Cryptocurrency Technology Is Driving Innovation

Interest in cryptocurrency and its underlying technology has steadily rose over the past several years. The final week of 2017 alone saw the debut of over a dozen new cryptocurrencies within the market. Moreover, Bitcoin’s explosive increase in value in 2017 from $1,000 to almost $20,000 has made “Bitcoin” and “cryptocurrency” household terms.[1] The accelerating rate of creation of new currencies and the fluctuation in value of various existing currencies have provided investors with substantial profit opportunities. Unsurprisingly, the financial services industry is making significant investments in the underlying block-chain technology. From individual programmers to large fintech firms, there is a race to secure the intellectual property rights for all aspects of block-chain and cryptocurrency technology.

Financial Services

The block-chain technology functions to increase security and decrease inefficiencies regarding cyber transactions. The software accomplishes this by securely hosting a transaction between two individuals without the requirement of a third party to transfer and record the exchange of funds (i.e. banks, credit card companies, etc.). The transactions are then publicly memorialized in a distributed ledger as a link in the chain’s archive. At its core, the block-chain model is a peer-to-peer system; because of this, the software has the potential to revolutionize the financial services industry by reducing the number of parties required to send and receive payments. This decentralized model is one of the characteristics that makes block-chain unique, and financial firms have recognized the tremendous value of the software.

As the value of the block-chain model became more apparent, the United States Patent and Trademark Office (“USPTO”) was flooded with new patent applications concerning block-chain and cryptocurrencies. At the end of 2017, Bank of America, Mastercard, Paypal and Capital One were leading the field in research and development, and represented the top four patent holding entities in the realm of block-chain and cryptocurrencies.[2] The primary technological focus of these top four firms has been financial forecasting, digital data processing and transmission of secure digital data.[3] In fact, Bank of America was recently issued its latest patent from the USPTO, which outlined a cryptocurrency exchange system that would seamlessly convert one digital currency to another.[4] It may be no coincidence that the top four firms leading research and development on block-chain are those that stand to lose the most from the elimination of third-parties in cyber transactions. It is important, at this point in block-chain’s development, that such firms secure a position on the new playing field if cryptocurrency does displace traditional transaction models.

Internet Data Usage

The sprint to secure intellectual property rights does not, however, solely focus on the current block-chain technology; firms are also looking ahead on how to improve the software and how to benefit from future developments and applications. Several firms are focusing specifically on the distributed ledger aspect of block-chain in order to create a personal virtual identity for each of the software’s users.[5] This concept has significant potential to allow individuals to begin to profit off of their personal data. Currently, websites such as Google, Amazon and Facebook track individual’s internet usage and gain considerable value from their personal data with little to no benefit to the user. The creation of an online avatar that hoards this data in a ledger, and makes it available only with the user’s permission, could bring significance to an individual’s internet browsing data. Users could begin to charge companies a fee to gain limited access to this information, even in miniscule amounts. Cryptocurrency effortlessly weaves itself into the system because currencies like Bitcoin are divisible to the hundredth of a millionth degree. This divisibility makes it possible for you to extract value from as little as 0.00000001 of a Bitcoin for a company to see that you have been looking at Volkswagens on Craigslist all afternoon.

This virtual identity system may not be too far off. In 2017, the state of Illinois launched a block-chain pilot for the digitization of personal data, such as birth certificates.[6] The system has the potential to be the framework for the digital identities discussed above, and could further establish an extraordinarily convenient method of sharing verified personal documents.[7] Although this system immediately raises the question of cybersecurity in the minds of most, block-chain technology is, in fact, vastly more secure than our current systems.[8]

Cyber Security

In 2017, Equifax saw one of the largest cyber security breaches in history. The current method of storing millions of individuals’ personal data is piling it together on the same system, which is then encrypted and secured. The issue, as illustrated by Equifax, is that once the security mechanisms are breached, the cyber burglar then has access to the entirety of the stored data.[9] Block-chain, however, stores each individual’s data separately in its own encrypted and secured space. If a hacker wished to steal data from a block-chain, they would be required to decrypt each of the individual’s data separately; in the case of Equifax, the hacker(s) would have been required to bypass 140,000,000 encryptions.[10] For this reason, cyber security firms are becoming increasingly involved in block-chain technology as well.

