news/press-release/2018-236; the underlying report may be found at www.sec.gov/litigation/investreport/34-84429.pdf.    [2]   SEC Press Release (Sept. 16, 2018), available at www.sec.gov/news/press-release/2018-213.  This enforcement action was particularly notable as the first occasion the SEC relied upon the rules requiring financial advisory firms to maintain a robust program for preventing identify theft, thus emphasizing the significance of those rules.    [3]   SEC Press Release (Apr. 24, 2018), available at www.sec.gov/news/press-release/2018-71.    [4]   SEC Press Release (Oct. 2, 2017), available at www.sec.gov/news/press-release/2017-186.    [5]   SEC Press Release (Feb. 21, 2018), available at www.sec.gov/news/press-release/2018-22; the guidance itself can be found at www.sec.gov/rules/interp/2018/33-10459.pdf.  The SEC provided in-depth guidance in this release on disclosure processes and considerations related to cybersecurity risks and incidents, and complements some of the points highlighted in the Section 21A report. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Securities Enforcement or Privacy, Cybersecurity and Consumer Protection practice groups, or the following authors: Marc J. Fagel – San Francisco (+1 415-393-8332, mfagel@gibsondunn.com) Alexander H. Southwell – New York (+1 212-351-3981, asouthwell@gibsondunn.com) Please also feel free to contact the following practice leaders and members: Securities Enforcement Group: New York Barry R. Goldsmith – Co-Chair (+1 212-351-2440, bgoldsmith@gibsondunn.com) Mark K. Schonfeld – Co-Chair (+1 212-351-2433, mschonfeld@gibsondunn.com) Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com) Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (+1 212-351-3824, ldunst@gibsondunn.com) Laura Kathryn O’Boyle (+1 212-351-2304, loboyle@gibsondunn.com) Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com) Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com) Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com) Washington, D.C. Richard W. Grime – Co-Chair (+1 202-955-8219, rgrime@gibsondunn.com) Stephanie L. Brooker  (+1 202-887-3502, sbrooker@gibsondunn.com) Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com) Stuart F. Delery (+1 202-887-3650, sdelery@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) San Francisco Marc J. Fagel – Co-Chair (+1 415-393-8332, mfagel@gibsondunn.com) Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com) Thad A. Davis (+1 415-393-8251, tdavis@gibsondunn.com) Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com) Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com) Palo Alto Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com) Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com) Denver Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com) Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com) Los Angeles Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com) Privacy, Cybersecurity and Consumer Protection Group: Alexander H. Southwell – Co-Chair, New York (+1 212-351-3981, asouthwell@gibsondunn.com) M. Sean Royall – Dallas (+1 214-698-3256, sroyall@gibsondunn.com) Debra Wong Yang – Los Angeles (+1 213-229-7472, dwongyang@gibsondunn.com) Christopher Chorba – Los Angeles (+1 213-229-7396, cchorba@gibsondunn.com) Richard H. Cunningham – Denver (+1 303-298-5752, rhcunningham@gibsondunn.com) Howard S. Hogan – Washington, D.C. (+1 202-887-3640, hhogan@gibsondunn.com) Joshua A. Jessen – Orange County/Palo Alto (+1 949-451-4114/+1 650-849-5375, jjessen@gibsondunn.com) Kristin A. Linsley – San Francisco (+1 415-393-8395, klinsley@gibsondunn.com) H. Mark Lyon – Palo Alto (+1 650-849-5307, mlyon@gibsondunn.com) Shaalu Mehra – Palo Alto (+1 650-849-5282, smehra@gibsondunn.com) Karl G. Nelson – Dallas (+1 214-698-3203, knelson@gibsondunn.com) Eric D. Vandevelde – Los Angeles (+1 213-229-7186, evandevelde@gibsondunn.com) Benjamin B. Wagner – Palo Alto (+1 650-849-5395, bwagner@gibsondunn.com) Michael Li-Ming Wong – San Francisco/Palo Alto (+1 415-393-8333/+1 650-849-5393, mwong@gibsondunn.com) Ryan T. Bergsieker – Denver (+1 303-298-5774, rbergsieker@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 11, 2018 |
Financing Arrangements and Documentation: Considerations Ahead of Brexit

Click for PDF Since the result of the Brexit referendum was announced in June 2016, there has been significant commentary regarding the potential effects of the UK’s withdrawal from the EU on the financial services industry. As long as the UK is negotiating its exit terms, a number of conceptual questions facing the sector still remain, such as market regulation and bank passporting. Many commentators have speculated from a ‘big picture’ perspective what the consequences will be if / when exit terms are agreed.  From a contractual perspective, the situation is nuanced. This article will consider certain areas within English law financing documentation which may or may not need to be addressed. Bank passporting The EU “passporting” regime has been the subject of much commentary since the result of the Brexit referendum.  In short, in some EU member states, lenders are required under domestic legislation to have licences to lend.  Many UK lenders have relied on EU passporting (currently provided for in MiFID II), which allows them to lend into EU member states simply by virtue of being regulated in the UK (and vice versa). The importance for the economy of the passporting regime is clear. Unless appropriate transitional arrangements are put in place to ensure that the underlying principle survives, however, there is a risk that following Brexit passporting could be lost.  Recent materials produced by the UK Government suggest that the loss of passporting may be postponed from March 2019 until the end of 2020, although financial institutions must still consider what will happen after 2020 if no replacement regime is agreed.  The UK Government has committed to legislate (if required) to put in place a temporary recognition regime to allow EU member states to continue their financial services in the UK for a limited time (assuming there is a “no deal” scenario and no agreed transition period). However, there has not to date been a commitment from the EU to agree to a mirror regime. Depending on the outcome of negotiations on passporting, financial institutions will need to consider the regulatory position in relation to the performance of their underlying financial service, whether that is: lending, issuance of letters of credit / guarantees, provision of bank accounts or other financial products, or performing agency / security agency roles. Financial institutions may need to look to transfer their participations to an appropriately licensed affiliate (if possible) or third party, change the branch through which it acts, resign from agency or account bank functions, and/or exit the underlying transaction using the illegality protections (although, determining what is “unlawful” for these purposes in terms of a lender being able to fund or maintain a loan will be a complex legal and factual analysis).  More generally, we expect these provisions to be the subject of increasing scrutiny, although there seems to be limited scope for lenders to move illegality provisions in their favour and away from an actual, objective illegality requirement, owing to long-standing commercial convention. From a documentary perspective, it will be necessary to analyse loan agreements individually to determine whether any provisions are invoked and/or breached, and/or any amendments are required.  For on-going structuring, it may be appropriate for facilities to be tranched – such tranches (to the extent the drawing requirements of international obligor group can be accurately determined ahead of time) being “ring-fenced”, with proportions of a facility made available to different members of the borrower group and to be participated in by different lenders – or otherwise structured in an alternative, inventive manner – for example, by “fronting” the facility with a single, adequately regulated lender with back-to-back lending mechanics (e.g. sub-participation) standing behind.  In the same way, we also expect that lenders will exert greater control – for example by requiring all lender consent in all instances – on the accession of additional members of the borrowing group to existing lending arrangements in an attempt to diversify the lending jurisdictions.  Derivatives If passporting rights are lost and transitional relief is not in place, this could have a significant impact on the derivatives markets.  Indeed, without specific transitional or equivalence agreements in place between the EU and the UK, market participants may not be able to use UK clearing houses to clear derivatives subject to mandatory clearing under EMIR.  Additionally, derivatives executed on UK exchanges could be viewed as “OTC derivatives” under EMIR and would therefore be counted towards the clearing thresholds under EMIR.  Further, derivatives lifecycle events (such as novations, amendments and portfolio compressions) could be viewed as regulated activities thereby raising questions about enforceability and additional regulatory restrictions and requirements. In addition to issues arising between EU and UK counterparties, equivalence agreements in the derivatives space between the EU and other jurisdictions, such as the United States, would not carry over to the UK.  Accordingly, the UK must put in place similar equivalence agreements with such jurisdictions or market participants trading with UK firms could be at a disadvantage compared to those trading with EU firms. As a result of the uncertainty around Brexit and the risk that passporting rights are likely to be lost, certain counterparties are considering whether to novate their outstanding derivatives with UK derivatives entities to EU derivatives entities ahead of the exit date.  Novating derivatives portfolios from a UK to an EU counterparty is a significant undertaking involving re-documentation, obtaining consents, reviewing existing documentation, identifying appropriate counterparties, etc. EU legislation and case law Loan agreements often contain references to EU legislation or case law and, therefore, it is necessary to consider whether amendments are required. One particular area to be considered within financing documentation is the inclusion of Article 55 Bail-In language[1].  In the last few years, Bail-In clauses have become common place in financing documentation, although they are only required for documents which are governed by the laws of a non-EEA country and where there is potential liability under that document for an EEA-incorporated credit institution or investment firm and their relevant affiliates, respectively.  Following withdrawal from the EU, the United Kingdom will (subject to any transitional or other agreed arrangements) cease to be a member of the EEA and therefore English law governed contracts containing in-scope liabilities of EU financial institutions may become subject to the requirements of Article 55.  Depending on the status of withdrawal negotiations as we head closer to March 2019, it may be appropriate as a precautionary measure to include Bail-In clauses ahead of time – however, this analysis is very fact specific, and will need to be carefully considered on a case-by-case basis. Governing law and jurisdiction Although EU law is now pervasive throughout the English legal system, English commercial contract law is, for the most part, untouched by EU law and therefore withdrawal from the EU is expected to have little or no impact.  Further, given that EU member states are required to give effect to the parties’ choice of law (regardless of whether that law is the law of an EU member state or another state)[2], the courts of EU member states will continue to give effect to English law in the same way they do currently.  Many loan agreements customarily include ‘one-way’ jurisdiction clauses which limit borrowers/obligors to bringing proceedings in the English courts (rather than having the flexibility to bring proceedings in any court of competent jurisdiction). This allows lenders to benefit from the perceived competency and commerciality of the English courts as regards disputes in the financial sector. Regardless of the outcome of the Brexit negotiations, such clauses  are likely to remain unchanged due to the experience of English judges in handling such disputes and the certainty of the common law system. It is possible that the UK’s withdrawal will impact the extent to which a judgement of the English courts will be enforceable in other EU member states.  Currently, an English judgement is enforceable in all other EU member states pursuant to EU legislation[3].  However, depending on the withdrawal terms agreed with the EU, the heart of this regulation may or may not be preserved. In other words, English judgements could be in the same position to that of, for example, judgements of the New York courts, where enforceability is dependent upon the underlying law of the relevant EU member state; or, an agreement could be reached for automatic recognition of English judgements across EU member states.  In the same vein, the UK’s withdrawal could also impact the enforcement in the UK of judgements of the courts of the remaining EU member states. Conclusion Just six months ahead of the UK’s 29 March 2019 exit date, there remains no agreed legal position as regards the terms of the UK’s withdrawal from the EU. It is clear that, for so long as such impasse remains, the contractual ramifications will continue to be fluid and the subject of discussion.  However, what is apparent is that the financial services sector, and financing arrangements more generally, are heavily impacted and it will be incumbent upon contracting parties, and their lawyers, to consider the relevant terms, consequences and solutions at the appropriate time. [1]   Article 55 of the Bank Resolution and Recovery Directive [2]   Rome I Regulation [3]   Brussels I regulation. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Global Finance practice group, or the authors: Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alex Hillback – Dubai (+971 (0)4 318 4626, ahillback@gibsondunn.com) Please also feel free to contact the following leaders and members of the Global Finance and Financial Institutions practice groups: Global Finance Group: Thomas M. Budd – London (+44 (0)20 7071 4234, tbudd@gibsondunn.com) Gregory A. Campbell – London (+44 (0)20 7071 4236, gcampbell@gibsondunn.com) Richard Ernest – Dubai (+971 (0)4 318 4639, rernest@gibsondunn.com) Jamie Thomas – Singapore (+65 6507 3609, jthomas@gibsondunn.com) Michael Nicklin – Hong Kong (+852 2214 3809, mnicklin@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213 229 7582, lcurtis@gibsondunn.com) Aaron F. Adams – New York (+1 212 351 2494, afadams@gibsondunn.com) Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 10, 2018 |
Why We Think the UK Is Heading for a “Soft Brexit”

Click for PDF Our discussions with politicians, civil servants, journalists and other commentators lead us to believe that the most likely outcome of the Brexit negotiations is that a deal will be agreed at the “softer” end of the spectrum, that the Conservative Government will survive and that Theresa May will remain as Prime Minister at least until a Brexit deal is agreed (although perhaps not thereafter).  There is certainly a risk of a chaotic or “hard” Brexit.  On the EU side, September’s summit in Salzburg demonstrated the possibility of unexpected outcomes.  And in the UK, the splits in the ruling Conservative Party and the support it relies upon from the DUP (the Northern Irish party that supports the Government) could in theory result in the ousting of Prime Minister May, which would likely lead to an extension of the Brexit deadline of 29 March 2019.  However, for the reasons set out below we believe a hard or chaotic Brexit is now less likely than more likely. Some background to the negotiations can be found here.  It should be noted that any legally binding deal will be limited to the terms of the UK’s departure from the EU (“the Withdrawal Agreement”) and will not cover the future trading relationship.  But there will be a political statement of intent on the future trading relationship (“the Future Framework”) that will then be subject to further detailed negotiation. There is a European Council meeting on 17/18 October although it is not expected that a final agreement will be reached by then.  However, the current expectation is that a special meeting of the European Council will take place in November (probably over a weekend) to finalise both the Withdrawal Agreement and the Future Framework. Whatever deal Theresa May finally agrees with the EU needs to be approved by the UK Parliament.  A debate and vote will likely take place within two or three weeks of a deal being agreed – so late November or early December.  If Parliament rejects the deal the perceived wisdom is that the ensuing political crisis could only be resolved either by another referendum or a general election. However: the strongest Brexiteers do not want to risk a second referendum in case they lose; the ruling Conservative Party do not want to risk a general election which may result in it losing power and Jeremy Corbyn becoming Prime Minister; and Parliament is unlikely to allow the UK to leave without a deal. As a result we believe that Prime Minister May has more flexibility to compromise with the EU than the political noise would suggest and that, however much they dislike the eventual deal, ardent Brexiteers will likely support it in Parliament.  This is because it will mean the UK has formally left the EU and the Brexiteers live to fight another day. The UK’s current proposal (the so-called “Chequers Proposal”) is likely to be diluted further in favour of the EU, but as long as the final deal results in a formal departure of the UK from the EU in March 2019, we believe Parliament is more likely than not to support it, however unsatisfactory it is to the Brexiteers. The key battleground is whether the UK should remain in a Customs Union beyond a long stop date for a transitional period.  The UK Government proposes a free trade agreement in goods but not services, with restrictions on free movement and the ability for the UK to strike its own free trade deals.  This has been rejected by the EU on the grounds that it seeks to separate services from goods which is inconsistent with the single market and breaches one of the fundamental EU principles of free movement of people.  The Chequers Proposal is unlikely to survive in its current form but the EU has acknowledged that it creates the basis for the start of a negotiation. There has also been discussion of a “Canada style” free-trade agreement, which is supported by the ardent Brexiteers but rejected by the UK Government because it would require checks on goods travelling across borders.  This would create a “hard border” in Northern Ireland which breaches the Good Friday Agreement and would not be accepted by any of the major UK political parties or the EU.  The consequential friction at the borders is also unattractive to businesses that operate on a “just in time” basis – particularly the car manufacturers.  The EU has suggested there could instead be regulatory alignment between Northern Ireland and the EU, but this has been accepted as unworkable because it would create a split within the UK and is unacceptable to the DUP, the Northern Ireland party whose support of the Conservatives in Parliament is critical to their survival.  This is the area of greatest risk but it remains the case that a “no deal” scenario would guarantee a hard border in Ireland. If no deal is reached by 21 January 2019 the Prime Minister is required to make a statement to MPs.  The Government would then have 14 days to decide how to proceed, and the House of Commons would be given the opportunity to vote on these alternate plans.  Although any motion to reject the Government’s proposal would not be legally binding, it would very likely catalyse the opposition and lead to an early general election or a second referendum.  In any of those circumstances, the EU has already signalled that it would be prepared to grant an extension to the Article 50 period. This client alert was prepared by London partners Charlie Geffen and Nicholas Aleksander and of counsel Anne MacPherson. We have a working group in London (led by Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) addressing Brexit related issues.  Please feel free to contact any member of the working group or any of the other lawyers mentioned below. Ali Nikpay – Antitrust ANikpay@gibsondunn.com Tel: 020 7071 4273 Charlie Geffen – Corporate CGeffen@gibsondunn.com Tel: 020 7071 4225 Nicholas Aleksander – Tax NAleksander@gibsondunn.com Tel: 020 7071 4232 Philip Rocher – Litigation PRocher@gibsondunn.com Tel: 020 7071 4202 Jeffrey M. Trinklein – Tax JTrinklein@gibsondunn.com Tel: 020 7071 4224 Patrick Doris – Litigation; Data Protection PDoris@gibsondunn.com Tel:  020 7071 4276 Alan Samson – Real Estate ASamson@gibsondunn.com Tel:  020 7071 4222 Penny Madden QC – Arbitration PMadden@gibsondunn.com Tel:  020 7071 4226 Selina Sagayam – Corporate SSagayam@gibsondunn.com Tel:  020 7071 4263 Thomas M. Budd – Finance TBudd@gibsondunn.com Tel:  020 7071 4234 James A. Cox – Employment; Data Protection JCox@gibsondunn.com Tel: 020 7071 4250 Gregory A. Campbell – Restructuring GCampbell@gibsondunn.com Tel:  020 7071 4236 © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 5, 2018 |
OFAC Issues Economic Sanctions Guidance on Digital Currencies

Click for PDF Over the last several months, the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) has expressed a clear interest in protecting the U.S. financial system from illicit activities in the digital currency space and has posited that transactions involving digital currencies be treated similarly to transactions involving traditional fiat currency.[1]  OFAC released Frequently Asked Questions (FAQs) on March 19 and June 6, 2018 that addressed the treatment of digital currencies.  In particular, the FAQs suggest that compliance obligations apply to digital currencies in the same manner as they would apply to traditional fiat currencies.[2]  Moreover, the FAQs note that OFAC may add digital currency addresses associated with blocked persons to its List of Specially Designated Nationals (SDN List) and put the onus on individuals[3] engaging in such transactions to screen and ensure that they are not dealing with banned persons.[4]  Finally, an Executive Order from President Trump and related guidance from OFAC prohibited transactions involving “petro,” a digital currency issued by the Venezuelan government to evade U.S. sanctions.[5] Through this series of FAQs, OFAC has begun to stake out its position on certain compliance obligations for digital currency transactions as well as OFAC sanctions for those who use digital currency for illicit transactions.  However, key questions still remain around the scope and application of such obligations.  We discuss OFAC’s guidance on digital currencies in more detail below. FAQ 559: Definitions of “virtual currency,” “digital currency,” “digital currency wallet,” and “digital currency address” for purposes of OFAC sanctions programs OFAC’s FAQ 559 defined “virtual currency” as “a digital representation of value that functions as (i) a medium of exchange; (ii) a unit of account; and/or (iii) a store of value; is neither issued nor guaranteed by any jurisdiction; and does not have legal tender status in any jurisdiction.”[6]  Similarly, OFAC defined the broader term, “digital currency,” which involves “sovereign cryptocurrency, virtual currency (non-fiat), and a digital representation of fiat currency.”[7]  Next, it was explained that a “digital currency wallet” is typically a software application that holds, stores, and transfers digital currency.[8]  And finally, the FAQ explained that a “digital currency address” consists of “an alphanumeric identifier that represents a potential destination for a digital currency transfer.”[9]  These definitions are used throughout OFAC’s other FAQs. FAQ 560: Compliance obligations for digital currency and traditional fiat currency In FAQ 560, OFAC indicated its view that individuals are subject to identical compliance obligations regardless of whether a transaction involves digital currency or traditional fiat currency,[10] including prohibitions on the following:  trade or other transactions with persons on OFAC’s SDN List; “unauthorized transactions prohibited by OFAC sanctions, such as dealings with blocked persons or property, or engaging in prohibited trade or investment-related transactions”; and transactions involving entities in which a blocked person has an ownership interest of 50 percent or more.[11]  These restrictions include “transactions that evade or avoid, have the purpose of evading or avoiding, cause a violation of, or attempt to violate prohibitions imposed by OFAC under various sanctions authorities.”[12]  Accordingly, OFAC warns that “persons that provide financial, material, or technological support for or to a designated person may be designated by OFAC under the relevant sanctions authority.”[13] OFAC recommends that individuals should develop a compliance solution that is tailored to each circumstance.  In particular, the FAQ states that “technology companies; administrators, exchangers, and users of digital currencies; and other payment processors should develop a tailored, risk-based compliance program, which generally should include sanctions list screening and other appropriate measures.”[14] FAQ 561: Using the SDN List to sanction the illicit use of digital currencies OFAC recognizes in FAQ 561 that there is a “growing and evolving threat posed by malicious actors using new payment mechanisms” and is determined to sanction those who use digital currency and other emerging payment systems to conduct prohibited financial transactions and evade United States sanctions.[15]  Accordingly, the FAQ explains that in order “[t]o strengthen our efforts to combat the illicit use of digital currency transactions under our existing authorities, OFAC may include as identifiers on the SDN List specific digital currency addresses associated with blocked persons” (emphasis added).[16]  This practice of using the SDN list would mirror OFAC’s current practice of adding people and governments to such list and would enable OFAC and other users to screen for digital currency addresses. FAQ 562: Identifying digital currency-related information on the SDN List In FAQ 562, OFAC recognizes that although it may add digital currency addresses to the SDN List, those address listings are not likely to be exhaustive.[17]  Consequently, OFAC states that individuals should take the necessary steps to block questionable digital currencies and file reports with OFAC if and when they identify digital currency identifiers or wallets that they believe are owned by or are “associated with[] an SDN” (emphasis added).[18] FAQ 563: Format of digital currency addresses on the SDN List OFAC explains that the structure of a digital currency address on the SDN List will include a currency’s unique alphanumeric identifier and will identify the specific digital currency to which the address corresponds (e.g., Bitcoin (BTC), Litecoin (LTC), petro (PTR), etc.).[19] FAQ 594: Querying a digital currency address using OFAC’s Sanctions List Search tool OFAC confirmed that it is not possible to query for digital currency addresses using OFAC’s Sanctions List Search Tool.[20]  Instead, FAQ 594 recommends that OFAC will use its SDN List to screen for listed digital currency addresses.[21] OFAC’s Guidance and President Trump’s Executive Order Concerning Venezuela On March 19, 2018, OFAC released a set of FAQs to deal with the situation in Venezuela at the same time President Trump issued Executive Order 13827 on “Taking Additional Steps to Address the Situation in Venezuela” (“Executive Order”).[22]  The Executive Order aimed to combat Venezuela’s attempts to use digital currencies to bypass sanctions that were implemented against it by the United States.[23]  Specifically, the Executive Order bans individuals from engaging in transactions involving “any digital currency, digital coin, or digital token that was issued by, for, or on behalf of the Government of Venezuela on or after January 9, 2018.”[24]  In February 2018, the Venezuelan government launched a digital currency known as the “petro” to try to enable the national oil company of Venezuela, Petróleos de Venezuela, S.A., to engage in transactions that were not denominated in U.S. Dollars.  OFAC’s FAQ 564 confirmed that the phrases “digital currency, digital coin, or digital token” referenced in the Executive Order include the petro and petro-gold.[25] Concluding Thoughts Through issuing a series of FAQs, OFAC has begun to stake out its position on certain compliance obligations for digital currency transactions as well as OFAC sanctions for those who use digital currency for illicit transactions.  However, key questions still remain around the scope and application of such obligations.  For example, it is unclear how broadly OFAC will apply its definitions of “virtual currency” and “digital currency” to various cryptoassets that are fundamentally unlike major cryptocurrencies such as bitcoin.  Also, under FAQ 562, it is unclear to what extent an entity is “associated” with an SDN and when parties are obligated to block questionable digital currencies and file reports with OFAC.  Further, it is unclear under FAQ 560 as to what specifically should be included within a “tailored, risk-based compliance program, which include[s] . . . sanctions list screening and other appropriate measures.” The FAQs also fail to address significant practical concerns.  For example: To what extent do parties have the technical abilities to block incoming transactions?  Are there exceptions for companies that are hacked and subsequently forced to pay ransom to an address on the SDN List?  How will OFAC address the use of private blockchain addresses?  These uncertainties highlight the complexity and evolving nature of digital currency transactions and blockchain technology and, perhaps more importantly, they suggest the need for additional guidance from OFAC. [1] See Statements & Remarks, U.S. Department of the Treasury, U.S. Department of the Treasury Under Secretary Sigal Mandelker Speech before the Securities Industry and Financial Markets Association Anti-Money Laundering & Financial Crimes Conference (Feb. 13, 2018), https://home.treasury.gov/news/press-release/sm0286. [2] Office of Foreign Assets Control, Frequently Asked Questions, Questions 559-63, 594, available at https://www.treasury.gov/resource-center/faqs/Sanctions/Pages/faq_compliance.aspx [hereinafter “OFAC FAQ”]. [3] The term “individual,” as used by OFAC in its FAQs, generally encompasses persons, parties, corporations, and other entities subject to OFAC jurisdiction. See OFAC FAQ, Question 560. [4] Id. [5] Exec. Order No. 13827, 83 Fed. Reg. 12469 (Mar. 21, 2018). [6] OFAC FAQ, Question 559. [7] Id. [8] Id. [9] Id. [10] OFAC FAQ, Question 560. [11] Id. [12] Id. [13] Id. [14] Id. [15] OFAC FAQ, Question 561. [16] Id. (emphasis added). [17] OFAC FAQ, Question 562. [18] Id. (emphasis added). [19] OFAC FAQ, Question 563. [20] OFAC FAQ, Question 594. [21] Id. [22] Exec. Order No. 13827, 83 Fed. Reg. 12469 (Mar. 21, 2018). [23] Id. [24] Id. [25] Office of Foreign Assets Control, Frequently Asked Questions, Question 564, available at https://www.treasury.gov/resource-center/faqs/Sanctions/Pages/faq_other.aspx#venezuela. The following Gibson Dunn lawyers assisted in preparing this client update: Judith Lee and Jeffrey Steiner. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the above developments.  Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s International Trade or Financial Institutions practice groups: International Trade Group – United States: Judith Alison Lee – Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com) Ronald Kirk – Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com) Jose W. Fernandez – New York (+1 212-351-2376, jfernandez@gibsondunn.com) Marcellus A. McRae – Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com) Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com) Christopher T. Timura – Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com) Ben K. Belair – Washington, D.C. (+1 202-887-3743, bbelair@gibsondunn.com) Courtney M. Brown – Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com) Laura R. Cole – Washington, D.C. (+1 202-887-3787, lcole@gibsondunn.com) Stephanie L. Connor – Washington, D.C. (+1 202-955-8586, sconnor@gibsondunn.com) Helen L. Galloway – Los Angeles (+1 213-229-7342, hgalloway@gibsondunn.com) William Hart – Washington, D.C. (+1 202-887-3706, whart@gibsondunn.com) Henry C. Phillips – Washington, D.C. (+1 202-955-8535, hphillips@gibsondunn.com) R.L. Pratt – Washington, D.C. (+1 202-887-3785, rpratt@gibsondunn.com) Scott R. Toussaint – Palo Alto (+1 650-849-5320, stoussaint@gibsondunn.com) International Trade Group – Europe: Peter Alexiadis – Brussels (+32 2 554 72 00, palexiadis@gibsondunn.com) Attila Borsos – Brussels (+32 2 554 72 10, aborsos@gibsondunn.com) Patrick Doris – London (+44 (0)207 071 4276, pdoris@gibsondunn.com) Penny Madden – London (+44 (0)20 7071 4226, pmadden@gibsondunn.com) Benno Schwarz – Munich (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther – Munich (+49 89 189 33-180, mwalther@gibsondunn.com) Richard W. Roeder – Munich (+49 89 189 33-160, rroeder@gibsondunn.com) Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 27, 2018 |