Mobile Applications

The cyber security and financial services industries are not the only industries honing in on the cryptocurrency craze. It is also worth mentioning the flood of new applications from the mobile software market. The rapid origination rate of mobile applications, no matter how redundant or superfluous they may seem, is compelling United States intellectual property filings. Cryptocurrency mobile applications can provide a wide range of services for their users: market information through applications such as zTrader, Bitcoin Checker and Bitcoin Price IQ; portfolio services through Cryptonator, CoinDex and Mycelium; and trading platforms through Coinbase, CEX.IO and CoinCap. More significantly, many of the most popular websites which provide mobile application support are beginning to accept cryptocurrency as a payment method. Notably, online retailer Overstock.com, online dating service OkCupid.com, electronics retailer Newegg.com, and travel booking agency Expedia.com are among the firms now accepting bitcoin as payment for their services.[11] Cryptocurrency also has the potential to transform the mobile gaming industry.

A dimension of mobile applications which has received a lot of negative publicity over the past few years is predatory in-app purchases. Many mobile gaming applications, which are typically marketed to children and teenagers, are free to download and play, but incentivize frequent micro-transactions from the user. These aptly dubbed “freemium” games result in cases of young users racking up a bill in the range of several hundreds of dollars, to their parent’s surprise. In fact, many applications offer purchases of in-game currencies up to $99 per transaction. This model may change, for better or for worse, with the rise of cryptocurrency. As discussed above, the Bitcoin is divisible to the hundredth of a millionth degree. The mobile gaming industry could see a transition from incentivizing young players to make frequent large transactions, to mobile games charging a fraction of a Bitcoin per minute (or second) of game time. The application would likely request access to your Bitcoin wallet and simply deduct fragments of a Bitcoin for as long as the game remains active. Whether this will be a welcome change is to be determined.

Conclusion

Cryptocurrency and block-chain technology are causing us to rethink our current financial and cyber-social systems. The characteristics that make block-chain unique—the decentralized model, distributed ledger, individual security, sense of virtual identity—are quickly being applied in new and innovative ways. The result is a surge in new intellectual property from forward thinking firms as we move into what may be an important technological shift for many of our country’s industries.

____________________________________________________________________________________

[1] Coindesk, Bitcoin (USD) Price, Coindesk (last visited Jan. 2, 2018) https://www.coindesk.com/price/.

[2] Jay Sharma, How Bitcoin Became a Game Changer Overnight, IPWatchdog (Dec. 4, 2017), http://www.ipwatchdog.com/2017/12/04/bitcoin-game-changer-overnight/id=90519/.

[3] Id.

[4] Nikhilesh De, Bank of America Wins Patent for Crypto Exchange System (Dec. 7, 2017, 3:00 UTC), https://www.coindesk.com/bank-of-america-outlines-cryptocurrency-exchange-system-in-patent-award/; the Bank of America patent granted by the USPTO is identified by United States Patent No. 9,936,790.

[5] Michael Mainelli, Blockchain Could Help Us Reclaim Control of Our Personal Data, Harvard Business Review (Oct. 5, 2017), https://hbr.org/2017/10/smart-ledgers-can-help-us-reclaim-control-of-our-personal-data.

[6] Michael del Castillo, Illinois Launches Blockchain Pilor to Digitize Birth Certificates, Coindesk (Aug. 31, 2017, 23:00 UTC), https://www.coindesk.com/illinois-launches-blockchain-pilot-digitize-birth-certificates/.

[7] Id.

[8] See Mainelli, supra note 5.