New York Office of the Attorney General Publishes Report on Virtual Currency Platforms and Their Potential Risks

Click for PDF This Alert reviews the New York State Office of the Attorney General’s (the “OAG”) Virtual Markets Integrity Initiative Report (the “Report”), which was published on September 18, 2018.[1]  The publication of the OAG’s 42-page Report brings to a close its six-month fact-finding inquiry of several virtual currency platforms.[2]  The OAG sent out detailed letters and questionnaires to a number of virtual currency platforms seeking information from the platforms across a wide-range of issues, including trading operations, fees charged to customers, the existence of robust policies and procedures, and the use of risk controls. The OAG’s purpose in conducting this inquiry was to inform investors and consumers of the risks they face when considering whether to trade on virtual currency platforms.  The OAG is charged with enforcing laws that protect investors and consumers from unfair and deceptive practices and that safeguard the integrity of financial markets.  To that end, the OAG “compil[ed] and analyz[ed] the responses, compar[ed] [those responses] to the platforms’ publicly available disclosures,” and gave the platforms opportunities to confirm the OAG’s analysis in advance of the Report’s publication.[3] The Report focuses on three main concerns.  First, the OAG highlighted that virtual currency platforms may not sufficiently disclose or take measures to mitigate potential conflicts of interest.  Second, the OAG opined that virtual currency platforms currently do not take sufficient efforts to impede market manipulation and protect market integrity.  And third, the OAG expressed its view that virtual currency platforms may not have adequate safeguards for the protection of customer funds. We believe that the virtual currency industry (i.e., investors, consumers, platforms and other stakeholders) should view the Report as a best practices or best standards document, upon which virtual currency platforms may be measured in terms of their riskiness and viability. Please contact Gibson Dunn’s Digital Currencies and Blockchain Technology Team if you have any questions regarding the Report or any of the information discussed in this Alert. I.   The Virtual Currency Markets and New York’s Oversight Authority In order to have a better understanding of the potential impact of the Report, a primer on virtual currency markets generally and the State of New York’s oversight of virtual currency platforms is appropriate.             a.   Primer on Virtual Currency Markets The virtual currency markets have only been in existence for roughly ten years.  While these virtual or digital units of currency have no intrinsic value and are generally traded outside of the purview of direct government controls, the market’s popularity and trading volumes have catapulted it to a total market capitalization of approximately USD 218 billion as of September 27, 2018.[4]  One market analyst has estimated the existence of approximately 2,001 different virtual currencies, which are traded on platforms or “exchanges” around the globe.[5] The most popular virtual currency, Bitcoin, currently has a market capitalization of approximately USD 113 billion and a price of USD 6,523.[6]  There are several other virtual currencies—including ether, XRP, EOS, litecoin, and bitcoin cash—that are also widely traded. Investors and consumers generally access the virtual currency markets through trading platforms, most of which are unregistered and/or not subject to comprehensive governmental oversight in a manner similar to registered exchanges in other financial markets such as securities, commodities, and derivatives markets.  There are approximately 100 different virtual currency trading platforms in the world; not all are open to U.S. persons.[7] In the United States, government supervision over virtual currency markets continues to evolve at both the federal and state levels.  At the federal level, several federal regulators—including the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”)—have all begun to bring virtual currency trading more squarely under governmental supervision and control, either through defining their authority in federal court cases,[8] issuing regulatory guidance or consumer advisories,[9] or bringing enforcement actions against fraudsters and market participants and trading platforms, which violate existing laws.[10] In addition, states have enacted legislation or adopted regulations requiring virtual currency platforms to become licensed before offering trading access to their residents.  Some of these states, including New York, have also taken a more aggressive posture in warning consumers about fraudsters and platform operators that prey on their investor and consumer residents.[11]             b.   The State of New York’s Oversight of Virtual Currency Platforms New York has been a leader in establishing regulatory oversight over virtual currency markets in two important respects.  First, in 2014, New York—through its Department of Financial Services (“NYDFS”)—issued a comprehensive regulatory framework requiring virtual currency platforms and operators to secure a special business license called a “BitLicense” when engaging in virtual currency activities, and for those platforms and operators to establish consumer protections, anti-money laundering compliance, and cybersecurity guidelines.[12]  NYDFS has also granted limited purpose trust charters under New York banking law to virtual currency companies and has issued specific virtual currency product approvals.[13]  NYDFS has awarded eight BitLicenses, and it has granted two virtual currency limited-purpose trust company charters.[14] Second, New York has issued detailed guidance focusing on fraud detection and prevention.[15]  NYDFS’s guidance mandates that virtual currency licensees and chartered entities implement measures designed to effectively detect, prevent, and respond to fraud, attempted fraud, and similar wrongdoing in the trading of virtual currencies.  Many industry observers have viewed this guidance as amplifying and strengthening the monitoring requirements that already exist in New York’s regulations applying to BitLicensees. The OAG’s recent inquiry and its publication of the Report thus build on a developed framework of state regulation. II.   The Report and Its Three Key Areas of Concern The Report covers the following broad topics: (a) The jurisdiction in which virtual currency platforms operate; (b) The platforms’ acceptance of currencies (i.e., fiat and/or virtual); (c) Fees charged and disclosures of fee structures to customers; (d) The robustness of a platform’s trading policies and procedures; (e) How the platforms manage various types of conflicts of interest; (f) How the platforms safeguard customer funds through the establishment of security processes and procedures, the role of insurance, and the use of independent audits; and (g) The platforms’ processes around providing access to customers’ funds, as well as how the platforms handle trading suspensions and outages. We have produced the following chart that summarizes the OAG’s assessment of, and key findings from analyzing, the questionnaire responses received with respect to each of the topics above.  The Report also offered recommendations to assist virtual currency investors and consumers (i.e., platform customers) in making educated choices when deciding whether to invest or trade on a particular virtual currency platform. Topical Area Assessment Recommendations Jurisdiction Knowing where a platform is incorporated and headquartered is important because the platform’s domicile impacts which laws apply to any rights and remedies an investor or consumer may have in the event of a dispute, loss, theft or insolvency. Participating platforms claimed to limit trading access to authorized customers from particular locations; however, many of these platforms do not have effective know-your-customer (“KYC”) programs or actively monitor customers’ IP addresses in order ensure the identity and location of particular customers. Customers should know the jurisdictions from which their virtual currency trading platforms are located and headquartered. Platforms need to significantly enhance and improve their KYC programs and to develop effective IP monitoring systems in order to properly monitor and limit the platforms’ trading systems to authorized customers.   Acceptance of Currency To obtain virtual currency initially, customers must find a platform that accepts fiat currency (i.e., government-backed currency). It is important to know which trading platforms accept fiat currency; the acceptance of fiat currency demonstrates that the platform has a relationship with a regulated bank. Customers should be mindful of whether a virtual currency platform has a formal banking relationship in place.  The existence of such a relationship may offer customers a useful indicator for evaluating that a particular platform is a legitimate business concern. Fees and Fee Disclosures Most virtual currency trading platforms charge fees per transaction.  However, many virtual currency platforms’ fees may differ based on the price of the virtual asset that is bought or sold, the volume of trades executed by the customer, the order type chosen, or the timing of an order submission. Some platforms offer significant discounts to high-volume trading customers.  This discounting is known as a “maker-taker” fee model. Additionally, some platforms charge fees for withdrawals and deposits of customer fiat and virtual currencies. Customers should understand which actions will trigger fees, the size of those fees, and whether the platform will charge hidden fees.  To that end, the OAG recommends that customers should review and understand a platform’s complete fee schedule before the customer begins trading. Fee transparency is absolutely essential and customers should understand when a particular platform offers high-volume customer discounts. Trading Policies The Report drew several comparisons between virtual currency markets and the policies and market structure seen in securities trading. The OAG observed that, similar to securities platforms, the virtual currency platforms that participated in the inquiry do provide special features to professional traders. The OAG also noted that these platforms allow automated and algorithmic trading but few if any have robust policies in place to address such trading. The OAG noted that, while all of the participating platforms expressed a commitment to stamp out abusive trading practices, few had actual policies in place to define, detect, prevent, or penalize suspicious trading or market manipulation. The OAG noted that only a couple of platforms that responded to the questionnaire allow margin trading, whereby customers were allowed to borrow funds to trade a virtual asset. Since monitoring trading activity on a platform is critical to the integrity of the entire market, the OAG recommended that virtual currency platforms develop robust policies around automated and algorithmic trading, provide more transparency around the special trading features and order types offered to professional traders, improve customer onboarding procedures and implement serious market surveillance capabilities akin to those in securities trading venues  in order to detect and punish suspicious trading activity.   Conflicts of Interest The OAG noted that virtual currency platforms may have conflicts in terms of: (1) the standards applied when considering whether to list virtual assets; (2) compensation that they receive for listing particularly virtual assets; (3) the lack of consistent industry policies and procedures regarding platform employee trading; and (4) the ability of a platform to trade on its venue in a proprietary capacity. The OAG recommended that virtual currency platforms disclose payments and other compensation that they receive for listing a particular virtual currency. The OAG noted that, while the measures taken to monitor or prevent employee trading on platforms differed, virtual currency platforms should generally make their policies around employee trading more transparent to customers. Although proprietary trading certainly occurs in other markets, the OAG cautioned that customers should be aware that: (1) a platform could be trading on its own account on its own venue on an undisclosed basis; (2) high levels of proprietary trading may raise serious questions about the true available liquidity on a platform; and (3) the platforms may be trading with informational advantages. Safeguarding Customer Funds The OAG noted that, although safeguarding customer funds is of paramount importance, the virtual currency platforms that submitted responses did not consistently employ measures to ensure the security of those funds in the platforms’ custody The OAG also noted that industry standards have not yet developed around insurance for virtual currency platforms (i.e., what assets should be insured, against what risks, and at what price). The OAG noted that, although a number of the platforms reported that they have retained outside firms to conduct independent audits, the industry lacked common auditing standards. The OAG recommended that virtual currency platforms require two-factor identification by default to ensure that customer’s data is secure.  The OAG also recommended that platforms make better use of “cold storage” (i.e., a security practice wherein private keys to virtual currency are kept off of the internet).  Finally, the OAG recommended that platforms regularly conduct “penetration testing” in order to identify security holes in a platform’s information technology and data security infrastructure. The OAG recommended that customers should demand more information from trading platforms about how those platforms insure risks related to the virtual or fiat currency held within their custody. The OAG recommended that the industry come together to develop common auditing standards for virtual currency platforms. Access to Customer Funds During Suspensions/Outages The OAG noted that platforms often fail to detail their procedures for transferring virtual currency from customer accounts to private wallets, or for processing fiat currency withdrawals both under normal market conditions and during a suspension or outage.  The platforms that participated in the inquiry had differing policies. The OAG further noted that platforms do not have adequate policies or procedures for suspending trading or delaying pending trades, and the handling of open orders during and immediately following suspension and/or platform outage. The OAG recommended that customers should familiarize themselves with how pending trades and currency withdrawals are treated under normal market conditions and during a trading suspension or outage. Disclosure of Historical Outages The OAG noted that while most platforms notify customers of any trading suspensions or outages, few of the platforms provide full disclosure of past outages or suspensions, and the reasons for those events. The OAG suggested that customers examine whether a platform provides a history of prior outages and trading interruptions because by doing so it helps customers evaluate historical stability, reliability, and transparency of a venue. After conducting the general assessment described above, the OAG highlighted its three principal areas of concern: Virtual Currency Platforms Do Not Disclose or Take Measures to Mitigate Potential Conflicts of Interest.  Virtual currency platforms may operate with several conflicts of interest, including:  (1) operating several lines of business that would be restricted or carefully regulated if those platforms were exchanges in traditionally regulated markets; (2) receiving fees and other incentives to list particular virtual currencies; (3) having insufficient policies and procedures for limiting access to platforms employees to trade alongside of customers; and (4) engaging in proprietary trading alongside customers when platforms have access to nonpublic information. Virtual Currency Platforms Do Not Take Serious Efforts to Impede Market Manipulation and Protect Market Integrity.  The Report opined that many virtual currency platforms are susceptible to manipulative and fraudulent trading activity.  Such platforms lack robust real-time and historical market surveillance capabilities like those found in the securities and commodities and derivatives markets. Customer Fund Safeguards on Platforms are Limited and Often Illusory.  The Report also flagged that virtual currency markets may lack consistent and transparent approaches to ensure the protection of customer funds.  While many virtual currency platforms use independent auditors to conduct reviews of the platforms’ holdings, and some platforms have insurance, the scope and sufficiency of the audits and insurance do not provide adequate protections to customers for losses of their virtual or fiat currency. The OAG reiterated that New York’s virtual currency regulations address many of these concerns and the topics identified in its assessment.  The OAG reminded BitLicense registrants that they should be adhering to these requirements already. III.   Conclusion Although the Report was directed at New York investors and consumers, its assessment principles and recommendations may also establish more generally applicable industry standards.  Indeed, platforms operating outside of New York can use the OAG’s assessment and recommendations to enhance and improve their existing operations. The Report noted that the OAG has made referrals to NYDFS to initiate investigatory proceedings against three platforms that appear to engage in a virtual currency business in New York.  The Report may also influence other states and the federal government to consider developing regulations or guidance based on the OAG’s assessment and recommendations.    [1]   See Office of the New York State Attorney General, Virtual Markets Integrity Initiative Report, Sept. 18, 2018, available at https://ag.ny.gov/sites/default/files/vmii_report.pdf.    [2]   See Office of the New York State Attorney General, Press Release, A.G. Schneiderman Launches Inquiry Into Cryptocurrency “Exchanges”, Apr. 17, 2018, available at https://ag.ny.gov/press-release/ag-schneiderman-launches-inquiry-cryptocurrency-exchanges.    [3]   Report, p.2.    [4]   See CoinMarketCap, Sept 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [5]   See Report p.2 (“there are more than 1,800 different virtual currencies. . . .”); see also CoinMarketCap, Sept. 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [6]   See CoinMarketCap, Sept. 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [7]   The website CoinMarketCap estimates that there are 14,252 different “markets” for trading cryptocurrencies.  See id.  The definition of “markets” also includes offline commercial areas or arenas for trading.    [8]   Through administrative decisions issued in 2015, the CFTC set forth its interpretation that virtual currencies (which include cryptocurrencies like Bitcoin) are commodities under the Commodity Exchange Act.  See In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29, available here.    [9]   See, e.g., CFTC Advisory, Customer Advisory: Use Caution When Buying Digital Coins or Tokens, July 16, 2018, available at https://www.cftc.gov/sites/default/files/2018-07/customeradvisory_tokens0718.pdf. [10]   See, e.g., CFTC v. Kantor et al., Civ. Act. No. CV182247, Apr. 17, 2018, available at https://www.cftc. gov/sites/default/files/2018-04/enfbluebitbancorder041718.pdf. [11]   Georgia, Illinois, Kansas, Massachusetts, Tennessee, Texas and Washington have established streamlined application processes for financial technology firm applicants to obtain money transmitter licenses. [12]   See 23 NYCRR Part 200 (Virtual currencies) (2018). [13]   See https://www.dfs.ny.gov/banking/virtualcurrency.htm. [14]   See id. [15]   See NYSDFS, Guidance on Prevention of Market Manipulation and Other Wrongful Activity, Feb. 7, 2018, available at https://www.dfs.ny.gov/legal/industry/il180207.pdf. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the authors: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 24, 2018 |
Dodd Frank 2.0: U.S. Federal Banking Agencies Propose New HVCRE Capital Regulations

Click for PDF On September 18, 2018, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation (together, the Banking Agencies) proposed revisions to their Basel III capital rules regarding so-called High Volatility Commercial Real Estate (HVCRE) loans.  The purpose of the revisions is to conform the regulatory definition of HVCRE to the changes made by the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (EGRRCPA), which was enacted in May. The proposed regulations generally follow the statutory changes, with certain clarifications, as we discuss below.  The proposal, however, does not address certain interpretive issues that are still outstanding over five years after the original HVCRE regulations were promulgated, although the Banking Agencies do ask in the preamble’s request for comments whether the proposed rule is ambiguous in certain areas and whether “further discussion or interpretation is appropriate.” HVCRE Capital Treatment Under the Original Basel III Capital Rule and the Banking Agencies’ Interpretations HVCRE treatment is a purely American phenomenon; it was not included in the international Basel III framework.  A form of capital “gold plating,” it imposes a 50% heightened capital treatment on certain commercial real estate loans that are characterized as HVCRE exposures. Prior to enactment of the EGRRCPA, the Banking Agencies’ Basel III capital rule defined an HVCRE exposure as follows: A credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances: One- to four-family residential properties; Certain community development properties The purchase or development of agricultural land, provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development; or Commercial real estate projects in which: The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio under Banking Agency standards – e.g., 80% for a commercial construction loan; The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised “as completed” value; and The borrower contributed the amount of capital required before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.[1] The original rule provided that the life of a project concluded only when the credit facility was converted to permanent financing or was sold or paid in full.[2] The original Basel III capital rule raised many interpretative questions; few, however, were answered by the Banking Agencies, and others were answered in a non-intuitive, unduly conservative manner.[3]  In particular, the Banking Agencies interpreted the requirement relating to internally generated capital as foreclosing distributions of such capital even if the amount of capital in the project exceeded 15% of “as completed” value post-distribution.[4]  In addition, the Banking Agencies did not permit appreciated land value to be taken into account for purposes of the borrower’s capital contribution. Proposed Regulations – Definition of HVCRE The proposed regulations follow the statute in narrowing the definition of an HVCRE exposure, in particular by requiring that a credit facility have the purpose of improving property into income-producing property.  The proposal defines an HVCRE exposure as: A credit facility secured by land or improved real property that— (A) primarily finances or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility. The proposal interprets this provision as follows.  First, relying on the instructions to bank Call Reports, the proposed regulation defines a “credit facility secured by land or improved real property” as a credit facility where “the estimated value of the real estate collateral at origination (after deducting all senior liens held by others) is greater than 50 percent of the principal amount of the loan at origination.”  Second, the determination of whether the credit facility meets the above HVCRE definition is made once, at the facility’s origination.  Third, the Banking Agencies propose that the HVCRE definition include “other land loans” – generally loans secured by vacant land except land known to be used for agricultural purposes. Proposed Regulations – Exclusions from HVCRE Treatment The statute retained, and in certain important cases, expanded, the exclusions from HVCRE treatment.  The proposed regulations implement these provisions and provide additional definitional interpretation. Certain Commercial Real Estate Projects This exclusion proved the most controversial under the original Basel III treatment, and indeed the Banking Agencies’ conservative approach to the exclusion is likely responsible for the statute’s enactment. Under the proposal, as in the original regulation, the loan-to-value (LTV) ratio for the loan must be less than or equal to the applicable regulatory maximum LTV for the type of property at issue. Next, the borrower must have contributed “capital” of at least 15 percent of the real property’s appraised “as completed” value.  The proposal permits real property (including appreciated land value) to count as capital, along with cash, unencumbered readily marketable assets, and development expenses paid out-of-pocket, that is, “costs incurred by the project and paid by the borrower prior to the advance of funds” by the lending bank.  With respect to the value of contributed real property, the proposal follows the statute and defines it as “the appraised value” under a qualifying appraisal, reduced by the aggregate amount of any other liens on such property.  Notably, the Banking Agencies invite comment on “whether it is appropriate and clear that the cross-collateralization of land in a project would not be included as contributed real property.” The Banking Agencies state that in certain circumstances, such as in the case of purchasing raw land without near-term development plans,” an “as-is” appraisal may be used instead of an “as completed” one, and in certain cases, an evaluation is permissible – for transactions under $500,000 that are not secured by a single one- to four-family residential property and certain other transactions with values less than $400,000. The proposal includes a clarification for what a “project” is for purposes of the “as completed” value and 15 percent capital contribution calculation.  In the case of a project with multiple phases or stages, each phase or stage must have its own appraised “as completed” value, or if applicable, its own evaluation, in order for it to be deemed to be a separate “project.” Finally, the statute overrode the existing regulation by providing that HVCRE status may end prior to the replacement of an ADC loan with permanent financing, upon: the substantial completion of the development or construction of the real property being financed by the credit facility; and cash flow being generated by the real property being sufficient to support the debt service and expenses of the real property, in accordance with the bank’s applicable loan underwriting criteria for permanent financings. The proposed regulations do not further interpret these provisions – and although “substantial completion” is a term of art in the real estate industry, there is still some imprecision as to its exact meaning. One- to Four-Family Residential Properties With respect to the exclusion for one- to four-family residential properties, the proposal defines such properties as properties “containing fewer than five individual dwelling units, including manufactured homes permanently affixed to the underlying property (when deemed to be real property under state law).”  Condominiums and cooperatives would generally not qualify for the exclusion.  However, if the underlying property is a true one- to four-family residential property, the exclusion would cover ADC as well as construction loans, and, in addition, lot development loans.  The exclusion would not cover loans used solely to acquire undeveloped land. Community Development Properties With respect to this exclusion, the proposal refers to the Banking Agencies’ Community Reinvestment Act (CRA) regulations and their definition of community development investment to determine which properties qualify – the “primary purpose” of the applicable loan must be to foster such investment.  These regulations are quite detailed, and therefore a case-by-case analysis of particular properties will be required if the regulations are finalized as proposed. Agricultural Land Relying on bank Call Report Instructions, the Banking Agencies propose a broad definition for this exclusion – “all land known to be used or usable for agricultural purposes.” Existing Income-Producing Properties that Qualify as Permanent Financings Finally, the statute added a new exclusion, for credit facilities for: the acquisition or refinance of existing income-producing real property secured by a mortgage on such property;  and improvements to existing income-producing improved real property secured by a mortgage on such property, in each case, “if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings.” With respect to this exclusion, the Banking Agencies state only that they “may review the reasonableness of a depository institution’s underwriting criteria for permanent loans” as part of the regular supervisory process. Loans Made Prior to January 1, 2015 Under the statute, loans made prior to January 1, 2015 may not be classified as HVCRE loans.  A 100 percent risk weight may therefore now be applied to any such loans that were previously classified as HVCRE exposures unless a lower risk weight would apply, as long as the loans are not past 90 days or more past due or on nonaccrual. Conclusion With the HVCRE statute and this proposal, the door has closed on the Banking Agencies’ unfortunate prior approach to HVCRE exposures.  The proposed regulations, however, like the ones they replace, do not clearly state their application to the complex structures of real estate transactions, with multiple tranches of financing and different capital instruments, that are common in the market today.  In addition, although it is clear that certain of the 2015 Interagency FAQs are no longer applicable, the proposal does not discuss those FAQs at all – thus missing an opportunity to subject them to the full notice and comment process that the Banking Agencies only recently stated is necessary for agency interpretation to be considered binding law.[5]  It is hoped that the public comment period will provide the Banking Agencies with evidence of the proposal’s ambiguities and that “further discussion and interpretation” of HVCRE treatment in the final regulation is appropriate.    [1]   See, e.g., 12 C.F.R. § 3.2.    [2]   Id.    [3]   The Banking Agencies published certain responses to HVCRE Frequently Asked Questions (Interagency FAQs) in April 2015.    [4]   See Interagency FAQ Response 15.    [5]   See Interagency Statement Clarifying the Scope of Supervisory Guidance, September 11, 2018 (Banking Agencies and the National Credit Union Administration). The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Real Estate and Finance Groups: Jesse Sharf – Los Angeles (+1 310-552-8512, jsharf@gibsondunn.com) Erin Rothfuss – San Francisco (+1 415-393-8218, erothfuss@gibsondunn.com) Aaron Beim – New York (+1 212-351-2451, abeim@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213-229-7582, lcurtis@gibsondunn.com) Drew C. Flowers – Los Angeles (+1 213-229-7885, dflowers@gibsondunn.com) Noam I. Haberman – New York (+1 212-351-2318, nhaberman@gibsondunn.com) Andrew A. Lance – New York (+1 212-351-3871, alance@gibsondunn.com) Victoria Shusterman – New York (+1 212-351-5386, vshusterman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 10, 2018 |
Jeffrey Steiner Named a Cryptocurrency, Blockchain and Fintech Trailblazer

The National Law Journal named Washington, D.C. counsel Jeffrey Steiner a 2018 Cryptocurrency, Blockchain and Fintech Trailblazer [PDF]. Steiner is recognized for leading one of the Dodd-Frank rulemaking teams for OTC derivatives while at the U.S. Commodity Futures Trading Commission and helping create Gibson Dunn’s digital currencies and blockchain technology group. Steiner advises a range of clients, including commercial end-users, financial institutions, dealers, hedge funds, private equity funds, clearinghouses, industry groups and trade associations on regulatory, legislative and transactional matters related to OTC and listed derivatives, commodities and securities. The list was published in the September 2018 issue.

August 20, 2018 |
Dodd-Frank 2.0: Potential Reform to the Federal Reserve Board’s “Control Rules” — What Is at Stake and Who May Benefit

Click for PDF 2018 has seen significant but pragmatic developments in the implementation of bank regulation by the Board of Governors of the Federal Reserve System (Federal Reserve) under its new Vice Chairman for Bank Supervision, Randal Quarles.  Vice Chairman Quarles has frequently touted transparency in regulation as a significant virtue, and has himself frequently adopted such transparency in his public speeches, by signaling areas that he considers a priority. One area where the Federal Reserve has not yet published a reform is in the area of “control” under the Bank Holding Company Act of 1956, as amended (BHC Act).  In January, Vice Chairman Quarles suggested that it would be on his to-do list: Under the Board’s control framework – built up piecemeal over many decades – the practical determinants of when one company is deemed to control another are now quite a bit more ornate than the basic standards set forth in the statute and in some cases cannot be discovered except through supplication to someone who has spent a long apprenticeship in the art of Fed interpretation . . . . We are taking a serious look at rationalizing and recalibrating this framework.[1] This description would be an understatement.  The control rules have become challenging for corporate lawyers and clients alike – one may be greeted with “That can’t be right!” when explaining the likely Federal Reserve view of control.  As such, “rationalization and recalibration” in this area would be highly welcome. This Client Alert describes the most important aspects of the Federal Reserve’s control rules as of today’s date, and suggests certain areas of potential reform. Reform of the control rules would be important for quite a few constituencies.  It would certainly benefit private investors that wish to commit capital to banks but that do not wish to become regulated as BHCs.[2]  It would benefit nonbanking companies that might wish to partner with banks and acquire bank equity at the same time.  And it has the potential to affect certain rules applicable to bank holding companies (BHCs) themselves, particularly in the area of so-called 4(c)(6) investments and the Volcker Rule. The Statutory Language The BHC Act defines “control” as follows: Any company has control over a bank or over any company if— (A)   the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company; (B)   the company controls in any manner the election of a majority of the directors or trustees of the bank or company; or the [Federal Reserve] determines, after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank or company.[3] The Principal Federal Reserve Control Positions For over forty years, the Federal Reserve has issued interpretations of the “controlling influence” prong of the statutory definition to erect a detailed common law of control, and one that is more focused on “influence” than the statutory “controlling influence.”  Although some of the Federal Reserve’s positions are in its Regulation Y and some in policy statements,[4] many are set forth in interpretations granted to individual banks, and some are unwritten lore.  The Federal Reserve’s current principal positions may be described as follows: Voting Securities.  This definition is critical for purposes of the 25 percent control test that is the first part of the statutory definition.  Regulation Y defines “voting securities” as “shares of common or preferred stock, general or limited partnership shares or interests, or similar interests if the shares or interests, . . . in any manner, entitle the holder: To vote for or to select directors, trustees, or partners (or persons exercising similar functions) . . . or To vote on or to direct the conduct of the operations or other significant policies of the issuing company.”[5] The Federal Reserve takes the position that if a holder of a limited partnership interest has the right to vote on replacing a general partner or who the replacement general partner will be, the interest is a “voting security.” Class of Voting Securities.  The 25 percent control test applies to any “class” of voting securities.  Under Federal Reserve regulation, a class of voting securities is determined by considering whether the shares are voted together as a single class on all matters for which the shares have voting rights, other than certain very limited fundamental matters described immediately below (Fundamental Matters).[6] This approach makes it virtually impossible to give particular investors special voting rights outside of Fundamental Matters, because such rights will almost certainly make the investors own more than 25 percent of a separate class of voting securities and thus be in control.  Moreover, approval of a new line of business or a merger or acquisition that does not affect the rights of an investor’s security is not considered a Fundamental Matter for these purposes, and therefore cannot be subject to a separate class vote. The Federal Reserve considers the general partner of a partnership or a managing member of a limited liability company to hold 100% of a class of voting securities, and for that reason, a general partner or managing member always is deemed to control an entity. Nonvoting Securities.  One way of permitting an investor additional economic rights in a deal is to issue nonvoting securities.  The Federal Reserve, however, has placed substantial limitations on such securities.  Under Regulation Y, preferred shares, limited partnership shares or interests, or similar interests are not voting securities if: Any voting rights associated with the shares or interest are limited solely to the type customarily provided by statute with regard to Fundamental Matters; The shares or interest represent an essentially passive investment or financing device and do not otherwise provide the holder with control over the issuing company; and The shares or interest do not entitle the holder, . . . in any manner, to select or to vote for the selection of directors, trustees, or partners (or persons exercising similar functions).[7] Under Federal Reserve regulation and practice, Fundamental Matters are matters that “significantly and adversely affect the rights or preferences of the security,” and are generally limited to: the issuance of additional amounts or classes of senior securities; the modification of the terms of the security or interest; the dissolution of the issuing company; or the payment of dividends by the issuing company when preferred dividends are in arrears.[8] If a security is subject to a restriction on its voting rights, that restriction will be effective only if it is contained in the constitutive documents of the issuing entity – it cannot be in a side agreement.  The rationale for this position is that if contained in an agreement alone, the parties to the agreement could breach it and waive any consequences; such a breach is not possible when the restriction is contained in, for example, a corporate charter. Amount of Nonvoting Securities That May Be Held.  The Federal Reserve generally permits an investor to own one-third of the total equity of a company before finding control, as long as no more than 14.9 percent of that equity is voting.[9] Restrictions on Nonvoting Securities Becoming Voting Securities.  The Federal Reserve’s traditional position is that a security remains a voting or nonvoting security throughout its life – it cannot switch back and forth.  There is a long-standing exception designed to permit a degree of liquidity for nonvoting securities.  Such securities may become voting in a limited set of transfers: A transfer back to the issuer A transfer in a public offering A transfer in a private offering in which no transferee acquires more than 2% of the issuer’s voting securities A transfer in a change-of-control, where more than 50 percent of the issuer’s securities are transferred to a new owner (not counting the investor’s nonvoting securities for purposes of the 50 percent test) In practice, the Federal Reserve has also limited the transfers of nonvoting securities themselves to these four circumstances.[10]  This is because the Federal Reserve generally views control over the disposition of a security as control of the security. There is long-standing precedent for this position in the context of voting securities, although one may question its application to nonvoting securities.  In a 1982 letter, the Federal Reserve disapproved of a proposal whereby an investor that had an option for 32.4 percent of the voting shares of a bank holding company stated that it intended only to acquire 24.9 percent and sell the other 7.5 percent, stating: The [Federal Reserve] is concerned that approval of your proposal, which would effectively allow control of up to 32.4 per cent of the voting shares of Florida National, could seriously impair the objectives and purposes of the Change in Bank Control Act and Bank Holding Company Act. General approval of such arrangements would establish a precedent permitting acquirors of bank holding company stock to accumulate up to 24.9 per cent of voting shares, proceed to dispose of these shares in a form subject to their control, acquire additional shares up to the 24.9 per cent level, and then possibly repeat this process.[11] Options and Warrants as Voting Securities/Fed Math.  The Federal Reserve has taken the position that an option or warrant for a voting security that is freely exercisable must be counted as a voting security, no matter how out-of-the-money the warrant or option is.  Compounding the effects of this position, the Federal Reserve has also taken the position that when calculating the percentage of voting securities owned by an investor, one must treat the investor’s options or warrants as exercised (as long as they are freely exercisable, no matter how out of the money), but no one else’s.  This is the position that elicited the “That can’t be right!” statement cited above. Tear Down Rule.  The Federal Reserve has taken the position that if a party has control of a company – for example, controlling 25 percent of more of a class of voting securities – it is more difficult to shed control.  It has therefore insisted on sell downs to a lower level of control than would otherwise be the case – selling down to 24.9 percent has generally been insufficient, with 10 percent, and sometimes less, frequently desired.  This is a position more suited to metaphysics than law, and can have perverse results particularly when a BHC is seeking to divest a business but retain some form of economic interest in it. Directors/Observers.  The statute defines “control” as the ability to control the election or appointment of a majority of directors.  The Federal Reserve’s articulated position on “controlling influence,” however, is that a 24.9 percent voting share investor or a 14.9 percent voting/one-third total equity investor may generally only appoint one director to the company’s board.  Moreover, as a general matter, an investor’s director representation should be proportional to the percentage of voting shares it owns.  The Federal Reserve now generally permits an additional observer as long as the observer is truly an observer.[12] In addition, the director representative cannot be the chairman of the board and generally cannot chair a board committee.  Such a director may participate on a committee as long as he or she does not make up more than 25 percent of the seats on the committee or have the authority or practical ability to make or block the making of policy decisions.[13] Veto Rights.  Although an investor may wish to have the ability to veto material business decisions, the Federal Reserve has limited such veto rights generally to Fundamental Matters, not without some potential inconsistency in its written statements.  The 2008 Policy Statement declares that the Federal Reserve has traditionally been concerned about restrictions on the ability to raise “additional debt or equity capital,” but in the next paragraph states that it is permissible to have a veto over “issuing senior securities or borrowing on senior basis,”[14] in addition to modifications to the terms of the investor’s security or dissolution of the company. Business Relationships.  The extent of business connections between an investor and the company invested in is an area to which the Federal Reserve staff applies considerable attention.  The general principle is that such business relationships must be “quantitatively limited and qualitatively immaterial,”[15] but the Federal Reserve looks at the facts of each transaction and make its determination on a case-by-case basis.  Critical factors are that the connections be on market terms, be non-exclusive, and be terminable without penalty by the company invested in.  The 2008 Policy Statement stated a preference for allowing more extensive business relationships when the investor’s voting securities percentage was closer to 10 than 25 percent.[16] Why the Control Definition Is Important The Federal Reserve definition of control affects bank holding companies and nonbanks alike.  In the first instance, it limits the ability of private investors – principally private equity funds and hedge funds – from making equity investments in banks and their holding companies, because it is an extremely rare private fund that will take on the burdens of Federal Reserve supervision and regulation, including activity restrictions and capital requirements.  The disincentives have increased immeasurably with the Volcker Rule, which generally limits BHCs to owning no more than 3% of the ownership interests of any private fund they sponsor.  In the Financial Crisis, the current control rules – and other restrictions imposed by the Federal Deposit Insurance Corporation – clearly limited the ability of private capital to support the banking sector. In addition to private investors, the control definitions are relevant to nonbanking companies that wish to partner with banking organizations and may wish to obtain equity in their partner as well – since a controlling investment would subject them to the restrictions on commercial activities contained in the BHC Act. Finally, revised control interpretations would also be relevant to BHCs themselves.  One legal authority available to BHCs to make equity investments is the so-called “Section 4(c)(6)” authority permitting an investment in up to 5 percent of the voting shares of any company.  Such investments – which may also include nonvoting securities – must also be noncontrolling.  And because the Volcker Rule applies to every company that a BHC or other insured depository institution holding company controls, reform of the control rules would have beneficial effects in this area as well. Areas of Potential Rationalization and Recalibration The areas below are only certain examples where current Federal Reserve precedent may be an unduly restrictive interpretation of the statutory language.  Any suggested recalibrations, too, are only possible ones. Combination of Voting and Nonvoting Securities.  The current limitations to 14.9% voting and one-third total equity do not derive from any particular aspect of the statute – which is focused only on control of voting securities.  In another context, so-called “portfolio investments” under the Federal Reserve’s Regulation K, an investor may own 19.9% voting securities and up to 40 percent total equity of a company without being deemed in control.[17]  But this is but one alternative to the current limitation. Fed Math/Tear Down Rule.  It is very difficult to justifying treating freely exercisable but out-of-the-money warrants and options as voting securities, particularly when that rule applies only to the investor in question, but no other holder of the same securities – and so this “new math” should be one of the first candidates for “rationalization.”  Similarly, the so-called “tear down” rule is unanchored to the statutory language and thus is a prime candidate for reconsideration. Directors.  The Federal Reserve has stated that generally the number of directors must be proportionate to voting shareholdings.  Again, although a greater number of directors suggests “influence,” it does not necessarily lead to a “controlling influence.”  If an investor has contributed 40 percent of a company’s total equity, it does not seem unreasonable to permit a right to appoint 40 percent of a company’s board.  Moreover, the restriction on committee chairing is arguably inconsistent with the statutory language, and keeps qualified candidates – for example, retired Federal Reserve Governors or Reserve Bank Presidents affiliated with private investors – on the sidelines. Limitations on Transfer of Nonvoting Securities. Although one can understand the Federal Reserve’s concern about the circumstances in which nonvoting securities can become voting, this is a separate issue from the issue of transfers of nonvoting securities.  If one focuses on the statutory term “controlling influence,” it would seem reasonable to permit transfers of nonvoting securities to a wider group of transferees than the four limited circumstances in which nonvoting securities can currently become voting.  This is a prime example of the side effects of the piecemeal construction of the current control framework – one might have concerns about “seriously impair[ing] the objectives and purposes” of the BHC Act when control over transfer of 25 percent or more voting securities is at issue.  It is not clear that these concerns apply in the nonvoting securities context where there are substantial limitations on the securities ever becoming voting at all. In addition, recalibrating the circumstances when nonvoting securities may become voting should also be given consideration, because certain aspects of the current rules – such as not counting the transfer of an investor’s nonvoting securities for purposes of the 50 percent transfer test – seem to be conservative simply for conservatism’s sake. Veto Rights/Class Votes. Current Federal Reserve regulation and policy limit an investor’s veto rights to matters that “significantly and adversely affect the rights and privileges” of the investor’s security.  Even if this formulation is correct as an original matter (and a recalibration subject to notice and comment would allow for discussion of this point), there may well be more corporate matters than those the Federal Reserve currently permits that may be viewed as having such an effect.  Holding an equity interest of course gives economic rights, but it can also be considered as taking a fundamental stake in a particular business – and therefore, to use but one example, it is not clear why a material change to the nature of that business should not be a Fundamental Matter subject to an investor veto.  To the extent the scope of permissible investor vetoes is broadened, similar broadening of matters that may be subject to a class vote without creating a separate class of voting securities should also be considered. Business Relationships. The area of permitted business relationships between an investor and a bank or other company is one in particular where “supplication to someone who has spent a long apprenticeship in the art of Fed[eral Reserve] interpretation” is frequently necessary.  Granting that it is impossible to predict in advance every possible contemplated business relationship, it does seem that a retreat from the current all-facts-and-circumstances test is both possible and desirable, such as through the use of regulatory presumptions of permissible arrangements, in a manner similar to the approach taken in aspects of the proposed recalibration of the Volcker Rule. Conclusion If the hinted-at rationalization and recalibration of the control rules occurs, it is hoped that the Federal Reserve will do so – as it has done this year in other areas of federal banking law – in the transparent manner of a proposal subject to notice and comment.  The peculiarities of the common law of control that have developed over more than four decades provide considerable material for interested parties to share their perspectives on improvements for the future.    [1]   Vice Chairman Randal K. Quarles, “Early Observations on Improving the Effectiveness of Post-Crisis Regulation,” January 19, 2018.    [2]   Although this Client Alert focuses on control under the BHC Act, with the abolition of the Office of Thrift Supervision, the Federal Reserve also interprets control under the Savings and Loan Holding Company Act, which has a similar, if not identical, definition, including a “controlling influence” prong.    [3]   12 U.S.C. § 1841(a)(2).    [4]   See, e.g., 12 C.F.R. §§ 225.31, 225.143; Policy Statement on Investments in Banks and Bank Holding Companies (2008).    [5]   12 C.F.R. § 225.2(q)(1).    [6]   Id. § 225.2(q)(3).    [7]   Id. § 225.2(q)(2).  The Federal Reserve has considered certain subordinated debt to be a nonvoting security.    [8]   Id. [9]   See Policy Statement on Investments in Banks and Bank Holding Companies (2008). [10]   See, e.g., Letter from Scott G. Alvarez, Esq. to Peter Heyward, Esq., June 29, 2011.  An investor may also generally transfer nonvoting securities to one of its affiliates. [11]   See Letter of William W. Wiles (March 18, 1982). [12]   See Policy Statement on Investments in Banks and Bank Holding Companies (2008). [13]   See id. [14]   Id.  The two statements are reconcilable if a veto over additional pari passu and subordinated instruments is impermissible, but one over senior debt and equity issuances is permissible. [15]   Id. [16]   Id. [17]   See 12 C.F.R. § 211.8(c)(3). Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the authors: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

August 6, 2018 |
The U.S. Office of the Comptroller of the Currency Will Permit Special Purpose National Bank Charters for Fintech Firms

Click for PDF Last week, the Office of the Comptroller of the Currency (OCC) announced that it would begin accepting proposals from Fintech firms to charter special purpose national banks (SPNBs).  This decision comes over 18 months after the White Paper proposing such charters was issued under President Obama’s Comptroller, Thomas Curry, in his last month in that position.  The OCC accompanied this announcement with a policy statement (Policy Statement) and a supplement to its licensing manual for national banks (Licensing Manual Supplement). This announcement, while expected, is an extremely significant development in federal banking law, and one almost assuredly to be legally challenged, at a time when the Chevron doctrine of administrative agency deference is receiving a fresh look. The OCC’s decision, when considered with its historical approach to preemption under the National Bank Act, could expand the scope of federal banking regulation considerably and provide substantial opportunities.  These opportunities could benefit not merely Fintech firms but investors in many such firms, who would appear to be able to control certain SPNBs and still avoid regulation under the Bank Holding Company Act (BHC Act), including the Volcker Rule. Powers of a Fintech SPNB When former Comptroller Curry introduced his Fintech national bank proposal in December 2016, he noted that “the number of Fintech companies in the United States and United Kingdom has ballooned to more than 4,000, and in just five years investment in this sector has grown from $1.8 billion to $24 billion worldwide.”[1]  The Policy Statement – consistent with the OCC’s traditional approach to the “business of banking” under the National Bank Act – makes clear that the special purpose charter is a response to this development, noting: The OCC recognizes that the business of banking evolves over time, as do the institutions that provide banking services. As the banking industry changes, companies that engage in the business of banking in new and innovative ways should have the same opportunity to obtain a national bank charter as companies that provide banking services through more traditional means.[2] Consistent with its existing regulations, the Policy Statement takes an expansive view of the National Bank Act’s powers provision, 12 U.S.C. § 24(SEVENTH).  Under this provision, a national bank is permitted, when a charter is issued, to: [E]xercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes . . .[3] Prior to issuing the Policy Statement, the OCC had interpreted this provision to permit it to grant a charter to an institution that engaged in “any of the three core banking functions of receiving deposits, paying checks, or lending money.”[4]  Consistent with this existing regulation, a Fintech firm seeking a SPNB charter must conduct “at least one of these three core banking functions.”[5]  The Licensing Manual Supplement, however, provides greater elasticity to this requirement, as it states that “[t]he OCC views the National Bank Act as sufficiently adaptable to permit national banks to engage in traditional activities like paying checks and lending money in new ways. For example, facilitating payments electronically may be considered the modern equivalent of paying checks.”[6] Depending on the OCC’s ultimate position on “modern equivalence,” a Fintech SPNB charter could be available not only to Fintech firms engaged in lending activities without taking deposits (such as peer-to-peer lending companies), but also to companies engaged in payments broadly understood – including traditional money transmitters, and, in addition, virtual currency exchanges, because such exchanges also engage in money transmission, and indeed many have been licensed by the states as such.  It is noteworthy that the Licensing Manual Supplement states that: Beyond those core activities [deposits, lending, paying checks], the activities of an SPNB are limited to those that are permissible for national banks under a statute, regulation, or federal judicial precedent, or that the OCC has determined to be permissible. See e.g. 12 USC 24(Seventh); 12 CFR 7.5002; NationsBank of North Carolina, N.A. v. Variable Annuity Life Ins. Co., 513 U.S. 251 (1995).[7] In the NationsBank case cited, the Supreme Court, per Justice Ginsburg, “expressly h[e]ld” that “the ‘business of banking’ is not limited to the enumerated powers in § 24 Seventh and that the Comptroller therefore has discretion to authorize activities beyond those specifically enumerated.”[8] OCC Expectations As it indicated in its 2016 White Paper, the OCC is not proposing a “bank-lite” approach to Fintech SPNBs. The OCC expects any charter proposal to have a comprehensive business plan covering at a minimum three years.  