[9] See Mainelli, supra note 5.

[10] Id.

[11] Mariam Nishanian, 8 surprising places where you can pay with bicoin, Business Insider (Oct. 11, 2017 6:00 PM), http://www.businessinsider.com/bitcoin-price-8-surprising-places-where-you-can-use-2017-10/#expediacom-1.

The Federal Criminal Forfeiture Statute: Reining in the Government’s Previously Unbridled Ability to Seize Pretrial Assets

Abstract

American organized crime movies are synonymous with a climatic raid and seizure of illegal assets – typically drugs and guns. But what is really encompassed within the Government’s grasp; what are the “illegal assets”? The truth is that the Government has a wide reach and the criminal seizures don’t end when the screen goes black and the credits roll. The Federal Criminal Forfeiture Statute, as applied to RICO and CCE cases, typically entails the forfeiture of any asset connected to the underlying crimes. Given that criminal forfeiture penalties have ethical and constitutional considerations, it is not surprising to learn that a recent United States Supreme Court decision has scaled back the Government’s power over its ability to seize. This Note will provide an overview of the Federal Criminal Forfeiture Statute, as well as RICO and CCE in order to provide context, will detail the case law history of the statute in application, will examine the ethical and constitutional considerations, and will question the future of the controversially applied law.

Click Here for full article

Orginally Published in Pace Law Review

Kristyn Fleming Francese, The Federal Criminal Forfeiture Statute: Reining in The Government’s Previously Unbridled Ability to Seize Pretrial Assets, 38 Pace L. Rev. 634 (2018)

Available at: https://digitalcommons.pace.edu/plr/vol38/iss2/10

Non-Practicing Entities & Patent Reform

Abstract

The patent system is designed to promote innovation and supply a blueprint for innovative minds to improve upon, but the behavior of some patent owners is contrary to these principles. Non-practicing entities obtain patent rights, and rather than produce the product claimed in the patent, they assert their exclusionary rights broadly and aggressively against businesses producing similar products in order to induce settlement or licensing payments. These assertions account for a significant percentage of infringement claims and threaten a potentially innocent business with expensive litigation. The actions of these entities have a substantial effect on the patent system and have been the motivation behind reform and recent Supreme Court decisions. Each of the three branches of government has significant influence over the patent system, and each has the potential to promote change to reduce the impact of non-practicing entities on the United States patent system and on the United States economy.

Click Here for full article

Originally Published in Pace Law Review

Nicholas Douglas, Non-Practicing Entities & Patent Reform, 38 Pace L. Rev. 608 (2018)

Available at: https://digitalcommons.pace.edu/plr/vol38/iss2/9

Pastore & Dailey Successfully Secures Case Dismissal in Multi-Billion Dollar S&P Ratings Case

In a high profile matter, Pastore & Dailey represented a senior executive of S&P, formerly McGraw Hill Financial Inc., in connection with claims brought by shareholders against S&P and its executives related to the financial services agency’s ratings of RMBS during the 2008 financial crisis.  Cahill Gordon was co-counsel.  The lower court rejected the shareholders’ arguments, and the New York Appellate Court affirmed and rejected the appeal in its entirety.  The Court also found that the claims were barred under the six-year or three-year statute of limitations.

Pastore & Dailey Successfully Secures Case Dismissal in Multi-Billion Dollar S&P Ratings Case

In a high profile matter, Pastore & Dailey represented a senior executive of S&P, formerly McGraw Hill Financial Inc., in connection with claims brought by shareholders against S&P and its executives related to the financial services agency’s ratings of RMBS during the 2008 financial crisis.  Cahill Gordon was co-counsel.  The lower court rejected the shareholders’ arguments, and the New York Appellate Court affirmed and rejected the appeal in its entirety.  The Court also found that the claims were barred under the six-year or three-year statute of limitations.