The plan should include comprehensive alternative business strategies to address various best-case and worst-case scenarios.  In keeping with its post-Financial Crisis approach to corporate governance, the OCC emphasized the role of an SPNB’s board of directors, who must have a prominent role in the overall governance framework, actively oversee management, provide “credible challenge,” and exercise independent judgment.[9] The OCC also emphasized the importance of capital, minimum and ongoing levels of which need to be commensurate with the risk and complexity of the proposed activities (including on- and off-balance sheet activities).[10]  Where a SPNB’s business activities are principally off-balance sheet, traditional minimum capital requirements may not adequately reflect all risks, and the OCC could therefore require applicants in such circumstances to propose a minimum level of capital that the proposed SPNB would meet or exceed at all times.  In this regard, the OCC noted that other types of limited charter banks often hold capital that “exceeds the capital requirements for other types of banks.”[11]  The OCC would expect a similarly granular presentation with respect to a SPNB’s liquidity, including consideration of planned and unplanned balance sheet changes, varying interest ratio scenarios, and market conditions. Charter applicants would also be expected to demonstrate appropriate systems and programs to identify, assess, manage and monitor risk, including policies and procedures, practices, training, internal control and audit.  Of particular importance is a compliance program for anti-money laundering and OFAC sanctions, as well as a consumer compliance program designed to ensure fair treatment of customers. Two very important criteria for receiving an SPNB charter are financial inclusion and contingency planning.  As to the first, the OCC states: Consistent with the agency’s mission to ensure fair treatment of customers and fair access to financial services, the OCC expects any entity seeking an SPNB charter to demonstrate a commitment to financial inclusion that includes providing or supporting fair access to financial services and fair treatment of customers.  The nature of that commitment will depend on the proposed bank’s business model, and the types of products, services, or activities it intends to provide. An SPNB applicant should describe the proposed bank’s commitment to financial inclusion in its application. The description should include the proposed goals, approaches, activities, milestones, commitment measures, and metrics for serving the anticipated market and community consistent with the bank’s activities, business model, and product and service offerings.[12] On the second, because many SPNBs are likely not to be FDIC-insured, the OCC will be such institutions’ receiver in insolvency.  As a result, the OCC will insist on a detailed contingency plan to be prepared: Before receiving final approval for a charter, an SPNB will be required to develop a contingency plan to address significant financial stress that could threaten the viability of the bank. The contingency plan should outline strategies for restoring the bank’s financial strength and options for selling, merging, or liquidating the bank in the event the recovery strategies are not effective. The format and content of the plan are flexible and should be tailored to the bank’s specific business and reviewed and updated as the bank’s business evolves. As a condition for preliminary approval of a charter, an SPNB will be required to develop the contingency plan during the bank’s organization phase. The OCC’s final approval will require the bank to implement and adhere to the plan. The bank will be expected to review the contingency plan annually and update it as needed. Any significant changes to the contingency plan will require the non-objection of the appropriate supervisory office.[13] As a national banking association, a Fintech SPNB would be subject to the federal statutes applicable to other national banks, such as lending limits, limits on real estate and securities investments, the Bank Secrecy Act and other anti-money laundering laws, OFAC sanctions requirements, and, where applicable, such as with respect to lending, federal consumer law.  A Fintech SPNB would be required to become a member bank in the Federal Reserve System and subscribe for stock in its applicable Federal Reserve Bank in an amount equal to six percent of the bank’s paid-up capital and surplus. Benefits of a Special Purpose Charter to Fintech Firms The principal benefits of the special purpose charter to Fintech firms are national licensing and federal preemption.  Currently, peer-to-peer lending firms, money transmission companies, and virtual currency exchanges are all licensed by the states.  For such firms to carry out a national business, licensing on a state-by-state basis, and ongoing state examination processes, can be burdensome.  The SPNB charter will provide a federal alternative – and one regulator – to the state-by-state approach for qualifying firms. Second, an SPNB will benefit from federal preemption under the National Bank Act.  Such federal preemption is still broad, notwithstanding the Dodd-Frank Act’s attempt to narrow it.  After the Dodd-Frank Act, the OCC may preempt “state financial consumer law” if its application would have a discriminatory effect on national banks in comparison with its effect on state-chartered banks; the state consumer financial law prevents or significantly interferes with the execution by a national bank of its powers (the Barnett standard); or the state law is preempted by a federal consumer financial law other than Dodd-Frank.[14] Significantly, Dodd-Frank left unchanged the ability of a national bank to export interest rates of its home state nationally without regard to state law usury limitations; such interest rate exportation will be a significant benefit to SPNBs engaged in lending activities. Benefits of a Special Purpose Charter to Fintech Investors The SPNB charter may also provide benefits to Fintech investors, who would appear to be able to make controlling investments in certain SPNBs without becoming subject to the BHC Act, including the Volcker Rule.  The BHC Act defines a “bank” as either an FDIC-insured bank or as an institution that both accepts demand deposits and is engaged in the business of making commercial loans.[15]  Under the Policy Statement, the OCC can charter a SPNB that does not accept deposit funding – that is, one that is engaged in making loans or paying checks, or both such activities, as its core banking functions; such a SPNB would not be a BHC Act “bank.”  As a result, such an SPNB may be “controlled” by an investor without that investor becoming a bank holding company. This means that there is now another alternative to the state industrial bank charter available for investors such as private equity firms that wish to obtain the benefits of controlling a banking entity without the burdens of regulation by the Board of Governors of the Federal Reserve System.  In addition, although the OCC can be expected to require some form of capital support from a controlling investor of a non-deposit-taking SPNB, the explicit “source of strength” requirement added by the Dodd-Frank Act for a controlling investor will not apply, because that requirement applies only to controlling shareholders of insured depository institutions.[16] As a result, a Fintech firm that seeks a non-depository SPNB charter may find itself attractive to a wide range of investors. ________________________ It seems highly likely that certain state regulators will challenge the OCC’s Fintech SPNB determination, given its potential to shift a wide variety of firms to federal supervision and examination and preempt areas of state regulation.  Earlier such suits filed after the OCC’s December 2016 White Paper were dismissed as unripe; however, once the chartering process begins, litigation by state regulators could well be expected.  If the OCC’s interpretation of the National Bank Act is upheld by a reviewing court, the Fintech SPNB charter could be the most revolutionary development of regulatory reform in the Trump era, for both Fintech firms and their investors.    [1]   OCC, Exploring Special Purpose National Bank Charters for Fintech Companies (December 2016), at 3-4.    [2]   OCC, Policy Statement on Financial Technology Companies’ Eligibility to Apply for National Bank Charters (July 31, 2018), at 1.    [3]   12 U.S.C. § 24(SEVENTH).    [4]   12 C.F.R. § 5.20.    [5]   OCC, Policy Statement, at 2.    [6]   OCC, Licensing Manual Supplement:  Considering Charter Applications from Financial Technology Companies, at 2 n.5.    [7]   Id. at n.4.    [8]   513 U.S. 251, 258 n.2 (1995).  Given the Valic holding, the OCC would appear to have substantial discretion regarding permissible activities for SPNBs, as long as one core banking function was present.  The degree to which the OCC will exercise such discretion is currently unknown.    [9]   OCC Licensing Manual Supplement, at 16. [10]   Id. at 8. [11]   Id. at 9, n.26. [12]   Id. at 10. [13]  Id. [14]   12 U.S.C. § 25b(b)(1). [15]   Id. § 1841(c)(1). [16]   Id. § 1831o-1. The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Jeffrey Steiner and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 30, 2018 |
2018 Mid-Year Securities Enforcement Update

Click for PDF I.  Significant Developments A.  Introduction For a brief moment in time, after several years with as many as 3 of the 5 commissioner seats vacant, the SEC was operating at full force, with the January 2018 swearing in of newest commissioners Hester Peirce and Robert Jackson.  This situation was short-lived, as Commissioner Piwowar, a Republican appointee with a deregulatory bent who had pulled back on certain enforcement powers, stepped down at the beginning of July.  While the president has named a potential replacement, the Senate has not yet held confirmation hearings; with Democratic Commissioner Kara Stein also set to leave the agency sometime later this year, the Senate may defer consideration until both the Republican and Democratic nominees have been named.  The vacancy could cause the Commission, which has already split on several key rulemakings, to defer some more controversial regulatory initiatives and even some enforcement actions which pose thornier policy questions. Meanwhile, the most noteworthy Enforcement-related event came with the Supreme Court’s Lucia decision, in which the Court held that the agency’s administrative law judges have been unconstitutionally appointed, resolving a technical but significant legal issue which has dogged the SEC’s administrative proceedings for several years.  As discussed further below, the decision throws a wrench in the works for the Enforcement Division, which until the past couple years had been litigating a growing number of enforcement actions in its administrative forum rather than in federal court. In terms of enforcement priorities, the SEC has continued to pursue a relatively small number of significant public company cases; despite a push in recent years to increase its focus on accounting fraud, few new actions were filed in the first half of 2018.  In contrast, the Division filed a surprisingly large number of cases against investment advisers and investment companies, including advisers to individual retail clients, private fund managers, and mutual fund managers. And the SEC’s concentration on all things “cyber” continued to make headlines in the initial months of 2018.  The SEC rolled out guidance on appropriate cybersecurity disclosures, and filed its first (and to date only) case against a public company for allegedly failing to report a data breach to investors on a timely basis.  Additionally, the SEC continues to institute enforcement actions in the cryptocurrency space, though is focus remains primarily on outright frauds, leaving ongoing uncertainty as to the regulatory status of certain digital assets. B.  Significant Legal Developments On June 21, 2018, the Supreme Court ruled in Lucia v. SEC that the SEC’s administrative law judges (ALJs) were inferior officers of the United States for purposes of the Constitution’s Appointments Clause, and that the SEC had failed to properly appoint its ALJs in a manner consistent with the Clause.[1]  (Mr. Lucia was represented by Gibson Dunn before the Supreme Court.)  After several years in which the SEC had increasingly filed contested proceedings administratively rather than in federal district court, the agency reversed course in the face of mounting court challenges to the constitutionality of its ALJs (who had been appointed by a government personnel office rather than by the commissioners themselves).  Even with the reduced number of pending, litigated administrative proceedings, the SEC still faces the prospect of retrying dozens of cases which had been tried before improperly-appointed ALJs.  As this report went to press, the SEC had yet to determine how it would handle these pending cases, or how or when it would go about appointing ALJs to hear litigated administrative proceedings going forward. Even with Lucia resolving the primary legal question which had been floating about in recent years, other questions about the legality of ALJs may continue to complicate administrative proceedings, and thus for the time being the SEC has determined to pursue most litigated cases in court.  (Though the SEC continues to bring settled administrative proceedings, as such settled orders are issued by the Commission itself rather than by an ALJ.) Another Supreme Court decision that curtailed SEC enforcement actions, SEC v. Kokesh, continues to impact the enforcement program.  As detailed previously, in June 2017 the Supreme Court overturned a lower court ruling that required the defendant to disgorge $34.9 million for conduct dating back to 1995.  The Supreme Court found that disgorgement was a form of penalty and was therefore subject to a five-year statute of limitations.[2]  In March 2018, on remand, the Tenth Circuit determined that the statute of limitations still did not bar the SEC’s action since the “clock” restarted with each act of misappropriation.[3]  Moreover, notwithstanding Kokesh, the issue of whether SEC actions seeking injunctive relief or other non-monetary sanctions (such as industry bars) are governed by the five-year statute remains hotly contested.  In a May 2018 speech, Co-Enforcement Director Steven Peiken noted that the SEC continues to maintain that injunctive relief is not subject to the five-year statute of limitations under Kokesh, and admonished parties that the staff would not forgo pursuing actions based on such arguments.[4]  However, the issue is far from settled, and just this month a district court came to a different conclusion.[5] In June, the Supreme Court granted a petition of certiorari filed by Francis V. Lorenzo, an investment banker who copied and pasted his boss’s allegedly fraudulent email into a message to his clients and who the D.C. Circuit found liable for fraud as a result[6].  Mr. Lorenzo has argued that, based on the Supreme Court’s 2011 decision in Janus Capital Group Inc. v. First Derivative Traders, he should not be considered the “maker” of the allegedly fraudulent statements.  Mr. Lorenzo’s petition asserts that the D.C. Circuit decision allows the SEC to avoid the requirements of Janus by characterizing fraud claim as “fraudulent scheme” claims.  A circuit split exists as to whether a misstatement alone can form the basis of a fraudulent scheme claim. C.  Whistleblower Developments The first half of 2018 saw the SEC’s largest whistleblower bounties to date, as well as some related rulemaking proposals which could potentially cap such awards.  As of April, the SEC reported that it had paid more than $266 million to 55 whistleblowers since 2012.[7] In March, the SEC announced its highest-ever whistleblower awards, paying a combined $50 million to two individuals and an additional $33 million to a third.[8]  While the SEC may not disclose the identities of whistleblowers, their counsel subsequently publicly disclosed that the awards were paid in connection with a $415 million SEC settlement with a major financial institution alleged to have misused customer cash.[9]  In its Order granting the awards, the Commission declined to grant awards to additional putative whistleblowers and, in doing so, clarified the standard for finding that a tip “led to” the success of a particular action.[10]  For a tip to “significantly contribute[] to the success of an . . . action” and entitle the whistleblower to an award, the “information must have been ‘meaningful,'” i.e., must “‘make a substantial and important contribution’ to the success of the . . . action.”  The Commission declined to adopt a more flexible standard. In a separate action the following month, the SEC awarded $2.2 million to a former company insider.[11]  The SEC noted that the $2.2 million award was paid under the 120-day “safe harbor” rule, which provides that, when a whistleblower reports to another federal agency and then submits the same information to the SEC within 120 days, the SEC will treat the information as having been submitted on the day it was submitted to the other agency.  A week later, the SEC announced a $2.1 million award to a former company insider whose tips had led to “multiple” successful enforcement actions.[12] In addition to developments relating to award payments, the first half of 2018 also included a Supreme Court decision affecting the rights of whistleblowers pursuant to anti-retaliation protections.  In Digital Realty Trust, the Court overturned the Ninth Circuit’s decision (described in our 2017 Year-End Update) and found that Dodd-Frank’s anti-retaliation measures protect only whistleblowers who report their concerns to the SEC and not those who only report internally.[13] Finally, in a late June open meeting, the Commission voted to propose various amendments to its whistleblower program.[14]  In response to the record-breaking award noted above, the proposed rules would give the SEC discretion to limit the size of awards in cases resulting in monetary sanctions greater than $100 million (which, given a permissible award size of 10-30% of money collected by the SEC, would effectively create a $30 million award cap).  Other proposed amendments include: allowing awards based on deferred prosecution agreements and non-prosecution agreements entered into in criminal cases; permitting awards made when the Commission reaches a settlement outside the context of a judicial or administrative proceeding; allowing the SEC to bar individuals from later seeking awards after they submit false or frivolous claims; and, in response to Digital Realty, requiring a whistleblower to submit information in writing to receive retaliation protection. D.  Cybersecurity and Cryptocurrency In 2017, the SEC touted cybersecurity as a major enforcement priority and created a dedicated “Cyber Unit” to investigate and prosecute cyber-related threats.  The SEC’s cyber-focus continued in the first half of 2018 with its February release of interpretive guidance on public companies’ disclosure obligations regarding cybersecurity risks and incidents.[15]  The Guidance, which reaffirms and expands upon the SEC Division of Corporation Finance’s existing guidance on the topic from 2011, encourages companies to adopt “comprehensive policies and procedures related to cybersecurity,” and to consider how their insider trading policies address trading related to cybersecurity incidents.  While not creating any bright-line rules, it discusses that the “materiality of cybersecurity risks and incidents depends upon their nature, extent, and potential magnitude,” as well as “the range of harm that such incidents could cause,” including “harm to a company’s reputation, financial performance, and customer and vendor relationships, as well as the possibility of litigation or regulatory investigations or actions.”  The SEC further noted that the existence of an ongoing internal or external investigation into an incident “would not on its own provide a basis for avoiding disclosures” of an otherwise material incident.  As discussed further below, the Guidance was followed two months later by the SEC’s announcement of its first enforcement action against a company arising out of a data breach. Regarding the continuing proliferation of digital (or “crypto”) currencies, the staff of the SEC’s Divisions of Enforcement and Trading and Markets issued a statement in March reinforcing that digital platforms that trade securities and operate as an “exchange,” as defined by the federal securities laws, must register as a national securities exchange or operate under an exemption from registration.[16]  The statement also outlines a list of questions that potential investors should consider before deciding to trade on such platforms.  The statement came on the heels of a litigated enforcement action charging a bitcoin-denominated platform, BitFunder, and its founder with operating an unregistered securities exchange, defrauding users by misappropriating their bitcoins and failing to disclose a cyberattack, and making false and misleading statements in connection with an unregistered offering of securities.[17]  In a parallel criminal case, the U.S. Attorney’s Office charged BitFunder’s founder with perjury and obstruction of the SEC’s investigation. The SEC also brought a handful of initial coin offering (ICO) enforcement actions in the first half of 2018.  In January, the SEC obtained a court order halting an ICO it characterized as “an outright scam,” which had raised $600 million in just two months by claiming to be the world’s first “decentralized bank” and falsely representing that it had purchased an FDIC-insured bank.[18]  In April, the SEC charged two co-founders of a financial services start-up with orchestrating a fraudulent ICO by falsely claiming to offer a debit card backed by major credit card companies that would allow users to convert cryptocurrencies into U.S. dollars.[19]  The U.S. Attorney’s Office for the Southern District of New York brought parallel criminal actions against the co-founders, and the SEC later charged a third co-founder with fraud after discovery of text-messages revealing fraudulent intent.[20]  Then, in May, the SEC obtained a court order halting an ICO by a self-proclaimed “blockchain evangelist” who had fabricated customer testimonials and misrepresented having business relationships with the Federal Reserve and dozens of companies.[21] Additionally, in April, the SEC obtained a court order freezing over $27 million in proceeds raised by Longfin Corp. after the company and its CEO allegedly violated Section 5 by issuing unregistered shares to three other individuals so they could sell them to the public right after the company’s stock had risen dramatically due to announcement of acquisition of a cryptocurrency platform.[22] II.  Issuer and Auditor Cases A.  Accounting Fraud and Other Misleading Disclosures In March, the SEC settled charges of accounting fraud against a California-based energy storage and power delivery product manufacturer and three of its former officers.[23]  The SEC alleged that the company prematurely recognized revenue to better meet analyst expectations, that a former sales executive inflated revenues by executing secret deals with customers and concealing them from finance and accounting personnel, and that the former CEO and former controller failed to adequately respond to red flags that should have alerted them to the misconduct.  Without admitting or denying the allegations, the company agreed to pay penalties of $2.8 million; the former CEO and controller agreed to pay a combined total of approximately $100,000 in disgorgement, interest and penalties; and the former sales executive agreed to be barred from serving as an officer or director of a public company for five years and pay a $50,000 penalty. In April, the SEC settled charges of accounting fraud against a Japanese electronics company.[24]  The SEC alleged that the company’s U.S. subsidiary prematurely recognized more than $82 million in revenue by backdating an agreement with an airline and providing misleading information to an auditor.  The matter involved FCPA allegations as well. Also in April, the SEC instituted settled proceedings against a California internet services and content provider.[25]  The SEC alleged that the company failed to timely disclose a major data breach in which hackers stole personal data relating to hundreds of millions of user accounts.  In addition, the SEC alleged that the company did not share its knowledge of the breach with its auditors or outside counsel, and failed to maintain adequate controls and procedures to assess its cyber-disclosure obligations.  Without admitting the allegations, the company agreed to pay a $35 million penalty to settle the charges. In May, the SEC filed a complaint against three former executives of a Houston-based health services company.[26]  The complaint alleged that the executives falsified financial information—including financial statements for three fictitious subsidiaries acquired by the company—to induce a private firm to acquire a majority of the company’s equity.  In a parallel action, DOJ brought criminal charges against the defendants. In June, the SEC filed a complaint against a California-based telecommunications equipment manufacturer and three of its executives.[27]  According to the SEC’s complaint, the executives inflated company revenues by prematurely recognizing revenue on sales and entering into undisclosed side agreements that relieved customers of payment obligations.  The SEC also alleged that the defendants inflated the prices of products to hit revenue targets with the agreement that the company would later repay the difference as marketing development fees.  Without admitting or denying the charges, the defendants agreed to pay penalties totaling $75,000.  In addition, two of the individual defendants consented to five-year officer and director bars; the other individual defendant consented to a bar from appearing or practicing before the SEC as an accountant for five years. B.  Auditor Cases In February, in a case the SEC said underscores its determination to pursue violations “regardless of the location of the violators,” a foreign auditor and his U.S.-based accounting firm, settled charges alleging they providing substantial assistance in a fraudulent shell company scheme by issuing misleading audit reports for numerous companies.