 

Pastore & Dailey Represents Boca Raton Financial Advisor in Arbitration Against High-Profile Financial Services Company

Pastore & Dailey was retained by one of Boca Raton’s top producing financial advisors.  Our client brought hundreds of millions of dollars in assets to a major financial services company.  Pastore & Dailey attorneys have brought a FINRA arbitration in the Boca Raton regional office.

 

Connecticut’s New Pass Through Entity Tax

On May 31, 2018, Governor Malloy signed P.A. 18-49, which fundamentally changes how income earned by pass through entities such as S corporations, partnerships, and multi-member LLCs are taxed. The new legislation does not affect the taxation of publicly traded partnerships, sole proprietorships, or single member LLCs.

The legislation is retroactively effective to January 1, 2018. For tax years beginning on or after that date, a pass-through entity is now subject to tax, at a rate of 6.99%, on its own income. The new law provides a tax credit that partners may claim on their Connecticut income tax return, intended, generally, to ensure that the pass-through entity’s income is not taxed twice.

The policy goal of the legislation is fairly novel. It is intended as a revenue-neutral work around to the $10,000 limitation to the deduction for state and local taxes contained in the revisions to the federal tax law. The new Connecticut tax law transfers the Connecticut income tax deduction from the business owners to the entity itself. Because the new state tax will be an expense of the pass-through entity that pays it, the tax reduces the federal taxable income of the individual owners of pass-through entities, it offsets, at least in part, the effects of the federal law’s new limitation on the deduction for state and local taxes. Each such owner is now provided a refundable credit against the Connecticut personal income tax in an amount equal to 93.01% of that owner’s pro rata share of the tax paid by the pass-through entity. An individual owner who is either a full year or part year resident of Connecticut is also entitled to a credit against the Connecticut personal income tax for that individual’s pro rata share of taxes paid to another state or the District of Columbia on income of the pass-through business entity if the Commissioner of Revenue Services determines that the tax is substantially similar to the new Connecticut pass through entity tax.

A nonresident individual whose only Connecticut source income is from one or more Connecticut pass-through entities which entities pay the pass-through entity tax will not need to file a Connecticut personal income tax return. However, an individual member of a pass-through entity that has elected to file a “combined return” with one or more other pass through entities and pass-through chooses to file a combined return and the offsetting credit for the pass-through’s tax payment does not completely satisfy the nonresident’s Connecticut personal income tax liability.

Because the new Connecticut tax law is made retroactive to the beginning of 2018 and requires pass-through entities to make estimated tax payments quarterly (i.e. April 15, June 15, and September 15 of 2018, and January 15 of 2019), the affected entities are, in effect already late on the first payment due. The Department of Revenue Services has stated that entities may make solve this issue in any of three ways:

  1. Make a catch-up payment with the June 15, 2018 estimated payment that satisfies both the first and second estimated payment requirements;
  2. Make three estimated payments (by each of June 15 and September 15 in 2018, and by January 15 in 2019) each equaling 22.5% of the total tax liability, with the final payment due with the tax return; or
  3. Annualize their estimated payments for the taxable year

Further, DRS will allow pass-through entities to recharacterize all or a portion of any April 15, 2018, June 15, 2018, or September 15, 2018, income tax estimated payments made by any of their individual partners, with such partner’s consent, so that the payments are applied against the pass-through entity’s 2018 estimated payment requirements. The recharacterization of these 2018 income tax estimated payments must be completed by December 31, 2018. The recharacterized amount will be deemed to have been made by the pass-through entity on the date that the individual partner remitted the estimated payment to DRS. DRS will provide information by September 30, 2018, about the mechanism to re-characterize these estimated payments.

A pass-through entity may make its June 15, 2018 estimated tax payment by completing an estimated tax payment coupon and mailing it to DRS with a check. The estimated tax payment coupon may be downloaded here.  For the September 15, 2018 estimated payment, a pass-through entity may also make its estimated payment at http://www.ct.gov/tsc.

Because individual partners will get a credit for the Pass-Through Entity Tax paid by their pass-through entity, many resident individual and trust partners will no longer need to make estimated income tax payments to cover their Connecticut income tax liability arising from their pass-through entity income. A partner may still be required to make estimated income tax payments depending upon the method the pass-through entity uses to calculate the Pass-Through Entity Tax, if the partner has income from other sources, or if the individual partner is an employee who will not have enough income tax withheld from their wages. Partners should consult with their pass-through entities and tax counsel to determine how they will be affected.

DRS has stated it is aware that some individual partners have already remitted the first-quarter estimated income tax payment and may have scheduled the automatic payment of the second, third and fourth quarter estimated income tax payments. If an individual partner determines that he or she no longer needs to make estimated income tax payments, the partner may cancel any pending scheduled payments.

In circumstances where partners or other owners of affected pass through entities have already made estimated individual income tax payments, there are two options:

  1. The individual partners (or other owners) will receive a refund when they file their 2018 Connecticut returns; or
  2. The individual partners may have all or a portion of their 2018 income tax estimated payments re-characterized so that the payments are applied against their pass-through entity’s 2018 estimated payment requirements. This must be done by December 31, 2018.

The new law provides for a taxpayer to elect either of two methods of calculating the tax:

  1. Multiply the applicable rate by the entity’s Connecticut source income; or
  2. If timely elected, the taxpayer may apply the rate to an “alternative tax base” that is equal to the “resident portion of unsourced income” plus “modified Connecticut source income.”

 

 

Some definitions will help here.

Unsourced income generally equals the business’s net income as calculated for federal tax purposes, increased or decreased by applicable personal tax deductions and without regard to the location from which the items of income and adjustments are derived, minus the business’s Connecticut sourced income without any adjustments for tiered business entities and also minus the business’s net income, for federal tax purposes, that is derived from sources in another state with jurisdiction to tax the entity, as increased or decreased by any adjustments that apply under the personal income tax that are derived from, or connected to, sources in another state with jurisdiction to tax the entity.

Modified Connecticut source income is defined as the business’s Connecticut source income multiplied by a percentage equal to the sum of ownership interests in the business that are owned by individual members that are (i) subject to the Connecticut personal income tax or (ii) pass-through businesses subject to the entity tax to the extent that such businesses are directly or indirectly owned by individuals subject to the Connecticut personal income tax.

The resident portion of unsourced income is “unsourced income” multiplied by a percentage equal to the portion of the ownership interests in the business entity owned by individual members who are Connecticut residents.

While there is not yet published guidance, election of the alternative tax base seems likely to be more attractive to Connecticut residents because it increases the available tax credit to include “unsourced income” as well as Connecticut sourced income. This alternative tax calculation should also permit a business to avoid paying the pass-through entity tax to the extend of income earned by owners who are not subject to the Connecticut personal income tax, such as Subchapter C corporations and tax-exempt entities.

Partners in a pass-through entity that files on a fiscal year basis appear to need to continue to make 2018 estimated income tax payments. If a pass-through entity is a fiscal year filer, the distributive share of the entity’s income from its 2018 return will be included in such partner’s 2019 income tax return. Hence, the credit associated with the entity’s 2018 return will not be claimed until the partner’s 2019 Connecticut income tax return is filed.

We are still awaiting guidance on some issues that remain unresolved with the new law, such as:

(i)      The impact on nonresident owners who reside in jurisdictions with an income tax that

may not grant a credit for the new Connecticut tax;

(ii)     The applicability of the tax to guaranteed payments; and

(iii)    The impact of the Connecticut modification from federal adjusted gross income for

Connecticut taxes. In addition, any sole proprietorship operated as a single member

limited liability company treated for federal tax purposes as a disregarded entity, should

consult with a tax advisor as to whether the owner should convert to pass-through status

by adding a nominal partner to take advantage of the tax benefit afforded by this legislation

 

This information is provided as a review of general principles only and is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstance with a qualified practitioner before taking any action.