[28]  The SEC suspended the auditor and his firm from appearing or practicing before the Commission. In March, the SEC announced settled charges against several foreign firms of the large international accounting networks based on allegations that the firms improperly relied on component auditors that were not registered with the PCAOB, even though the component auditors performed substantial work that should have triggered registration.[29] The SEC alleged violations of PCAOB standards that require sufficient analysis and inquiry when relying on another auditor.  Without admitting or denying the allegations, the four foreign firms agreed to pay roughly $400,000 combined in disgorgement and penalties. Additionally, an auditing firm, two of its partners and a registered financial advisory firm settled charges in May relating to violations of the Custody Rule.[30]  According to the SEC, the auditors failed to meet the independence requirements of the Custody Rule by both preparing and auditing financial statements of several funds and because they had a direct business relationship with the financial advisory firm through a fee-referral relationship.  The SEC also charged the respondents for failing to comply with the requirement of regular PCAOB inspections and cited multiple professional conduct violations, including for failing to design and implement appropriate oversight mechanisms, insufficient quality control and violation of professional due care, among others.  Without admitting or denying the allegations, the defendants were barred from appearing before the Commission and agreed to pay roughly $52,000 combined in disgorgement and penalties. The SEC is also ensuring that firms are not associating with barred auditors. In April, an accounting firm and its sole officer and founder settled charges with the SEC for allegedly violating the Sarbanes Oxley Act of 2012, which prohibits auditors barred by the PCAOB from association with a registered public accounting firm from associating with corporate issuers in an accountancy or financial management capacity.[31]  Without admitting or denying the findings, the company and its founding officer agreed to cease and desist from the association and agreed to pay a $22,500 civil penalty. C.  Private Company Cases While the number of cases against public companies remains low, the SEC has continued to step up its enforcement efforts against private companies. In March, the SEC instituted settled proceedings against a California-based financial technology company.[32]  The SEC alleged that the respondent offered unregistered stock options to its employees without providing the employees with timely financial statements and risk disclosures.  Without admitting the allegations, the company agreed to pay a $160,000 penalty to settle the charges. Also in March, the SEC filed a complaint against a California-based health care technology company, its former CEO, and a former president at the company.[33]  The complaint alleged that the defendants made numerous false statements in investor presentations, product demonstrations and media articles about their flagship product—including misrepresentations regarding expected revenue and the U.S. Department of Defense’s adoption of the product—which deceived investors into believing the product was revolutionary.  Without admitting the allegations, the company and former CEO agreed to settle the charges.  Under the settlement terms, the former CEO agreed to pay a $0.5 million penalty, be barred from serving as an officer or director of a public company for ten years, return 18.9 million shares of the company, and relinquish her voting control by converting her Class B Common shares to Class A Common shares.  The SEC will continue to litigate its claims against the former president in federal court. And in April, the SEC filed a fraud complaint against four parties:  a biotechnology startup formerly based in Massachusetts, its CEO, an employee, and the CEO’s close friend.[34]  According to the SEC, the CEO and the employee made false claims to investors about the company’s finances and the company’s progress in seeking FDA approval for one of its products.  The complaint also alleged that the defendants engaged in a fraudulent scheme to acquire and merge the company with a publicly traded company, manipulated the shares of the new entity, and diverted a portion of the sale proceeds.  The SEC is litigating the case in federal court and seeks to freeze the company’s and CEO’s assets, as well as prohibit the defendants from soliciting money from investors.  In addition, the SEC seeks a permanent injunction, the return of the ill-gotten gains with penalties, and industry and penny stock bars.  The DOJ brought parallel criminal charges against the individual defendants. III.  Investment Advisers and Funds A.  Fees and Expenses In June, a private equity firm settled allegations that it had charged accelerated monitoring fees on portfolio company exits without adequate disclosure.[35]  According to the SEC, the undisclosed receipt of accelerated fees from portfolio companies resulted in negligent violations of various provisions of the Advisers Act.  To settle the matter, the Respondents agreed to pay $4.8 million in disgorgement and prejudgment interest and $1.5 million in penalties. Shortly thereafter, the SEC filed a settled action against a New York-based venture capital fund adviser for allegedly failing to offset consulting fees against management fees in accordance with organizational documents for the funds it advised.[36]  The SEC alleged that the adviser received $1.2 million in consulting fees from portfolio companies in which the funds had invested, and that those fees were not properly offset against advisory or management fees paid by investors, resulting in an overpayment of over $750,000.  The adviser reimbursed its clients, plus interest, and agreed to pay a $200,000 penalty.  Significantly, the SEC’s press release cites to the adviser’s remediation and cooperation, indicating that this was taken into account in determining the appropriate resolution. B.  Conflicts of Interest In March, the SEC instituted settled proceedings against two investment adviser subsidiaries for undisclosed conflicts of interest with regard to the practice of recalling securities on loan.[37]  The SEC alleged that the advisers were affiliated with insurance companies, but also served as investment advisers to insurance-dedicated mutual funds.  The advisers would lend securities held by the mutual funds, and then recall those securities prior to their dividend record dates.  This meant that the insurance company affiliates, as record shareholders of such shares, would receive a tax benefit on the basis of the dividends received.  However, according to the SEC, this recall system resulted in the mutual funds (and their investors) losing income, while the insurance company affiliates reaped a tax benefit.  Without admitting or denying the allegations, the advisers agreed to pay approximately $3.6 million to settle the charges. In April, the SEC instituted proceedings against a New York-based investment adviser in connection with the receipt of revenue sharing compensation from a service provider without disclosing conflicts of interest to its private equity clients.[38]  According to the SEC, the investment adviser entered into an agreement with a company that provided services to portfolio companies.  Pursuant to that agreement, when portfolio companies made purchases, the service provider would receive revenue, and, in turn, the investment adviser would receive a portion of that revenue.  Without admitting or denying the allegations of Advisers Act violations, the investment adviser agreed to pay nearly $800,000 in disgorgement, prejudgment interest, and civil penalties. In early June, the SEC instituted settled proceedings against a New York-based investment adviser in connection with alleged failures to disclose conflicts of interest to clients and prospective clients relating to compensation paid to the firm’s individual advisers and an overseas affiliate.[39]  According to the SEC, this undisclosed compensation, which came from overseas third-party product and service providers recommended by the adviser, incentivized the adviser to recommend certain products and services and a pension transfer.  The SEC also found that the adviser made misleading statements regarding investment options and tax treatment of investments.  In settling the action without admitting or denying the allegations, the investment adviser agreed to pay an $8 million civil penalty and to engage an independent compliance consultant.  In a parallel action, the Commission filed a complaint in federal court in Manhattan against the adviser’s former CEO and a former manager. On the same day, the SEC filed another settled administrative proceeding relating to undisclosed conflicts of interest with a Delaware-based investment adviser.[40]  The settlement order alleges that the adviser negotiated side letters with outside asset managers resulting in arrangements under which the asset managers would make payments to the adviser based on the amount of client assets placed or maintained in funds advised by those asset managers.  This was not disclosed to clients, and contravened the adviser’s agreements with two specific advisory clients.  The SEC also alleged that the adviser failed to implement policies and procedures to prevent conflicts of interest and failed to maintain accurate records relating to the payments from the outside asset managers.  Without admitting or denying the Commission’s findings, the adviser agreed to pay a $500,000 penalty. C.  Fraud and Other Misconduct In January, the SEC filed settled charges against a California-based investment adviser and its CEO and President for failing to adequately disclose the risks associated with investing in their advisory business.[41]  According to the SEC, the firm decided to borrow cash from investors—including its own retail investor clients whose portfolio accounts were managed by the CEO—in the form of promissory notes, in order to fund its business expenses, which exceeded the amount of money received from advisory fees.  In their efforts to market the promissory notes, the CEO and President failed to disclose the true financial state of the firm or the significant risk of default.  In settling the action, the investment adviser agreed to various undertakings, including an in-depth review and enhancement of compliance policies and procedures, and the provision of detailed information regarding noteholders to the staff.  In addition, the firm paid a $50,000 penalty and each principal paid a $25,000 penalty. Also in January, the SEC filed charges in the District of Massachusetts against two Boston-based investment advisers, alleging they engaged in various schemes to defraud their clients, including stealing client funds, failing to disclose conflicts of interest, and secretly using client funds to secure financing for their own investments.[42]  The SEC also alleged that one of the individuals violated his fiduciary duties to clients by obtaining a loan from a client on unfavorable terms to that client and charging advisory fees over 50% higher than the promised rate.  According to the complaint, the pair in one instance misappropriated nearly $450,000 from an elderly client, using the funds to make investments in their own names and to pay personal expenses for one of the individual advisers.  The U.S. Attorney’s Office for the District of Massachusetts also filed criminal charges against the same advisers in a parallel action.  While the SEC action remains pending, the individuals have both pleaded guilty to criminal charges.[43] The SEC also initiated a number of enforcement actions for alleged cherry-picking by investment advisers.  In February, the SEC instituted a litigated action against a California-based investment adviser, its president and sole owner, and its former Chief Compliance Officer for allocating profitable trades to the investment adviser’s account at the expense of its clients.[44]  The SEC’s complaint also alleges that the adviser and president misrepresented trading and allocation practices in Forms ADV filed with the Commission.  The former CCO agreed to settle the charges against him—without admitting or denying allegations that he ignored red flags relating to the firm’s allocation practices—and pay a fine of $15,000; the litigation against the investment adviser and president remains ongoing.  And in March the SEC instituted settled proceedings against a Texas-based investment adviser and its sole principal for disproportionately allocating unprofitable trades to client accounts and profitable trades to their own accounts.[45]  The investment adviser agreed to pay a total of over $700,000 in disgorgement, prejudgment interest, and civil penalties, and the principal agreed to a permanent bar from the securities industry. In April, the SEC filed a settled administrative proceedings against an Illinois-based investment adviser and its president in connection with allegedly misleading advertisements about investment performance.[46]  According to the SEC, the adviser did not disclose that performance results included in advertisements—in the form of written communications and weekly radio broadcasts and video webcasts by its president—were often based on back-tested historical results generated by the adviser’s models, rather than actual results.  The adviser also allegedly failed to adopt written policies and procedures designed to prevent violations of the Advisers Act.  In reaching the agreed-upon resolution, the SEC took into account remediation efforts undertaken by the adviser during the course of the SEC’s investigation, including hiring a new CCO and engaging an outside compliance consultant who conducted an in-depth review of the compliance program and made recommendations which were then implemented by the adviser.  The investment adviser agreed to pay a $125,000 penalty, and the adviser’s president agreed to pay a $75,000 penalty. In May, the SEC charged a California-based individual investment adviser with lying to clients about investment performance and strategy, inflating asset values and unrealized profits in order to overpay himself in management fees and bonuses, and failing to have the private funds audited.[47]  The adviser settled the charges without admitting or denying the allegations, agreeing pay penalties and disgorgement in amounts to be determined by the court. Later that month, the SEC filed settled charges against a Delaware-based investment adviser and its managing member for allegedly making misrepresentations and omissions about the assets and performance of a hedge fund they managed.[48]  According to the SEC, the adviser misrepresented the performance and value of assets in the hedge fund after losing nearly all of its investments after the fund’s trading strategy led to substantial losses.  In addition to making false representations to the fund’s two investors, the adviser withdrew excessive advisory fees based on the inflated asset values.  Without admitting or denying the charges, the adviser and managing member agreed to a cease-and-desist order under which the individual also agreed to a broker-dealer and investment company bar, as well as a $160,000 penalty. In another pair of cases filed in May, the SEC charged a hedge fund and a private fund manager in separate cases involving inflated valuations.  In one case, the SEC alleged that the fund manager’s Chief Financial Officer failed to supervise portfolio managers who engaged in asset mismarking.[49]  The asset mismarking scheme resulted in the hedge fund reaping approximately $3.15 million in excess fees.  The SEC had previously charged the portfolio managers in connection with their misconduct in 2016.  The CFO agreed to pay a $100,000 penalty and to be suspended from the securities industry for twelve months, while the firm agreed to pay over $9 million in disgorgement and penalties.  In the other case, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against a New York-based investment adviser, the company’s CEO and chief investment officer, a former partner and portfolio manager at the company, and a former trader, in connection with allegations that the defendants inflated the value of private funds they advised.[50]  According to the complaint, the defendants fraudulently inflated the value of the company’s holdings in mortgage-backed securities in order to attract and retain investors, as well as to hide poor fund performance.  This litigation is ongoing. Finally, in late June the SEC announced a settlement with an investment adviser that allegedly failed to protect against advisory representatives misappropriating or misusing client funds.[51]  Without sufficient safeguards in place, one advisory representative was able to misappropriate or misuse $7 million from advisory clients’ accounts.  Without admitting or denying the SEC’s findings, the adviser agreed to pay a $3.6 million penalty, in addition to a cease-and-desist order and a censure.  The representative who allegedly misused the $7 million from client accounts faces criminal charges by the U.S. Attorney’s Office for the Southern District of New York. D.  Investment Company Share Price Selection The first half of 2018 saw the launch of the SEC’s Share Class Selection Disclosure Initiative (SCSD Initiative), as well as several cases involving share class selections.  Under the SCSD Initiative, announced in February, the SEC’s Division of Enforcement agreed not to recommend financial penalties against mutual fund managers which self-report violations of the federal securities laws relating to mutual fund share class selection and promptly return money to victimized investors.[52]  Where investment advisers fail to disclose conflicts of interest and do not self-report, the Division of Enforcement will recommend stronger sanctions in future actions. In late February, a Minnesota-based broker-dealer and investment adviser settled charges in connection with the recommendation and sale of higher-fee mutual fund shares when less expensive share classes were available.[53]  In turn, those recommendations resulted in greater revenue for the company and decreased customers’ returns.  The company, without admitting or denying the allegations, consented to a penalty of $230,000. In April, three investment advisers agreed to settle charges in connection with their failure to disclose conflicts of interest and violations of their fiduciary duties by recommending higher-fee mutual fund share classes despite the availability of less expensive share classes.[54]  Collectively, the companies agreed to pay nearly $15 million in disgorgement, prejudgment interest, and penalties.  The SEC used the announcement of the cases to reiterate its ongoing SCSDC Initiative. E.  Other Compliance Issues In January, the SEC announced settled charges against an Arizona-based investment adviser and its sole principal in connection with a number of Advisers Act violations, including misrepresentations in filed Forms ADV, misrepresentations and failure to produce documents to the Commission examination staff, and other compliance-related deficiencies.[55]  According to the SEC, the adviser’s Forms ADV for years misrepresented its principal’s interest in private funds in which its advisory clients invested.  While the clients were aware of the principal’s involvement with the funds, the adviser falsely stated in filings that the principal had no outside financial industry activities and no interests in client transactions.  Additionally, the SEC alleged that the adviser misstated its assets under management, failed to adopt written policies and procedures relating to advisory fees, and failed to conduct annual reviews of its policies and procedures.  Without admitting or denying the SEC’s allegations, the investment adviser agreed to pay a $100,000 penalty, and the principal agreed to a $50,000 penalty and to a prohibition from acting in a compliance capacity. In April, the SEC filed settled charges against a Connecticut-based investment adviser and its sole owner for improper registration with the Commission and violations of the Commission’s custody and recordkeeping rules.[56]  According to the settled order, the adviser misrepresented the amount of its assets under management in order to satisfy the minimum requirements for SEC registration.  The adviser also allegedly—while having custody over client assets—failed to provide quarterly statements to clients or to arrange for annual surprise verifications of assets by an independent accountant, as required by the Custody Rule, and also failed to make and keep certain books and records required by SEC rules.  Without admitting or denying the allegations, the adviser and its owner agreed to the entry of a cease-and-desist order, and the owner agreed to pay a $20,000 civil penalty and to a 12-month securities industry suspension. A few weeks later, a fund administrator settled cease-and-desist proceedings in connection with the company’s alleged noncompliance in maintaining an affiliated cash fund.[57]  According to the SEC, from mid-2008 to the end of 2012, the firm’s pricing methodology for its affiliated unregistered money market fund was flawed.  The SEC alleged that the deficiencies in the pricing methodology caused the affiliated cash fund to violate Investment Company Act.  To settle the charges, the trust agreed to pay a civil monetary penalty of $225,000. And in June, the SEC announced settlements with 13 private fund advisers in connection with their failures to file Form PF.[58]  Advisers who manage $150 million or more of assets are obligated to file annual reports on Form PF that indicate the amount of assets under management and other metrics about the private funds that they advise.  In turn, the SEC uses the data contained in Form PF in connection with quarterly reports, to monitor industry trends, and to evaluate systemic risks posed by private funds.  Each of the 13 advisers failed to timely file Form PF over a number of years.  Without admitting or denying the allegations, each of the 13 advisers agreed to pay a $75,000 civil penalty. IV.  Brokers and Financial Institutions A.  Supervisory Controls and Internal Systems Deficiencies The SEC brought several cases during the first half of 2018 relating to failures of supervisory controls and internal systems.  In March, the SEC filed a litigated administrative proceeding against a Los Angeles-based financial services firm for failing to supervise one of its employees who was involved in a long-running pump-and-dump scheme and who allegedly received undisclosed benefits for investing her customers in microcap stocks that were the subject of the scheme.[59]  The employee agreed to settle fraud charges stemming from the scheme.  The SEC alleged that the firm ignored multiple signs of the employee’s fraud, including a customer email outlining her involvement in the scheme and multiple FINRA arbitrations and inquiries regarding her penny stock trading activity.  The firm even conducted two investigations, deemed “flawed and insufficient” by the SEC, but failed to take action against the employee.  The SEC previously charged the orchestrator of the pump-and-dump scheme, as well as 15 other individuals and several entities. Also in March, the SEC announced settled charges against a New York-based broker-dealer for its failure to perform required gatekeeping functions in selling almost three million unregistered shares of stock on behalf of a China-based issuer and its affiliates.[60]  The SEC alleged that the firm ignored red flags indicating that the sales could be part of an unlawful unregistered distribution. At the end of June, the SEC charged a New York-based broker-dealer and two of its managers for failing to supervise three brokers, all three of whom were previously charged with fraud in September 2017.[61]  According to the SEC, the firm lacked reasonable supervisory policies and procedures, as well as systems to implement them, and if those systems had been in place, the firm likely would have prevented and detected the brokers’ wrongdoing.  In separate orders, the SEC found that two supervisors ignored red flags indicating excessive trading and failed to supervise brokers with a view toward preventing and detecting their securities-laws violations. B.  AML Cases During the first half of 2018, the SEC brought a number of cases in the anti-money laundering (“AML”) arena.  In March, the SEC brought settled charges against a New York-based brokerage firm for failure to file Suspicious Activity Reports (or “SARs”) reporting numerous suspicious transactions.[62]  The brokerage firm admitted to the charges, and agreed to retain a compliance expert and pay a $750,000 penalty.  The SEC also brought charges against the brokerage firm’s CEO for causing the violation, and its AML compliance officer for aiding and abetting the violation.  Without admitting or denying the charges, the CEO and AML compliance officer respectively agreed to pay penalties of $40,000 and $25,000. In May, the SEC instituted settled charges against two broker-dealers and an AML officer for failing to file SARs relating to the suspicious sales of billions of shares in penny stock.[63]  Without admitting or denying the SEC’s findings, the broker-dealers agreed to penalties; the AML officer agreed to a penalty and an industry and penny stock bar for a minimum of three years. C.  Regulatory Violations In January, the SEC instituted a settled administrative proceeding against an international financial institution for repeated violations of Rule 204 of Regulation SHO, which requires timely delivery of shares to cover short sales.[64]  The SEC’s order alleged that the firm improperly claimed credit on purchases and double counted purchases, resulting in numerous, prolonged fail to deliver positions for short sales.  Without admitting or denying the allegations, the firm agreed to pay a penalty of $1.25 million and entered into an undertaking to fully cooperate with the SEC in all proceedings relating to or arising from the matters in the order. In March, the SEC announced settled charges against a Los-Angeles broker dealer for violating the Customer Protection Rule, which requires that broker-dealers safeguard the cash and securities of customers, by illegally placing more than $25 million of customers’ securities at risk to fund its own operations.[65]  Specifically, the broker-dealer on multiple occasions moved customers’ securities to its own margin account without obtaining the customers’ consent.  The SEC’s Press Release noted that it had recently brought several cases charging violations of the Customer Protection Rule.  Without admitting or denying the allegations, the broker dealer agreed to pay a penalty of $80,000. Also in March, the SEC filed a settled action against a New York-based broker dealer and its CEO and founder for violating the net capital rule, which requires a broker-dealer to maintain sufficient liquid assets to meet all obligations to customers and counterparties and have adequate additional resources to wind down its business in an orderly manner if the firm fails financially.[66]  The SEC found that for ten months, the firm repeatedly failed to maintain sufficient net capital, failed to accrue certain liabilities on its books and records, and misclassified certain assets when performing its net capital calculations.  According to the SEC, the firm’s CEO was involved in discussions about the firm’s unaccrued legal liabilities and was aware of the misclassified assets, but he nevertheless prepared the firm’s erroneous net capital calculations.  As part of the settlement, he agreed to not serve as a financial and operations principal (FINOP) for three years and to pass the required licensing examination prior to resuming duties as a FINOP; the firm agreed to pay a $25,000 penalty. And in a novel enforcement action also arising in March, the SEC filed a settled action against the New York Stock Exchange and two affiliated exchanges in connection with multiple episodes, including several disruptive market events, such as erroneously implementing a market-wide regulatory halt, negligently misrepresenting stock prices as “automated” despite extensive system issues ahead of a total shutdown of two of the exchanges, and applying price collars during unusual market volatility on August 24, 2015, without a rule in effect to permit them.[67]  The SEC also, for the first time, alleged a violation of Regulation SCI, which was adopted by the Commission to strengthen the technology infrastructure and integrity of the U.S. securities markets.  The SEC charged two NYSE exchanges with violating Regulation SCI’s business continuity and disaster recovery requirement.  Without admitting or denying the allegations, the exchanges agreed to pay a $14 million penalty to settle the charges. D.  Other Broker-Dealer Enforcement Actions In June, the SEC settled with a Missouri-based broker-dealer, alleging that the firm generated large fees by improperly soliciting retail customers to actively trade financial products called market-linked investments, or MLIs, which are intended to be held to maturity.[68]  The SEC alleged that the trading strategy, whereby the MLIs were sold before maturity and the proceeds were invested in new MLIs, generated commissions for the firm, which reduced the customers’ investment returns.  The order also found that certain representatives of the firm did not reasonably investigate or understand the significant costs of the MLI exchanges.  The SEC also alleged that the firm’s supervisors routinely approved the MLI transactions despite internal policies prohibiting short-term trading or “flipping” of the products. Later in June, the SEC announced that it had settled with a New York-based broker-dealer for the firm’s violations of its record-keeping provisions by failing to remediate an improper commission-sharing scheme in which a former supervisor received off-book payments from traders he managed.[69]  The SEC also filed a litigated complaint in federal court against the former supervisor and former senior trader for their roles in the scheme.  As alleged by the SEC, the former supervisor and another trader used personal checks to pay a portion of their commissions to the firm’s former global co-head of equities and to another trader.  The practice violated the firm’s policies and procedures and resulted in conflicts of interest that were hidden from the firm’s compliance department, customers, and regulators. E.  Mortgage Backed Securities Cases The SEC appeared to be clearing out its docket of enforcement actions dating back to the mortgage crisis. In February, the SEC announced a settlement against a large financial institution and the former head of its commercial mortgage-backed securities (“CMBS”) trading desk, alleging that traders and salespeople at the firm made false and misleading statements while negotiating secondary market CMBS sales.[70]  According to the SEC’s order, customers of the financial institution overpaid for CMBS because they were misled about the prices at which the firm had originally purchased them, resulting in increased profits for the firm to the detriment of its customers.  The order also alleged that the firm did not have in place adequate compliance and surveillance procedures which were reasonably designed to prevent and detect the misconduct, and also found supervisory failures by the former head trader for failing to take appropriate corrective action.  The firm and trader, without admitting or denying the allegations, agreed to respective penalties of $750,000 and $165,000.  The firm also agreed to repay $3.7 million to customers, which included $1.48 million ordered as disgorgement, and the trader agreed to serve a one-year suspension from the securities industry. Similarly, in mid-June, a large New York-based wealth management firm paid $15 million to settle SEC charges that its traders and salespersons misled customers into overpaying for residential mortgage backed securities (RMBS) by deceiving them about the price that the firm paid to acquire the securities.[71]  The SEC also alleged that the firm’s RMBS traders and salespersons illegally profited from excessive, undisclosed commissions, which in some instances were more than twice the amount that customers should have paid.  According to the SEC, the firm failed to have compliance and surveillance procedures in place that were reasonably designed to prevent and detect the misconduct. V.  Insider Trading A.  Classical Insider Trading And Misappropriation Cases In January, a former corporate insider and a former professional in the brokerage industry agreed to settle allegations that they traded on the stock of a construction company prior to the public announcement of the company’s acquisition.[72]  The insider purportedly tipped his friend, who was then a registered broker-dealer, about the impending transaction in return for assistance in obtaining a new job with his friend’s employer following the merger.  According to the SEC, the broker-dealer traded on that information for a profit exceeding $48,000.  Without admitting or denying the SEC’s findings, both individuals consented to pay monetary penalties, and the trader agreed to disgorge his ill-gotten gains. The following month, the SEC sued a pharmaceutical company employee who allegedly traded in the stock of an acquisition target despite an explicit warning not to do so.[73]  According to the SEC, the defendant bought stock in the other company a mere 14 minutes after receiving an e-mail regarding the acquisition.  Without admitting or denying the SEC’s allegations, the employee agreed to disgorgement of $2,287 and a $6,681 penalty. In February, the SEC charged the former CEO and a former officer of a medical products company with trading on information regarding a merger involving one of their company’s largest customers.[74]  Without admitting or denying the allegations, the two executives agreed to disgorge a total of about $180,000 in trading proceeds and to pay matching penalties. In March, the SEC charged a former communications specialist at a supply chain services company with garnering more than $38,000 in illicit profits after purchasing shares in his company prior to the public announcement of its acquisition.[75]  Without admitting or denying the allegations, the defendant subsequently agreed to $38,242 in disgorgement and the payment of a penalty to be determined following a subsequent motion by the SEC.[76] That same month, the SEC filed suit against the former chief information officer of a company who sold shares of his employer prior to public revelations that that company had suffered a data breach.[77]  In addition, the U.S. Attorney’s Office for the Northern District of Georgia brought  parallel criminal charges.  Both cases are still pending.  Subsequently, at the end of June, the SEC charged another employee at that same company with trading on nonpublic information that he obtained while creating a website for customers affected by the data breach.[78]  The defendant agreed to a settlement requiring him to return ill-gotten gains of more than $75,000 plus interest, and a criminal case filed by the U.S. Attorney’s Office for the Northern District of Georgia remains ongoing. In April, the SEC charged a New York man with tipping his brother and father about the impending acquisition of a medical-supply company based on information that he learned from his friend, the CEO of the company being acquired.[79]  The SEC alleged that the father and brother garnered profits of about $145,000 based on their unlawful trading, and—without admitting or denying the SEC’s allegations—the tipper agreed to pay a $290,000 penalty.  The SEC’s investigation remains ongoing. Also in April, the SEC and the U.S. Attorney’s Office for the District of Massachusetts filed parallel civil and criminal charges against a man accused of trading on a company’s stock based on information gleaned from an unidentified insider.[80]  The man purportedly purchased shares using his retirement savings in advance of eight quarterly earnings announcements over a two-year period, reaping over $900,000 in illicit profits.  The SEC’s complaint also names the man’s wife as a relief defendant, and the matter remains ongoing. Finally, in May, the SEC charged two men with reaping small profits by trading on non-public information in advance of a merger of two snack food companies based on information gained from a close personal friend at one of the merging companies.[81]  Both defendants agreed to settle the lawsuit by disgorging ill-gotten gains and paying penalties. B.  Misappropriation by Investment Professionals and Other Advisors At the end of May, the SEC charged a vice president at an investment bank with repeatedly using confidential knowledge to trade in advance of deals on which his employer advised.[82]  The defendant allegedly used client information to trade in the securities of 12 different companies via a brokerage account held in the name of a friend living in South Korea, evading his employer’s rules that he pre-clear any trades and use an approved brokerage firm.  The trader purportedly garnered approximately $140,000 in illicit profits, and the U.S. Attorney’s Office for the Southern District of New York filed a parallel criminal case.  Both matters are still being litigated. In June, the SEC sued a Canadian accountant for trading on information misappropriated from his client, a member of an oil and gas company’s board of directors.[83]  Based on this relationship, the defendant gained knowledge of an impending merger involving the company.  Without admitting or denying the SEC’s allegations, he agreed to be barred from acting as an officer or director of a public company, and to pay disgorgement and civil penalties of $220,500 each.  The defendant also consented to an SEC order suspending him from appearing or practicing before the Commission as an accountant. Finally, that same month, the SEC charged a credit ratings agency employee and the two friends he tipped about a client’s nonpublic intention to acquire another company.[84]  According to the SEC, the tipper learned the confidential information when the client reached out to the agency to assess the impact of the merger on the company’s credit rating.  Based on the information they received, the friends allegedly netted profits of $192,000 and $107,000, respectively.  In addition, the U.S. Attorney’s Office for the Southern District of New York filed a parallel criminal case against all three individuals.. C.  Other Trading Cases And Developments In February, the Third Circuit Court of Appeals issued a decision in United States v. Metro reversing the district court’s sentencing calculation following the appellant’s conviction on insider trading charges.[85]  The appellant, Steven Metro, was a managing clerk at a New York City law firm, and over the course of five years, he disclosed material nonpublic information to a close friend, Frank Tamayo, concerning 13 different corporate transactions.  Tamayo then transmitted that information to a third-party broker, who placed trades on behalf of Tamayo, himself, and other clients, yielding illicit profits of approximately $5.5 million.  Metro pleaded guilty to one count of conspiracy and one count of securities fraud, and the district court attributed the entire $5.5 million sum to Metro in calculating the length of his sentence.  Metro objected, arguing that he was unaware of the broker’s existence until after he stopped tipping Tamayo. On appeal, the Third Circuit vacated Metro’s sentence after determining that the district court made insufficient factual findings to substantiate imputation of all illicit profits to Metro, holding: “When the scope of a defendant’s involvement in a conspiracy is contested, a district court cannot rely solely on a defendant’s guilty plea to the conspiracy charge, without additional fact-finding, to support attributing co-conspirators’ gains to a defendant.”  The court emphasized that “when attributing to an insider-trading defendant gains realized by other individuals . . . a sentencing court should first identify the scope of conduct for which the defendant can fairly be held accountable . . . .”  Such an inquiry “may lead the court to attribute to a defendant gains realized by downstream trading emanating from the defendant’s tips, but, depending on the facts established at sentencing, it may not,” and the court therefore found that the government erred in propounding a “strict liability” standard. Finally, the first half of this year also saw limited activity by the SEC to freeze assets used to effectuate alleged insider trades.  In January, the SEC obtained an emergency court order freezing the assets of unknown defendants in Swiss bank accounts.[86]  According to the SEC, those unknown defendants were in possession of material nonpublic information regarding the impending acquisition of a biopharmaceutical company, and some of the positions taken in those accounts represented almost 100 percent of the market for those particular options.  The illicit trades allegedly yielded about $5 million in profits.. VI.  Municipal Securities and Public Pensions Cases In the first half of 2018, the SEC’s Public Finance Abuse Unit continued the slower pace of enforcement that began in 2017, pursuing two separate cases against municipal advisors. In January, the SEC charged an Atlanta, Georgia-based municipal advisor and its principal with defrauding the city of Rolling Fork, Mississippi.[87]  The SEC alleged that the municipal advisor had fraudulently overcharged Rolling Fork for municipal advisory services in connection with an October 2015 municipal bond offering and had failed to disclose certain related-party payments.  The related-party payments consisted of an undisclosed $2500 payment made to the advisor by an employee of a municipal underwriter shortly before the advisor recommended that the city hire the underwriter’s firm.  The parties subsequently agreed to settle the case.[88]  Without admitting or denying the allegations against them, the advisor and principal consented to the entry of judgments permanently enjoining them from violating Sections 15B(a)(5) and 15B(c)(1) of the Securities Exchange Act of 1934 and MSRB Rule G-17.  The judgment also requires the defendants to pay a total of about $111,000 in disgorgement, interest, and penalties. In addition, the SEC settled its case against the municipal underwriter.  Without admitting the SEC’s findings, the underwriter agreed to a six-month suspension and to pay a $20,000 penalty. And in May, the SEC brought settled administrative proceedings against another municipal advisor and its owner.[89]  The SEC alleged that, by misrepresenting their municipal advisory experience and failing to disclose conflicts of interest, the advisor and owner had defrauded a South Texas school district and breached their fiduciary duties to that district.  Without admitting to the allegations, the advisor and owner agreed to pay a combined total of approximately $562,000 in disgorgement, interest, and penalties.. [1] Lucia v. SEC, 585 U.S. __ (2018).  For more on Lucia, see Gibson Dunn Client Alert, SEC Rules That SEC ALJs Were Unconstitutionally Appointed (June 21, 2018), available at www.gibsondunn.com/supreme-court-rules-that-sec-aljs-were-unconstitutionally-appointed. [2] See Gibson Dunn Client Alert, U.S. Supreme Court Limits SEC Power to Seek Disgorgement Based on Stale Conduct (June 5, 2017), available at www.gibsondunn.com/united-states-supreme-court-limits-sec-power-to-seek-disgorgement-based-on-stale-conduct. [3] SEC v Kokesh, No. 15-2087 (10th Cir. Mar. 5, 2018); see also Jonathan Stempel, SEC Can Recoup Ill-gotten Gains from New Mexico Businessman: U.S. Appeals Court, Reuters (Mar. 5, 2018), available at www.reuters.com/article/us-sec-kokesh/sec-can-recoup-ill-gotten-gains-from-new-mexico-businessman-u-s-appeals-court-idUSKBN1GH2YK. [4] Adam Dobrik, Unhelpful to Threaten SEC with Trial, Says Enforcement Director, Global Investigations Review (May 10, 2018), available at globalinvestigationsreview.com/article/jac/1169315/unhelpful-to-threaten-sec-with-trial-says-enforcement-director. [5] See SEC v. Cohen, No. 1:17-CV-00430 (E.D.N.Y. July 12, 2018) (holding claims for injunctive relief time-barred). [6] Dunstan Prial, High Court Agrees To Review Banker’s Copy-Paste Fraud, Law360 (Jun. 18, 2018), available at https://www.law360.com/securities/articles/1054568. [7] SEC Press Release, SEC Awards Whistleblower More Than $2.1 Million (Apr. 12, 2018), available at www.sec.gov/news/press-release/2018-64. [8] SEC Press Release, SEC Announces Its Largest-Ever Whistleblower Awards (Mar. 19, 2018), available at https://www.sec.gov/news/press-release/2018-44. [9] Ed Beeson, SEC Whistleblowers Net $83M In Largest Ever Bounties, Law360 (Mar. 19, 2018), available at www.law360.com/articles/1023646/sec-whistleblowers-net-83m-in-largest-ever-bounties. [10] In re Claims for Award in connection with [redacted], Admin. Proc. File No. 2018-6 (Mar. 19, 2018), available at https://www.sec.gov/rules/other/2018/34-82897.pdf. [11] SEC Press Release, SEC Awards More Than $2.2 Million to Whistleblower Who First Reported Information to Another Federal Agency Before SEC (Apr. 5, 2018), available at www.sec.gov/news/press-release/2018-58. [12] SEC Press Release, SEC Awards Whistleblower More Than $2.1 Million (Apr. 12, 2018), available at www.sec.gov/news/press-release/2018-64. [13] Digital Realty Trust, Inc. v. Somers, 583 U.S. __ (2018); see Dunstan Prial, Supreme Court Narrows Definition Of Whistleblower, Law360 (Feb. 21, 2018), available at www.law360.com/securities/articles/1003954. [14] Jennifer Williams Alvarez, SEC Proposes Changes to Whistle-Blower Program, Agenda: A Financial Times Services (Jun. 28, 2018), available at [insert]. [15] SEC Public Statement, Statement on Cybersecurity Interpretive Guidance (Feb. 21, 2018), available at www.sec.gov/news/public-statement/statement-clayton-2018-02-21. [16] SEC Public Statement, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (March 7, 2018), available at https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading. [17] SEC Press Release, SEC Charges Former Bitcoin-Denominated Exchange and Operator with Fraud (Feb. 21, 2018), available at https://www.sec.gov/news/press-release/2018-23. [18] SEC Press Release, SEC Halts Alleged Initial Coin Offering Scam (Jan. 30, 2018), available at www.sec.gov/news/press-release/2018-8. [19] SEC Press Release, SEC Halts Fraudulent Scheme Involving Unregistered ICO (April 2, 2018), available at www.sec.gov/news/press-release/2018-53. [20] SEC Press Release, SEC Charges Additional Defendant in Fraudulent ICO Scheme (April 20, 2018), available at www.sec.gov/news/press-release/2018-70. [21] SEC Press Release, SEC Obtains Emergency Order Halting Fraudulent Coin Offering Scheme (May 29, 2018), available at www.sec.gov/news/press-release/2018-94. [22] SEC Press Release, SEC Obtains Emergency Freeze of $27 Million in Stock Sales of Purported Cryptocurrency Company Longfin (April 6, 2018), available at www.sec.gov/news/press-release/2018-61. [23] SEC Press Release, SEC Charges Energy Storage Company, Former Executive in Fraudulent Scheme to Inflate Financial Results (Mar. 27, 2018), available at www.sec.gov/news/press-release/2018-48. [24] SEC Press Release, Panasonic Charged with FCPA and Accounting Fraud Violations (Apr. 30, 2018), available at www.sec.gov/news/press-release/2018-73. [25] SEC Press Release, Altaba, Formerly Known as Yahoo!, Charged With Failing to Disclose Massive Cybersecurity Breach; Agrees To Pay $35 Million (Apr. 24, 2018), available at www.sec.gov/news/press-release/2018-71. [26] SEC Press Release, SEC Charges Three Former Healthcare Executives With Fraud (May 16, 2018), available at www.sec.gov/news/press-release/2018-90. [27] SEC Litig. Rel. No. 24181, SEC Charges California Company and Three Executives with Accounting Fraud (July 2, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24181.htm. [28] SEC Press Release, SEC Obtains Bars and Suspensions Against Individuals and Accounting Firm in Shell Factory Scheme (Feb. 16, 2018), available at www.sec.gov/news/press-release/2018-21. [29] SEC Press Release, Foreign Affiliates of KPMG, Deloitte, BDO Charged in Improper Audits (Mar. 13, 2018), available at www.sec.gov/news/press-release/2018-39. [30] In the Matter of Winter, Kloman, Moter & Repp, S.C., Curtis W. Disrud, CPA, and Paul R. Sehmer, CPA, Admin. Proc. File No. 3-18466 (May 04, 2018), available at www.sec.gov/litigation/admin/2018/34-83168.pdf. [31] AP File No. 3-18442, SEC Charges New Jersey-Based Company and Founder for Impermissible Association with Barred Auditor (Apr. 19, 2018), available at www.sec.gov/enforce/34-83067-s. [32] SEC Admin. Proc. File No. 3-18398, Fintech Company Charged For Stock Option Offering Deficiencies, Failed To Provide Required Financial Information To Employee Shareholders (Mar. 12, 2018), available at www.sec.gov/litigation/admin/2017/34-82233-s.pdf. [33] SEC Press Release, Theranos, CEO Holmes, and Former President Balwani Charged With Massive Fraud (Mar. 14, 2018), available at www.sec.gov/news/press-release/2018-41. [34] SEC Litig. Rel. No. 24121, SEC Charges Biotech Start-up, CEO With Fraud (Apr. 24, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24121.htm. [35] In the Matter of THL Managers V, LLC, and THL Managers, VI, LLC, Admin. Proc. File No. 3-18565 (June 29, 2018), available at www.sec.gov/litigation/admin/2018/ia-4952.pdf. [36] SEC Admin. Proc. File No. 3-18564, SEC Charges New York-Based Venture Capital Fund Adviser for Failing to Offset Consulting Fees (June 29, 2018), available at www.sec.gov/enforce/ia-4951-s. [37] SEC Press Release, (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-35. [38] SEC Admin. Proc. File No. 3-18449, SEC Charges a New York-Based Investment Adviser for Breach of Fiduciary Duty (Apr. 24, 2018), available at www.sec.gov/enforce/ia-4896-s. [39] SEC Press Release, SEC Charges Investment Adviser and Two Former Managers for Misleading Retail Clients (June 4, 2018), available at www.sec.gov/news/press-release/2018-101. [40] In re Lyxor Asset Management, Inc., Admin Proc. File No. 3-18526 (June 4, 2018), available at www.sec.gov/litigation/admin/2018/ia-4932.pdf. [41] SEC Admin. Proc. File No. 3-18349, Investment Adviser and Its Principals Settle SEC Charges that They Failed to Disclose Risks of Investing in Their Advisory Business (Jan. 23, 2018), available at  www.sec.gov/enforce/33-10454-s. [42] SEC Litig. Rel. No. 24037, SEC Charges Two Boston-Based Investment Advisers with Fraud (Jan. 31, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24037.htm. [43] Nate Raymond, Ex-Morgan Stanley adviser sentenced to U.S. prison for fraud, Reuters (June 28, 2018), available at www.reuters.com/article/morgan-stanley-fraud/ex-morgan-stanley-adviser-sentenced-to-u-s-prison-for-fraud-idUSL1N1TU28Q. [44] SEC Litig. Rel. No. 24054, SEC Charges Orange County Investment Adviser and Senior Officers in Fraudulent “Cherry-Picking” Scheme (Feb. 21, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24054.htm. [45] SEC Press Release, Investment Adviser Settles Charges for Cheating Clients in Fraudulent Cherry-Picking Scheme (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-36. [46] In re Arlington Capital Management, Inc. and Joseph L. LoPresti, Admin. Proc. File No. 3-18437 (Apr. 16, 2018), available at www.sec.gov/litigation/admin/2018/ia-4885.pdf. [47] SEC Litig. Rel. No. 24142, SEC Charges California Investment Adviser in Multi-Million Dollar Fraud (May 15, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24142.htm. [48] In re Aberon Capital Management, LLC and Joseph Krigsfeld, Admin. Proc. File No. 3-18503 (May 24, 2018), available at www.sec.gov/litigation/admin/2018/ia-4914.pdf. [49] SEC Press Release, Hedge Fund Firm Charged for Asset Mismarking and Insider Trading (May 8, 2018), available at www.sec.gov/news/press-release/2018-81. [50] SEC Press Release, SEC Charges Hedge Fund Adviser With Deceiving Investors by Inflating Fund Performance (May 9, 2018), available at www.sec.gov/news/press-release/2018-83. [51] SEC Press Release, SEC Charges Morgan Stanley in Connection With Failure to Detect or Prevent Misappropriation of Client Funds (June 29, 2018), available at www.sec.gov/news/press-release/2018-124. [52] SEC Press Release, SEC Launches Share Class Selection Disclosure Initiative to Encourage Self-Reporting and the Prompt Return of Funds to Investors (Feb. 12, 2018), available at www.sec.gov/news/press-release/2018-15. [53] SEC Press Release, SEC Charges Ameriprise With Overcharging Retirement Account Customers for Mutual Fund Shares (Feb. 28, 2018), available at www.sec.gov/news/press-release/2018-26. [54] SEC Press Release, SEC Orders Three Investment Advisers to Pay $12 Million to Harmed Clients (Apr. 6, 2018), available at www.sec.gov/news/press-release/2018-62. [55] SEC Admin. Proc. File No. 3-18328, Formerly Registered Investment Adviser Settles SEC Charges Related to Filing False Forms ADV and Other Investment Advisers Act Violations (Jan. 3, 2018), available at