Connecticut’s New Pass Through Entity Tax

On May 31, 2018, Governor Malloy signed P.A. 18-49, which fundamentally changes how income earned by pass through entities such as S corporations, partnerships, and multi-member LLCs are taxed. The new legislation does not affect the taxation of publicly traded partnerships, sole proprietorships, or single member LLCs.

The legislation is retroactively effective to January 1, 2018. For tax years beginning on or after that date, a pass-through entity is now subject to tax, at a rate of 6.99%, on its own income. The new law provides a tax credit that partners may claim on their Connecticut income tax return, intended, generally, to ensure that the pass-through entity’s income is not taxed twice.

The policy goal of the legislation is fairly novel. It is intended as a revenue-neutral work around to the $10,000 limitation to the deduction for state and local taxes contained in the revisions to the federal tax law. The new Connecticut tax law transfers the Connecticut income tax deduction from the business owners to the entity itself. Because the new state tax will be an expense of the pass-through entity that pays it, the tax reduces the federal taxable income of the individual owners of pass-through entities, it offsets, at least in part, the effects of the federal law’s new limitation on the deduction for state and local taxes. Each such owner is now provided a refundable credit against the Connecticut personal income tax in an amount equal to 93.01% of that owner’s pro rata share of the tax paid by the pass-through entity. An individual owner who is either a full year or part year resident of Connecticut is also entitled to a credit against the Connecticut personal income tax for that individual’s pro rata share of taxes paid to another state or the District of Columbia on income of the pass-through business entity if the Commissioner of Revenue Services determines that the tax is substantially similar to the new Connecticut pass through entity tax.

A nonresident individual whose only Connecticut source income is from one or more Connecticut pass-through entities which entities pay the pass-through entity tax will not need to file a Connecticut personal income tax return. However, an individual member of a pass-through entity that has elected to file a “combined return” with one or more other pass through entities and pass-through chooses to file a combined return and the offsetting credit for the pass-through’s tax payment does not completely satisfy the nonresident’s Connecticut personal income tax liability.

Because the new Connecticut tax law is made retroactive to the beginning of 2018 and requires pass-through entities to make estimated tax payments quarterly (i.e. April 15, June 15, and September 15 of 2018, and January 15 of 2019), the affected entities are, in effect already late on the first payment due. The Department of Revenue Services has stated that entities may make solve this issue in any of three ways:

  1. Make a catch-up payment with the June 15, 2018 estimated payment that satisfies both the first and second estimated payment requirements;
  2. Make three estimated payments (by each of June 15 and September 15 in 2018, and by January 15 in 2019) each equaling 22.5% of the total tax liability, with the final payment due with the tax return; or
  3. Annualize their estimated payments for the taxable year

Further, DRS will allow pass-through entities to recharacterize all or a portion of any April 15, 2018, June 15, 2018, or September 15, 2018, income tax estimated payments made by any of their individual partners, with such partner’s consent, so that the payments are applied against the pass-through entity’s 2018 estimated payment requirements. The recharacterization of these 2018 income tax estimated payments must be completed by December 31, 2018. The recharacterized amount will be deemed to have been made by the pass-through entity on the date that the individual partner remitted the estimated payment to DRS. DRS will provide information by September 30, 2018, about the mechanism to re-characterize these estimated payments.

A pass-through entity may make its June 15, 2018 estimated tax payment by completing an estimated tax payment coupon and mailing it to DRS with a check. The estimated tax payment coupon may be downloaded here.  For the September 15, 2018 estimated payment, a pass-through entity may also make its estimated payment at http://www.ct.gov/tsc.

Because individual partners will get a credit for the Pass-Through Entity Tax paid by their pass-through entity, many resident individual and trust partners will no longer need to make estimated income tax payments to cover their Connecticut income tax liability arising from their pass-through entity income. A partner may still be required to make estimated income tax payments depending upon the method the pass-through entity uses to calculate the Pass-Through Entity Tax, if the partner has income from other sources, or if the individual partner is an employee who will not have enough income tax withheld from their wages. Partners should consult with their pass-through entities and tax counsel to determine how they will be affected.