www.sec.gov/litigation/admin/2018/ia-4836-s.pdf. [56] SEC Admin. Proc. File No. 3-18423, SEC Charges Investment Adviser for Improperly Registering with the Commission and Violating Several Rules (Apr. 5, 2018), available at www.sec.gov/enforce/ia-4875-s. [57] In re SEI Investments Global Funds Services, Admin. Proc. File No. 3-18457 (Apr. 26, 2018), available at www.sec.gov/litigation/admin/2018/ic-33087.pdf. [58] SEC Press Release, SEC Charges 13 Private Fund Advisers for Repeated Filing Failures (June 1, 2018), available at www.sec.gov/news/press-release/2018-100. [59] SEC Press Release, SEC Charges Recidivist Broker-Dealer in Employee’s Long-Running Pump-and-Dump Fraud (Mar. 27, 2018), available at www.sec.gov/news/press-release/2018-49. [60] SEC Press Release, Merrill Lynch Charged With Gatekeeping Failures in the Unregistered Sales of Securities (Mar. 8, 2018), available at www.sec.gov/news/press-release/2018-32. [61] SEC Press Release, SEC Charges New York-Based Firm and Supervisors for Failing to Supervise Brokers Who Defrauded Customers (June 29, 2018), available at www.sec.gov/news/press-release/2018-123. [62] SEC Press Release, Broker-Dealer Admits It Failed to File SARs (Mar. 28, 2018), available at www.sec.gov/news/press-release/2018-50. [63] SEC Charges Brokerage Firms and AML Officer with Anti-Money Laundering Violations (May 16, 2018), available at www.sec.gov/news/press-release/2018-87. [64] Administrative Proceeding File No. 3-18341, Industrial and Commercial Bank of China Financial Services LLC Agrees to Settle SEC Charges Relating to Numerous Regulation SHO Violations That Resulted in Prolonged Fails to Deliver (Jan. 18, 2018), available at www.sec.gov/litigation/admin/2018/34-82533-s.pdf. [65] SEC Press Release, Broker Charged with Repeatedly Putting Customer Assets at Risk (Mar. 19, 2018), available at www.sec.gov/news/press-release/2018-45. [66] Admin. Proc. File No. 3-18409, SEC Charges Broker-Dealer, CEO With Net Capital Rule Violations (Mar. 27, 2018), available at www.sec.gov/enforce/34-82951-s. [67] SEC Press Release, NYSE to Pay $14 Million Penalty for Multiple Violations (Mar. 6, 2018), available at www.sec.gov/news/press-release/2018-31. [68] SEC Press Release, Wells Fargo Advisors Settles SEC Chargers for Improper Sales of Complex Financial Products (June 25, 2018), available at www.sec.gov/news/press-release/2018-112. [69] Lit. Rel. No. 24179, SEC Charges Cantor Fitzgerald and Brokers in Commission-Splitting Scheme (June 29, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24179.htm. [70] SEC Press Release, Deutsche Bank to Repay Misled Customers (Feb. 12, 2018), available at www.sec.gov/news/press-release/2018-13. [71] SEC Press Release, SEC Charges Merrill Lynch for Failure to Supervise RMBS Traders (June 12, 2018), available at www.sec.gov/news/press-release/2018-105. [72] Admin. Proc. File No. 3-18335, Former Corporate Insider and Brokerage Industry Employee Settle Insider Trading Charges with SEC (Jan. 11, 2018), available at www.sec.gov/litigation/admin/2018/34-82485-s.pdf. [73] Lit. Rel. No. 24056,  SEC: Insider Bought Minutes After Warnings Not to Trade (Feb. 28., 2018), available at www.sec.gov/litigation/litreleases/2018/lr24056.htm. [74] Lit Rel. No. 24044, SEC Charges Former Medical Products Executives with Insider Trading (Feb. 12, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24044.htm. [75] Lit Rel. No. 24065, SEC Charges Corporate Communications Specialist with Insider Trading Ahead of Acquisition Announcement (Mar. 8, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24065.htm. [76] Lit Rel. No. 24163, Court Enters Consent Judgment against Robert M. Morano (June 11, 2018), available at https://www.sec.gov/litigation/litreleases/2018/lr24163.htm. [77] Press Release, Former Equifax Executive Charged With Insider Trading (Mar. 14, 2018), available at www.sec.gov/news/press-release/2018-40. [78] Press Release, Former Equifax Manager Charged With Insider Trading (June 28, 2018), available at www.sec.gov/news/press-release/2018-115. [79] Lit Rel. No. 24104, SEC Charges New York Man with Insider Trading (Apr. 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24104.htm. [80] Lit Rel. No. 24097, SEC Charges Massachusetts Man in Multi-Year Trading Scheme (Apr. 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24097.htm. [81] Lit Rel. No. 24134, SEC Charges Two Pennsylvania Residents with Insider Trading (May 4, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24134.htm. [82] Press Release, SEC Charges Investment Banker in Insider Trading Scheme (May 31, 2018), available at www.sec.gov/news/press-release/2018-97. [83] Lit Rel. No. 24165, SEC Charges Canadian Accountant with Insider Trading (June 12, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24164.htm. [84] Lit Rel. No. 24178, SEC Charges Credit Ratings Analyst and Two Friends with Insider Trading (June 29, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24178.htm. [85] 882 F.3d 431 (3d Cir. 2018); see also Tom Gorman, “SEC Disgorgement: A Path For Reform?,” SEC Actions Blog (Feb. 20, 2018), available at http://www.lexissecuritiesmosaic.com/net/Blogwatch/Blogwatch.aspx?ID=32139&identityprofileid=PJ576X25804. [86] Lit Rel. No. 24035, SEC Freezes Assets Behind Alleged Insider Trading (Jan. 26, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24035.htm. [87] SEC Press Release, SEC Charges Municipal Adviser and its Principal with Defrauding Mississippi City (January 5, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24025.htm. [88] SEC Press Release, SEC Obtains Judgments Against Municipal Adviser and Its Principal for Defrauding Mississippi City (July 2, 2018), available at www.sec.gov/litigation/litreleases/2018/lr24182.htm. [89] SEC Press Release, SEC Levies Fraud Charges Against Texas-Based Municipal Advisor, Owner for Lying to School District (May 9, 2018), available at www.sec.gov/news/press-release/2018-82. The following Gibson Dunn lawyers assisted in the preparation of this client update:  Marc Fagel, Mary Kay Dunning, Amruta Godbole, Amy Mayer, Jaclyn Neely, Joshua Rosario, Alon Sachar, Tina Samanta, Lindsey Young and Alex Zbrozek. Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators. Our Securities Enforcement Group offers broad and deep experience.  Our partners include the former Directors of the SEC’s New York and San Francisco Regional Offices, the former head of FINRA’s Department of Enforcement, the former United States Attorneys for the Central and Eastern Districts of California, and former Assistant United States Attorneys from federal prosecutors’ offices in New York, Los Angeles, San Francisco and Washington, D.C., including the Securities and Commodities Fraud Task Force. Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work or any of the following: New York Reed Brodsky (+1 212-351-5334, rbrodsky@gibsondunn.com) Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com) Lee G. Dunst (+1 212-351-3824, ldunst@gibsondunn.com) Barry R. Goldsmith – Co-Chair (+1 212-351-2440, bgoldsmith@gibsondunn.com) Laura Kathryn O’Boyle (+1 212-351-2304, loboyle@gibsondunn.com) Mark K. Schonfeld – Co-Chair (+1 212-351-2433, mschonfeld@gibsondunn.com) Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com) Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com) Lawrence J. Zweifach (+1 212-351-2625, lzweifach@gibsondunn.com) Washington, D.C. Stephanie L. Brooker  (+1 202-887-3502, sbrooker@gibsondunn.com) David P. Burns (+1 202-887-3786, dburns@gibsondunn.com) Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com) Stuart F. Delery (+1 202-887-3650, sdelery@gibsondunn.com) Richard W. Grime – Co-Chair (+1 202-955-8219, rgrime@gibsondunn.com) Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com) F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com) San Francisco Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com) Thad A. Davis (+1 415-393-8251, tadavis@gibsondunn.com) Marc J. Fagel – Co-Chair (+1 415-393-8332, mfagel@gibsondunn.com) Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com) Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com) Palo Alto Paul J. Collins (+1 650-849-5309, pcollins@gibsondunn.com) Benjamin B. Wagner (+1 650-849-5395, bwagner@gibsondunn.com) Denver Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com) Monica K. Loseman (+1 303-298-5784, mloseman@gibsondunn.com) Los Angeles Michael M. Farhang (+1 213-229-7005, mfarhang@gibsondunn.com) Douglas M. Fuchs (+1 213-229-7605, dfuchs@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 12, 2018 |
Developments in the Defense of Financial Institutions

To Disclose or Not to Disclose: Analyzing the Consequences of Voluntary Self-Disclosure for Financial Institutions Click for PDF One of the most frequently discussed white collar issues of late has been the benefits of voluntarily self-disclosing to the U.S. Department of Justice (“DOJ”) allegations of misconduct involving a corporation.  This is the beginning of periodic analyses of white collar issues unique to financial institutions, and in this issue we examine whether and to what extent a financial institution can expect a benefit from DOJ for a voluntary self-disclosure (“VSD”), especially with regard to money laundering or Bank Secrecy Act violations.  Although the public discourse regarding VSDs tends to suggest that there are benefits to be gained, a close examination of the issue specifically with respect to financial institutions shows that the benefits that will confer in this area, if any, are neither easy to anticipate nor to quantify.  A full consideration of whether to make a VSD to DOJ should include a host of factors beyond the quantifiable benefit, ranging from the likelihood of independent enforcer discovery; to the severity, duration, and evidentiary support for a potential violation; and to the expectations of prudential regulators and any associated licensing or regulatory consequences, as well as other factors. VSD decisions arise in many contexts, including in matters involving the Foreign Corrupt Practices Act (“FCPA”), sanctions enforcement, and the Bank Secrecy Act (“BSA”).  In certain situations, the benefits of voluntary self-disclosure prior to a criminal enforcement action can be substantial.  Prosecutors have at times responded to a VSD by reducing charges and penalties, offering deferred prosecution and non-prosecution agreements, and entering into more favorable consent decrees and settlements.[1]  However, as Deputy Attorney General Rod Rosenstein stated in recent remarks, enforcement policies meant to encourage corporate disclosures “do[] not provide a guarantee” that disclosures will yield a favorable result in all cases.[2]  The outcome of a prosecution following a VSD is situation-specific, and, as such, the process should not be entered into without careful consideration of the costs and benefits. In the context of Bank Secrecy Act and anti-money laundering regulation (“BSA/AML”), VSDs present an uncertain set of tradeoffs.  The BSA and its implementing  regulations already require most U.S. financial institutions subject to the requirements of the BSA[3] to file suspicious activity reports (“SARs”) with the U.S. government when the institution knows, suspects or has reason to suspect that a transaction by, through or to it involves money laundering, BSA violations or other illegal activity.[4]  Guidance from DOJ encourages voluntary self-disclosure, and at least one recent non-prosecution agreement entered with the Department has listed self-disclosure as a consideration in setting the terms of a settlement agreement.[5]  Over the past three years, however, no BSA/AML criminal resolution has explicitly given an institution credit for voluntarily disclosing potential misconduct.  During this same period, DOJ began messaging an expanded focus on VSDs in the context of FCPA violations, announced the FCPA Pilot Project, and ultimately made permanent in the U.S. Attorney’s Manual the potential benefits of a VSD for FCPA violations. This alert addresses some of the considerations that financial institutions weigh when deciding whether to voluntarily self-disclose potential BSA/AML violations to criminal enforcement authorities.  In discussing these considerations, we review guidance provided by DOJ and the regulatory enforcement agencies, and analyze recent BSA/AML criminal resolutions, as well as FCPA violations involving similar defendants. Guidance from the Department of Justice – Conflicting Signals DOJ guidance documents describe the Department’s general approach to VSDs, but, until recently, they left unanswered many questions dealing specifically with self-disclosure by financial institutions.  The Department’s high-level approach to general voluntary self-disclosure is outlined in the United States Attorney Manual (“USAM”).  Starting from the principle that “[c]ooperation is a mitigating factor” that can allow a corporation to avoid particularly harsh penalties, the USAM instructs prosecutors that they “may consider a corporation’s timely and voluntary disclosure” when deciding whether and how to pursue corporate liability.[6] In the FCPA context, a self-disclosure is deemed to be voluntary—and thus potentially qualifying a company for mitigation credit—if (1) the company discloses the relevant evidence of misconduct prior to an imminent threat of disclosure or government investigation; (2) the company reports the conduct to DOJ and relevant regulatory agencies “within a reasonably prompt time after becoming aware of the offense”; and (3) the company discloses all relevant facts known to it, including all relevant facts about the individual wrongdoers involved.[7] DOJ has not yet offered specific instruction, however, on how prosecutors should treat voluntary self-disclosure in the BSA/AML context and, unlike other areas of enforcement, no formal self-disclosure program currently exists for financial institutions seeking to obtain mitigation credit in the money laundering context.  Indeed, the only guidance document to mention VSDs and financial institutions—issued by DOJ’s National Security Division in 2016[8]—specifically exempted financial institutions from the VSD benefits offered to other corporate actors in the export control and sanctions context, citing the “unique reporting obligations” imposed on financial institutions “under their applicable statutory and regulatory regimes.”[9] Despite this lack of guidance, the recent adoption of DOJ’s FCPA Corporate Enforcement Policy may provide insight on how prosecutors could treat voluntary disclosures by financial institutions moving forward.  Enacted in the fall of 2017, the Corporate Enforcement Policy arose from DOJ’s 2016 FCPA Pilot Program, which was created to provide improved guidance and certainty to companies facing DOJ enforcement actions, while incentivizing self-disclosure, cooperation, and remediation.[10]  One year later, based on the success of the program, many of its aspects were codified in the USAM.[11]  Specifically, the new policy creates a presumption that entities that voluntarily disclose potential misconduct and fully cooperate with any subsequent government investigation will receive a declination, absent aggravating circumstances.[12]  In early 2018, Acting Assistant Attorney General John Cronan announced that the Corporate Enforcement Policy would serve as non-binding guidance for corporate investigations beyond the FCPA context.[13] This expanded consideration of VSDs beyond the FCPA space was on display in March 2018, when, after an investigation by DOJ’s Securities and Financial Fraud Unit, the Department publicly announced that it had opted not to prosecute a financial institution in connection with the bank’s alleged front-running of certain foreign exchange transactions.[14]  DOJ’s Securities and Financial Fraud Unit specifically noted that DOJ’s decision to close its investigation without filing charges resulted, in part, from “timely, voluntary self-disclosure” of the alleged misconduct,[15] a sentiment echoed by Cronan in subsequent remarks at an American Bar Association white collar conference regarding the reasons for the declination.[16]  Cronan further commented that “[w]hen a company discovers misconduct, quickly raises its hand and tells us about it, that says something. . . . It shows the company is taking misconduct seriously . . . and we are rewarding those good decisions.”[17] Other Agency Guidance Guidance issued by other enforcement agencies similarly may offer clues as to how financial institutions can utilize VSDs to more successfully navigate a criminal enforcement action. In the context of export and import control, companies that self-disclose to the U.S. Treasury Department’s Office of Foreign Asset Control (“OFAC”) can benefit in two primary ways.  First, OFAC may be less likely to initiate an enforcement proceeding following a VSD, as OFAC considers a party’s decision to cooperate when determining whether to initiate a civil enforcement proceeding.[18]  Second, if OFAC decides it is appropriate to bring an enforcement action, companies that self-disclose receive a fifty-percent reduction in the base penalty they face, as detailed in the below-base-penalty matrix published in OFAC guidance:[19] As depicted by the chart, in the absence of a VSD, the base penalty for egregious violations[20] is the applicable statutory maximum penalty for the violation.[21]  In non-egregious cases, the base penalty is calculated based on the revenue derived from the violative transaction, capped at $295,141.[22]  When the apparent violation is voluntarily disclosed, however, OFAC has made clear that in non-egregious cases, the penalty will be one-half of the transaction value, capped at $147,571 per violation.[23]  This is applicable except in circumstances where the maximum penalty for the apparent violation is less than $295,141, in which case the base amount of the penalty shall be capped at one-half the statutory maximum penalty applicable to the violation.[24]  In an egregious case, if the apparent violation is self-disclosed, the base amount of the penalty will be one-half of the applicable statutory maximum penalty.[25] Other agencies tasked with overseeing the enforcement of financial regulations also have issued guidance encouraging voluntary disclosures.  Although the Financial Crimes Enforcement Network (“FinCEN”) has not provided guidance on how it credits voluntary disclosures,[26] guidance issued by the Federal Financial Institutions Examination Council (“FFIEC”), consisting of the Office of the Comptroller of the Currency (“OCC”), the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), the Office of Thrift Supervision (“OTS”), and the National Credit Union Administration (“NCUA”), has made clear that, in determining the amount and appropriateness of a penalty to be assessed against a financial institution in connection with various types of violations, the agencies will consider “voluntary disclosure of the violation.”[27] In 2016, the OCC published a revised Policies and Procedures Manual to ensure this and other factors are considered and to “enhance the consistency” of its enforcement decisions.[28]  That guidance includes a matrix with several factors, one of which is “concealment.”[29]  In the event that a financial institution self-discloses, they are not penalized for concealment.  Thus, while not directly reducing potential financial exposure, a VSD ensures that a financial institution is not further penalized for the potential violation. It is also worth noting that, unlike DOJ, these regulators do not appear to draw distinctions regarding the type of offense at issue (i.e., FCPA versus BSA versus sanctions violations).  Moreover, financial institutions contemplating not disclosing potential misconduct need to consider whether the nature of the potential misconduct at issue goes to the financial institution’s safety and soundness, adequacy of capital, or other issues of interest to prudential regulators such as the Federal Reserve, OCC, and FDIC.  To the extent such prudential concerns are implicated, a financial institution may be required to disclose the underlying evidence of misconduct and may face penalties for failing to do so. The Securities and Exchange Commission (“SEC”) also has indicated that it will consider VSDs as a factor in its enforcement actions under the federal securities laws.  In a 2001 report (the “Seaboard Report”), the SEC confirmed that, as part of its evaluation of proper enforcement actions, it would consider whether “the company voluntarily disclose[d] information [its] staff did not directly request and otherwise might not have uncovered.”[30]  The SEC noted that self-policing could result in reduced penalties based on how much the SEC credited self-reporting—from “the extraordinary step of taking no enforcement action to bringing reduced charges, seeking lighter sanctions, or including mitigating language in documents . . . use[d] to announce and resolve enforcement actions.”[31]  In 2010, the SEC formalized its cooperation program, identifying self-policing, self-reporting, and remediation and cooperation as the primary factors it would consider in determining the appropriate disposition of an enforcement action.[32]  In 2015, the former Director of the SEC’s Division of Enforcement, reaffirmed the importance of self-reporting to the SEC’s enforcement decisions, stating that previous cases “should send the message loud and clear that the SEC will reward self-reporting and cooperation with significant benefits.”[33]  As of mid-2016, the SEC had signed over 103 cooperation agreements, six non-prosecution agreements, and deferred nine prosecutions since the inception of the cooperation program.[34] Finally, like its federal counterparts, the New York Department of Financial Services (“NYDFS”) has previously signaled, at least in the context of export and import sanctions, that “[i]t is vital that companies continue to self-report violations,”[35] and warned that “those that do not [self-report] run the risk of even more severe consequences.”[36]  The NYDFS has not directly spoken to money laundering enforcement, but financial institutions considering disclosures to New York state authorities should keep this statement in mind.  Similar to the considerations an institution might face when dealing with federal regulators, to the extent DFS prudential concerns are implicated, a financial institution may be required to disclose the underlying evidence of misconduct and face penalties for failing to do so. Recent BSA/AML and FCPA Resolutions Even against this backdrop, over the last few years, voluntary self-disclosure has not appeared to play a significant role in the resolution of criminal enforcement proceedings arising from alleged BSA/AML violations.  Since 2015, DOJ, in conjunction with other enforcement agencies, has resolved BSA/AML charges against twelve financial institutions.[37]  In eleven of those cases, the final documentation of the resolution—the settlement agreements and press releases accompanying the settlement documents—make no mention of voluntary self-disclosure.  Even in the FCPA context, where DOJ has sought to provide greater certainty and transparency concerning the benefits of voluntary disclosure, there is a scant track record of financial institutions making voluntary disclosures in connection with FCPA resolutions.  Since 2015, DOJ has announced FCPA enforcement actions with six financial institutions.  The Justice Department did not credit any of them with voluntarily self-disclosing the conduct.[38] Although recent resolutions have not granted credit for VSDs, financial entities facing enforcement actions should consider how such a disclosure might affect the nature of a potential investigation and the ultimate disposition of an enforcement action.  It is worth noting that in the one recent BSA/AML resolution with a financial institution in which voluntary self-disclosure was referenced—DOJ’s 2017 resolution with Banamex USA—it was in the course of explaining why the financial institution did not receive disclosure credit.  In other words, there is no example of a criminal enforcement action commending a financial institution for a VSD, or of an agency softening the enforcement measures as a result of a VSD.[39]  The fact that the Banamex USA resolution affirmatively explains why the defendant did not receive VSD credit may imply that this type of credit may be available to financial institution defendants when they do make adequate VSDs. Furthermore, over the same time period, prosecutors have credited financial institutions for other forms of cooperation.  For example, in 2015, the Department of Justice deferred prosecution of CommerceWest Bank officials for a BSA charge arising from their willful failure to file a SAR, in part because of the bank’s “willingness to acknowledge and accept responsibility for its actions” and “extensive cooperation with [DOJ’s] investigation.”[40]  Similarly, a 2015 non-prosecution agreement with Ripple Labs Inc. credited the financial institution with, among other factors, “extensive cooperation with the Government.”[41]  These favorable dispositions signal that the government is willing to grant mitigation credit for cooperation, even when financial institutions are not credited with making VSDs. Other Relevant Considerations Relating to VSDs As discussed above, the government’s position regarding the value of VSDs and their effect on the ultimate resolution of a case vary based on the agency and the legal and regulatory regime(s) involved.  Given the lack of clear guidance from FinCEN about how it credits VSDs and the fact that BSA/AML resolutions tend not to explicitly reference a company’s decision to disclose as a relevant consideration, navigating the decision of whether to self-report to DOJ is itself a fraught one.  Beyond the threshold question of whether or not to self-disclose to DOJ, financial institutions faced with potential BSA/AML liability should be mindful of a number of other considerations, always with an eye on avoiding the specter of a full-blown criminal investigation and trying to minimize institutional liability to the extent possible. Likelihood of Discovery:  A financial institution deciding whether to self-disclose to DOJ must contemplate the possibility that the government will be tipped off by other means, including by the prudential regulators, and will investigate the potential misconduct anyway, without the financial institution gaining the benefits available for bringing a case to the government’s attention and potentially before the financial institution has had the opportunity to develop a remediation plan.  Financial institutions that plan to forego self-disclosure of possible misconduct will have to guard against both whistleblower disclosures and the possibility that other institutions aware of the potential misconduct will file a Suspicious Activity Report implicating the financial institution. Timing of Disclosure:  Even after a financial institution has decided to self-report to DOJ, it will have to think through the implications of when a disclosure is made.  A financial institution could decide to promptly disclose to maximize cooperation credit, but risks reporting without developing the understanding of the underlying facts that an internal investigation would provide.  Additionally, a prompt disclosure to DOJ may be met with a deconfliction request, in which the government asks that the company refrain from interviewing its employees until the government has had a chance to do so.  This may slow down the company’s investigation and impede its ability to take prompt and decisive remedial actions, including those related to personnel decisions.  On the other hand, waiting until after the internal investigation has concluded (or at least reached an advanced stage) presents the risk of the government finding out first in the interim.  The financial institution also will have to decide whether to wait longer to report to the government having already designed and begun to implement a remediation plan or to disclose while the remediation plan is still being developed. Selective or Sequential Disclosures:  Given the number of agencies with jurisdiction over the financial industry and the overlaps between their respective spheres of authority, financial institutions contemplating self-disclosure will often have to decide how much to disclose, whether to both prudential regulators and DOJ, and in what order.  In some cases, a financial institution potentially facing both regulatory and criminal liability may be well-advised to engage civil regulators first in the hope that, if DOJ does get involved, they will stand down and piggy-back on a global resolution with other regulators rather than seeking more serious penalties.  Indeed, DOJ prosecutors are required to consider the adequacy of non-criminal alternatives – such as civil or regulatory enforcement actions – in determining whether to initiate a criminal enforcement action.[42]  For example, the non-prosecution agreement DOJ entered in May 2017 with Banamex recognized that Citigroup, Banamex’s parent, was already in the process of winding down Banamex USA’s banking operations pursuant to a 2015 resolution with the California Department of Business Oversight and FDIC and was operating under ongoing consent orders with the Federal Reserve and OCC relating to BSA/AML compliance; consequently, DOJ sought only forfeiture rather than an additional monetary penalty.[43]  Of course, any decision to selectively disclose must be balanced carefully against the practical reality that banking regulators will, in certain instances, notify DOJ of potential criminal violations whether self-disclosed or identified in the examination process.  Whether that communication will occur often is influenced by factors such as the history of cooperation between the institutions or the relationships of those involved.  Nevertheless, the timing and nature of any referral by a regulator to DOJ might nullify any benefit from a selective or sequential disclosure. Conclusion In this inaugural Developments in the Defense of Financial Institutions Client Alert, we addressed whether and to what extent a financial institution should anticipate receiving a benefit when approaching the pivotal decision of whether to voluntarily self-disclose potential BSA/AML violations to DOJ.  We hope this publication serves as a helpful primer on this issue, and look forward to addressing other topics that raise unique issues for financial institutions in this rapidly-evolving area in future editions.    [1]   U.S. Dep’t of Justice, Guidance Regarding Voluntary Self-Disclosures, Cooperation, and Remediation in Export Control and Sanctions Investigations Involving Business Organizations (Oct. 2, 2016), https://www.justice.gov/nsd/file/902491/download.    [2]   Rod Rosenstein, Deputy Att’y Gen., Deputy Attorney General Rosenstein Delivers Remarks at the 34th International Conference on the Foreign Corrupt Practices Act (Nov. 29, 2017), https://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-34th-international-conference-foreign.    [3]   Throughout this alert, we use the term “financial institution” as it is defined in the Bank Secrecy Act.  “Financial institution” refers to banks, credit unions, registered stock brokers or dealers, currency exchanges, insurance companies, casinos, and other financial and banking-related entities.  See 31 U.S.C. § 5312(a)(2) (2012).  These institutions should be particularly attuned to the role that voluntary disclosures can play in the disposition of a criminal enforcement action.    [4]   See, e.g., 31 CFR § 1020.320 (FinCEN SAR requirements for banks); 12 C.F.R. § 21.11 (SAR requirements  for national banks).    [5]   See Non-Prosecution Agreement with Banamex USA, U.S. Dep’t of Justice (May 18, 2017), https://www.justice.gov/opa/press-release/file/967871/download (noting that “the Company did not receive voluntary self-disclosure credit because neither it nor Citigroup voluntarily and timely disclosed to the Office the conduct described in the Statement of Facts”).    [6]   U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9-28.700 (2017).    [7]   For a definition of self-disclosure in the sanctions space, see U.S. Dep’t of Justice, Guidance Regarding Voluntary Self-Disclosures, Cooperation, and Remediation in Export Control and Sanctions Investigations Involving Business Organizations (Oct. 2, 2016), https://www.justice.gov/nsd/file/902491/download.  For a definition in the FCPA context, see U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9-47.120 (2017).    [8]   U.S. Dep’t of Justice, Guidance Regarding Voluntary Self-Disclosures, Cooperation, and Remediation in Export Control and Sanctions Investigations Involving Business Organizations, at 4 n.7 (Oct. 2, 2016), https://www.justice.gov/nsd/file/902491/download.  Gibson Dunn’s 2016 Year-End Sanctions Update contains a more in-depth discussion of this DOJ guidance.    [9]   Id. at 2 n.3 [10]   Press Release, U.S. Dep’t of Justice, Criminal Division Launches New FCPA Pilot Program (Apr. 5, 2016), https://www.justice.gov/archives/opa/blog/criminal-division-launches-new-fcpa-pilot-program.  For a more in-depth discussion of the original Pilot Program, see Gibson Dunn’s 2016 Mid-Year FCPA Update, and for a detailed description of the FCPA Corporate Enforcement Policy, see our 2017 Year-End FCPA Update.  For discussion regarding specific declinations under the Pilot Program, in which self-disclosure played a significant role, see our 2016 Year-End FCPA Update and 2017 Mid-Year FCPA Update. [11]   Rod Rosenstein, Deputy Att’y Gen., Deputy Attorney General Rosenstein Delivers Remarks at the 34th International Conference on the Foreign Corrupt Practices Act (Nov. 29, 2017), https://www.justice.gov/opa/speech/deputy-attorney-general-rosenstein-delivers-remarks-34th-international-conference-foreign (announcing that the FCPA Corporate Enforcement Policy would be incorporated into the USAM); U.S. Dep’t of Justice, U.S. Attorneys’ Manual § 9-47.120 (2017). [12]   Id. [13]   Jody Godoy, DOJ Expands Leniency Beyond FCPA, Lets Barclays Off, Law360 (Mar. 1, 2018), https://www.law360.com/articles/1017798/doj-expands-leniency-beyond-fcpa-lets-barclays-off. [14]   U.S. Dep’t of Justice, Letter to Alexander Willscher and Joel Green Regarding Investigation of Barclays PLC (Feb. 28, 2018), https://www.justice.gov/criminal-fraud/file/1039791/download. [15]   Id. [16]   Tom Schoenberg, Barclays Won’t Face Criminal Case for Hewlett-Packard Trades, Bloomberg (Mar. 1, 2018), https://www.bloomberg.com/news/articles/2018-03-01/barclays-won-t-face-criminal-case-over-hewlett-packard-trades. [17]   Id. [18]   31 C.F.R. Pt. 501, app. A, § III.G.1 (2018). [19]   Id. § V.B.1.a.iv (2018). [20]   OFAC has established a two-track approach to penalty assessment, based on whether violations are “egregious” or “non-egregious.”  Egregious violations are identified based on analysis of several factors set forth in OFAC guidelines, including, among others: whether a violation was willful; whether the entity had actual knowledge of the violation, or should have had reason to know of it; harm caused to sanctions program objectives; and the individual characteristics of the entity involved. [21]   31 C.F.R. Pt. 501, app. A, § V.B.2.a.iv (2018). [22]   Id. § V.B.2.a.ii (2018). [23]   Id. § V.B.2.a.i (2018). [24]   Id. [25]   Id. § V.B.2.a.iii (2018). [26]   Robert B. Serino, FinCEN’s Lack of Policies and Procedures for Assessing Civil Money Penalties in Need of Reform, Am. Bar Ass’n (July 2016), https://www.americanbar.org/publications/blt/2016/07/07_serino.html.  It is worth noting, however, that there are certain circumstances in which FinCEN imposes a continuing duty to disclose, such as when there has been a failure to timely file a SAR (31 C.F.R. § 1020.320(b)(3)); failure to timely file a Currency Transaction Report (31 C.F.R. § 1010.306); and failure to timely register as a money-services business (31 C.F.R. § 1022.380(b)(3)).  In circumstances in which a financial institution identifies that it has not complied with these regulatory requirements and files belatedly, the decision whether to self-disclose to DOJ is impacted by the fact that the late filing will often be evident to FinCEN. [27]   Federal Financial Institutions Examination Council: Assessment of Civil Money Penalties, 63 FR 30226-02, 1998 WL 280287 (June 3, 1998). [28]   Office of the Comptroller of the Currency, Policies and Procedures Manual, PPM 5000-7 (Rev.) (Feb. 26, 2016), https://www.occ.gov/news-issuances/bulletins/2016/bulletin-2016-5a.pdf. [29]   Id. at 15-17. [30]   U.S. Secs. & Exch. Comm’n, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Release No. 44969 (Oct. 23, 2001), https://www.sec.gov/litigation/investreport/34-44969.htm. [31]   Id. [32]   U.S. Secs. & Exch. Comm’n, Enforcement Cooperation Program, https://www.sec.gov/spotlight/enforcement-cooperation-initiative.shtml (last modified Sept. 20, 2016). [33]   Andrew Ceresney, Director, SEC Division of Enforcement, ACI’s 32nd FCPA Conference Keynote Address (Nov. 17, 2015), https://www.sec.gov/news/speech/ceresney-fcpa-keynote-11-17-15.html. [34]   Juniad A. Zubairi & Brooke E. Conner, Is SEC Cooperation Credit Worthwhile?, Law360 (Aug. 30, 2016), https://www.law360.com/articles/833392. [35]   Press Release, N.Y. Dep’t Fin. Servs., Governor Cuomo Announced Bank of Tokyo-Mitsubishi UFJ to Pay $250 Million to State for Violations of New York Banking Law Involving Transactions with Iran and Other Regimes (June 20, 2013), https://www.dfs.ny.gov/about/press/pr1306201.htm. [36]   Id. [37]   Press Release, U.S. Dep’t of Justice, U.S. Gold Refinery Pleads Guilty to Charge of Failure to Maintain Adequate Anti-Money Laundering Program (Mar. 16, 2018), https://www.justice.gov/usao-sdfl/pr/us-gold-refinery-pleads-guilty-charge-failure-maintain-adequate-anti-money-laundering; Deferred Prosecution Agreement with U.S. Bancorp, U.S. Dep’t of Justice (Feb. 12, 2018), https://www.justice.gov/usao-sdny/press-release/file/1035081/download; Plea Agreement with Rabobank, National Association, U.S. Dep’t of Justice (Feb. 7, 2018), https://www.justice.gov/opa/press-release/file/1032101/download; Non-Prosecution Agreement with Banamex USA, U.S. Dep’t of Justice (May 18, 2017), https://www.justice.gov/opa/press-release/file/967871/download; Press Release, U.S. Dep’t of Justice, Western Union Admits Anti-Money Laundering and Consumer Fraud Violations, Forfeits $586 Million in Settlement with Justice Department and Federal Trade Commission (Jan. 19, 2017), https://www.justice.gov/opa/pr/western-union-admits-anti-money-laundering-and-consumer-fraud-violations-forfeits-586-million; Non-Prosecution Agreement Between CG Technology, LP and the United States Attorneys’ Offices for the Eastern District of New York and the District of Nevada, U.S. Dep’t of Justice (Oct. 3, 2016), https://www.gibsondunn.com/wp-content/uploads/documents/publications/CG-Technology-dba-Cantor-Gaming-NPA.PDF; Press Release, U.S. Dep’t of Justice, Normandie Casino Operator Agrees to Plead Guilty to Federal Felony Charges of Violating Anti-Money Laundering Statutes (Jan. 22, 2016), https://www.justice.gov/usao-cdca/pr/normandie-casino-operator-agrees-plead-guilty-federal-felony-charges-violating-anti; Press Release, U.S. Dep’t of Justice, Hong Kong Entertainment (Overseas) Investments, Ltd, D/B/A Tinian Dynasty Hotel & Casino Enters into Agreement with the United States to Resolve Bank Secrecy Act Liability (July 23, 2015), https://www.justice.gov/usao-gu/pr/hong-kong-entertainment-overseas-investments-ltd-dba-tinian-dynasty-hotel-casino-enters; Deferred Prosecution Agreement with Bank of Mingo, U.S. Dep’t of Justice (May 20, 2015), https://www.gibsondunn.com/wp-content/uploads/documents/publications/Bank-of-Mingo-NPA.pdf; Settlement Agreement with Ripple Labs Inc., U.S. Dep’t of Justice (May 5, 2015), https://www.justice.gov/file/421626/download; Deferred Prosecution Agreement with Commerzbank AG, U.S. Dep’t of Justice (Mar. 12, 2015), https://www.justice.gov/sites/default/files/opa/press-releases/attachments/2015/03/12/commerzbank_deferred_prosecution_agreement_1.pdf; Deferred Prosecution Agreement with CommerceWest Bank, U.S. Dep’t of Justice (Mar. 10, 2015) https://www.justice.gov/file/348996/download. [38]   Deferred Prosecution Agreement with Société Générale S.A., U.S. Dep’t of Justice (June 5, 2018), https://www.justice.gov/opa/press-release/file/1068521/download; Non-Prosecution Agreement with Legg Mason, Inc., U.S. Dep’t of Justice (June 4, 2018), https://www.justice.gov/opa/press-release/file/1068036/download; Non-Prosecution Agreement with Credit Suisse (Hong Kong) Limited, U.S. Dep’t of Justice (May 24, 2018), https://www.justice.gov/opa/press-release/file/1077881/download; Deferred Prosecution Agreement with Och-Ziff Capital Management Group, LLC, U.S. Dep’t of Justice (Sept. 29, 2016), https://www.justice.gov/opa/file/899306/download; Non-Prosecution Agreement with JPMorgan Securities (Asia Pacific) Ltd, U.S. Dep’t of Justice (Nov. 17, 2016), https://www.justice.gov/opa/press-release/file/911206/download; Non-Prosecution Agreement with Las Vegas Sands Corp., U.S. Dep’t of Justice (Jan. 17, 2017), https://www.justice.gov/opa/press-release/file/929836/download. [39]   See Non-Prosecution Agreement with Banamex USA, U.S. Dep’t of Justice, at 2 (May 18, 2017), https://www.justice.gov/opa/press-release/file/967871/download (explaining that Banamex “did not receive voluntary disclosure credit because neither it nor [its parent company] Citigroup voluntarily and timely disclosed to [DOJ’s Money Laundering and Asset Recover Section] the conduct described in the Statement of Facts”) (emphasis added). [40]   Deferred Prosecution Agreement Between United States and CommerceWest Bank, U.S. Dep’t of Justice, at 2-3 (Mar. 9, 2015), https://www.justice.gov/file/348996/download. [41]   Settlement Agreement Between United States and Ripple Labs Inc., U.S. Dep’t of Justice (May 5, 2015), https://www.justice.gov/file/421626/download; see also Press Release, U.S. Dep’t of Justice, Ripple Labs Inc. Resolves Criminal Investigation (May 5, 2015), https://www.justice.gov/opa/pr/ripple-labs-inc-resolves-criminal-investigation. [42]   See U.S. Attorney’s Manual 9-28.1200 (recommending the analysis of civil or regulatory alternatives). [43]   Non-Prosecution Agreement Between U.S. Dep’t of Justice, Money Laundering and Asset Recovery Section and Banamex USA at 2 (May 18, 2017), https://www.justice.gov/opa/press-release/file/967871/download. The following Gibson Dunn attorneys assisted in preparing this client update:  F. Joseph Warin, M. Kendall Day, Stephanie L. Brooker, Adam M. Smith, Linda Noonan, Elissa N. Baur, Stephanie L. Connor, Alexander R. Moss, and Jaclyn M. Neely. Gibson Dunn has deep experience with issues relating to the defense of financial institutions, and we have recently increased our financial institutions defense and anti-money laundering capabilities with the addition to our partnership of M. Kendall Day.  Kendall joined Gibson Dunn in May 2018, having spent 15 years as a white collar prosecutor, most recently as an Acting Deputy Assistant Attorney General, the highest level of career official in the U.S. Department of Justice’s Criminal Division.  For his last three years at DOJ, Kendall exercised nationwide supervisory authority over every Bank Secrecy Act and money-laundering charge, deferred prosecution agreement and non-prosecution agreement involving every type of financial institution. Kendall joined Stephanie Brooker, a former Director of the Enforcement Division at the U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN) and a former federal prosecutor and Chief of the Asset Forfeiture and Money Laundering Section for the U.S. Attorney’s Office for the District of Columbia, who serves as Co-Chair of the Financial Institutions Practice Group and a member of White Collar Defense and Investigations Practice Group.  Kendall and Stephanie practice with a Gibson Dunn network of more than 50 former federal prosecutors in domestic and international offices around the globe. For assistance navigating white collar or regulatory enforcement issues involving financial institutions, please contact any Gibson Dunn attorney with whom you usually work, or any of the following leaders and members of the firm’s White Collar Defense and Investigations or Financial Institutions practice groups: Washington, D.C. F. 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July 12, 2018 |
The Politics of Brexit for those Outside the UK

Click for PDF Following the widely reported Cabinet meeting at Chequers, the Prime Minister’s country residence, on Friday 6 June 2018, the UK Government has now published its “White Paper” setting out its negotiating position with the EU.  A copy of the White Paper can be found here. The long-delayed White Paper centres around a free trade area for goods, based on a common rulebook.  The ancillary customs arrangement plan, in which the UK would collects tariffs on behalf of the EU, would then “enable the UK to control its own tariffs for trade with the rest of the world”.  However, the Government’s previous “mutual recognition plan” for financial services has been abandoned; instead the White Paper proposes a looser partnership under the framework of the EU’s existing equivalence regime. The responses to the White Paper encapsulate the difficulties of this process.  Eurosceptics remain unhappy that the Government’s position is far too close to a “Soft Brexit” and have threatened to rebel against the proposed customs scheme; Remainers are upset that services (which represent 79% of the UK’s GDP) are excluded. The full detail of the 98-page White Paper is less important at this stage than the negotiating dynamics.  Assuming both the UK and the EU want a deal, which is likely to be the case, M&A practitioners will be familiar with the concept that the stronger party, here the EU, will want to push the weaker party, the UK, as close to the edge as possible without tipping them over.  In that sense the UK has, perhaps inadvertently, somewhat strengthened its negotiating position – albeit in a fragile way. The rules of the UK political game In the UK the principle of separation of powers is strong as far as the independence of the judiciary is concerned.  In January 2017 the UK Supreme Court decided that the Prime Minister could not trigger the Brexit process without the authority of an express Act of Parliament. However, unlike the United States and other presidential systems, there is virtually no separation of powers between legislature and executive.  Government ministers are always also members of Parliament (both upper and lower houses).  The government of the day is dependent on maintaining the confidence of the House of Commons – and will normally be drawn from the political party with the largest number of seats in the House of Commons.  The Prime Minister will be the person who is the leader of that party. The governing Conservative Party today holds the largest number of seats in the House of Commons, but does not have an overall majority.  The Conservative Government is reliant on a “confidence and supply” agreement with the Northern Ireland Democratic Unionist Party (“DUP”) to give it a working majority. Maintaining an open land border between Northern Ireland and the Republic of Ireland is crucial to maintaining the Good Friday Agreement – which underpins the Irish peace process.  Maintaining an open border between Northern Ireland and the rest of the UK is of fundamental importance to the unionist parties in Northern Ireland – not least the DUP.  Thus, the management of the flow of goods and people across the Irish land border, and between Northern Ireland and the UK, have become critical issues in the Brexit debate and negotiations.  The White Paper’s proposed free trade area for goods would avoid friction at the border. Parliament will have a vote on the final Brexit deal, but if the Government loses that vote then it will almost certainly fall and a General Election will follow – more on this below. In addition, if the Prime Minister does not continue to have the support of her party, she would cease to be leader and be replaced.  Providing the Conservative Party continued to maintain its effective majority in the House of Commons, there would not necessarily be a general election on a change in prime minister (as happened when Margaret Thatcher was replaced by John Major in 1990) The position of the UK Government The UK Cabinet had four prominent campaigners for Brexit: David Davis (Secretary for Exiting the EU), Boris Johnson (Foreign Secretary), Michael Gove (Environment and Agriculture Secretary) and Liam Fox (Secretary for International Trade).  David Davis and Boris Johnson have both resigned in protest after the Chequers meeting but, so far, Michael Gove and Liam Fox have stayed in the Cabinet.  To that extent, at least for the moment, the Brexit camp has been split and although the Leave activists are unhappy, they are now weaker and more divided for the reasons described below. The Prime Minister can face a personal vote of confidence if 48 Conservative MPs demand such a vote.  However, she can only be removed if at least 159 of the 316 Conservative MPs then vote against her.  It is currently unlikely that this will happen (although the balance may well change once Brexit has happened – and in the lead up to a general election).  Although more than 48 Conservative MPs would in principle be willing to call a vote of confidence, it is believed that they would not win the subsequent vote to remove her.  If by chance that did happen, then Conservative MPs would select two of their members, who would be put to a vote of Conservative activists.  It is likely that at least one of them would be a strong Leaver, and would win the activists’ vote. The position in Parliament The current view on the maths is as follows: The Conservatives and DUP have 326 MPs out of a total of 650.  It is thought that somewhere between 60 and 80 Conservative MPs might vote against a “Soft Brexit” as currently proposed – and one has to assume it will become softer as negotiations with the EU continue.  The opposition Labour party is equally split.  The Labour leadership of Jeremy Corbyn and John McDonnell are likely to vote against any Brexit deal in order to bring the Government down, irrespective of whether that would lead to the UK crashing out of the EU with no deal.  However it is thought that sufficient opposition MPs would side with the Government in order to vote a “Soft Brexit” through the House of Commons. Once the final position is resolved, whether a “Soft Brexit” or no deal, it is likely that there will be a leadership challenge against Mrs May from within the Conservative Party. The position of the EU So far the EU have been relatively restrained in their public comments, on the basis that they have been waiting to see the detail of the White Paper. The EU has stated on many occasions that the UK cannot “pick and choose” between those parts of the EU Single Market that it likes, and those it does not.  For this reason, the proposals in the White Paper (which do not embrace all of the requirements of the Single Market), are unlikely to be welcomed by the EU.  It is highly likely that the EU will push back on the UK position to some degree, but it is a dangerous game for all sides to risk a “no deal” outcome.  Absent agreement on an extension the UK will leave the EU at 11 pm on 29 March 2019, but any deal will need to be agreed by late autumn 2018 so national parliaments in the EU and UK have time to vote on it. Finally Whatever happens with the EU the further political risk is the possibility that the Conservatives will be punished in any future General Election – allowing the left wing Jeremy Corbyn into power. It is very hard to quantify this risk.  In a recent poll Jeremy Corbyn edged slightly ahead of Theresa May as a preferred Prime Minister, although “Don’t Knows” had a clear majority. This client alert was prepared by London partners Charlie Geffen and Nicholas Aleksander and of counsel Anne MacPherson. We have a working group in London (led by Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) addressing Brexit related issues.  Please feel free to contact any member of the working group or any of the other lawyers mentioned below. Ali Nikpay – Antitrust ANikpay@gibsondunn.com Tel: 020 7071 4273 Charlie Geffen – Corporate CGeffen@gibsondunn.com Tel: 020 7071 4225 Nicholas Aleksander – Tax NAleksander@gibsondunn.com Tel: 020 7071 4232 Philip Rocher – Litigation PRocher@gibsondunn.com Tel: 020 7071 4202 Jeffrey M. Trinklein – Tax JTrinklein@gibsondunn.com Tel: 020 7071 4224 Patrick Doris – Litigation; Data Protection PDoris@gibsondunn.com Tel:  020 7071 4276 Alan Samson – Real Estate ASamson@gibsondunn.com Tel:  020 7071 4222 Penny Madden QC – Arbitration PMadden@gibsondunn.com Tel:  020 7071 4226 Selina Sagayam – Corporate SSagayam@gibsondunn.com Tel:  020 7071 4263 Thomas M. Budd – Finance TBudd@gibsondunn.com Tel:  020 7071 4234 James A. Cox – Employment; Data Protection JCox@gibsondunn.com Tel: 020 7071 4250 Gregory A. Campbell – Restructuring GCampbell@gibsondunn.com Tel:  020 7071 4236 © 2018 Gibson, Dunn & Crutcher LLP, 333 South Grand Avenue, Los Angeles, CA 90071 Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.