DRS has stated it is aware that some individual partners have already remitted the first-quarter estimated income tax payment and may have scheduled the automatic payment of the second, third and fourth quarter estimated income tax payments. If an individual partner determines that he or she no longer needs to make estimated income tax payments, the partner may cancel any pending scheduled payments.

In circumstances where partners or other owners of affected pass through entities have already made estimated individual income tax payments, there are two options:

  1. The individual partners (or other owners) will receive a refund when they file their 2018 Connecticut returns; or
  2. The individual partners may have all or a portion of their 2018 income tax estimated payments re-characterized so that the payments are applied against their pass-through entity’s 2018 estimated payment requirements. This must be done by December 31, 2018.

The new law provides for a taxpayer to elect either of two methods of calculating the tax:

  1. Multiply the applicable rate by the entity’s Connecticut source income; or
  2. If timely elected, the taxpayer may apply the rate to an “alternative tax base” that is equal to the “resident portion of unsourced income” plus “modified Connecticut source income.”

Some definitions will help here.

Unsourced income generally equals the business’s net income as calculated for federal tax purposes, increased or decreased by applicable personal tax deductions and without regard to the location from which the items of income and adjustments are derived, minus the business’s Connecticut sourced income without any adjustments for tiered business entities and also minus the business’s net income, for federal tax purposes, that is derived from sources in another state with jurisdiction to tax the entity, as increased or decreased by any adjustments that apply under the personal income tax that are derived from, or connected to, sources in another state with jurisdiction to tax the entity.

Modified Connecticut source income is defined as the business’s Connecticut source income multiplied by a percentage equal to the sum of ownership interests in the business that are owned by individual members that are (i) subject to the Connecticut personal income tax or (ii) pass-through businesses subject to the entity tax to the extent that such businesses are directly or indirectly owned by individuals subject to the Connecticut personal income tax.

The resident portion of unsourced income is “unsourced income” multiplied by a percentage equal to the portion of the ownership interests in the business entity owned by individual members who are Connecticut residents.

While there is not yet published guidance, election of the alternative tax base seems likely to be more attractive to Connecticut residents because it increases the available tax credit to include “unsourced income” as well as Connecticut sourced income. This alternative tax calculation should also permit a business to avoid paying the pass-through entity tax to the extend of income earned by owners who are not subject to the Connecticut personal income tax, such as Subchapter C corporations and tax-exempt entities.

Partners in a pass-through entity that files on a fiscal year basis appear to need to continue to make 2018 estimated income tax payments. If a pass-through entity is a fiscal year filer, the distributive share of the entity’s income from its 2018 return will be included in such partner’s 2019 income tax return. Hence, the credit associated with the entity’s 2018 return will not be claimed until the partner’s 2019 Connecticut income tax return is filed.

We are still awaiting guidance on some issues that remain unresolved with the new law, such as:

(i)      The impact on nonresident owners who reside in jurisdictions with an income tax that

may not grant a credit for the new Connecticut tax;

(ii)     The applicability of the tax to guaranteed payments; and

(iii)    The impact of the Connecticut modification from federal adjusted gross income for

Connecticut taxes. In addition, any sole proprietorship operated as a single member

limited liability company treated for federal tax purposes as a disregarded entity,

should consult with a tax advisor as to whether the owner should convert to

pass-through status by adding a nominal partner to take advantage of the tax benefit

afforded by this legislation.

This information is provided as a review of general principles only and is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstance with a qualified practitioner before taking any action.

Pastore & Dailey Successfully Negotiates Agreement for Former Investment Professional of Hedge Fund

Pastore & Dailey attorneys successfully obtained a favorable agreement on behalf of a client in a dispute with a former hedge fund employer in a private EEOC complaint.  The complaint alleged employment discrimination and sexual harassment.  This favorable settlement prevented litigation in federal court and resulted in considerable compensation to our client.

SEC Proposes Regulation Best Interest for Brokers

On April 18, 2018, the SEC proposed “Regulation Best Interest,” which is the latest in a long and disputed line of proposed attempts by various governmental bodies to homogenize the duties owed by brokers and investment advisers to their respective clients. Professionals in the financial services industry and others should take note that they have until approximately July 23, 2018i to file a public comment on the proposed SEC rule, and investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.

BACKGROUND

For decades, customers of the financial services industry have been confused by (if not outright unaware of) the different “standards of care” that their “brokers” and “investment advisers” have owed them.

On the one hand, “[a]n investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care.”ii Investment advisers typically charge for their services via an annual fee assessed as a percentage of the “assets under management” (the so-called “AUM”) that the investment adviser “manages” for the client. The primary regulator of an investment adviser is either the SEC (usually for relatively larger investment advisers – i.e., those managing more than $100 million AUM) or a state securities commission (usually for relatively smaller investment advisers – i.e., those managing less than $100 million AUM).

On the other hand, brokers “generally must become members of FINRA” and are merely required to “deal fairly with their customers.”iii  FINRA Rule 2111 requires, in part, that a broker “must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [broker] to ascertain the customer’s investment profile” (the “suitability” standard).iv  Rather than a percentage of AUM, brokers’ compensation is typically derived from commissions they charge on each of the trades they execute for their clients. FINRA, a non-governmental organization, is the primary regulator for almost all brokers in the U.S.

At first blush, a layman retail client could easily be excused for struggling to understand the difference between the requirements of an investment adviser to “serve the best interests of its clients” and those of a broker to “deal fairly with their clients.” This confusion is exacerbated when a broker is also registered as an investment adviser, thus clouding what “hat” the advisor is wearing when dealing with a client.

Tortured Regulatory History

Regulator concern about this confusion has existed for decades.  In 2004, the SEC retained consultants to conduct focus group testing to ascertain, in part, how investors differentiate the roles, legal obligations, and  compensation between investment advisers and broker-dealers. The results were striking:

In general, [the focus] groups did not understand that the roles and legal obligations of investment advisers and broker-dealers were different. In particular, they were confused by the different titles (e.g., financial planner, financial advisor, financial consultant, broker-dealer, and investment adviser), and did not understand terms such as “fiduciary.”v

In 2006, the SEC engaged RAND to conduct a large-scale survey on household investment behavior, including whether investors understood the duties and obligations owed by investment advisers and broker-dealers to each of their clients. First, it should be noted, “RAND concluded that it was difficult for it to identify the business practices of investment advisers and broker-dealers with any certainty.”vi  Second, RAND surveyed 654 households (two-thirds of which were considered “experienced”) and conducted six focus groups, and reported that such participants –

…could not identify correctly the legal duties owed to investors with respect to the services and functions investment advisers and brokers performed. The primary view of investors was that the financial professional – regardless of whether the person was an investment adviser or a broker-dealer – was acting in the investor’s best interest.vii

In 2010, the Dodd-Frank Act mandated the SEC to conduct a study to evaluate, among other things, “Whether there are legal or regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers relating to the standards of care for providing personalized investment advice about securities to retail customers that should be addressed by rule or statute,” and to consider ”whether retail customers understand or are confused by the differences in the standards of care that apply to broker-dealers and investment advisers.”viii A conclusion of that study was as follows:

[T]he Staff recommends the consideration of rulemakings that would apply expressly and uniformly to both broker-dealers and investment advisers, when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2).

In 2013, the SEC issued a “request for information” on the subject of a  potential “uniform fiduciary standard,”ix but never promulgated a rule after receiving more than 250 comment letters from “industry groups, individual market participants, and other interested persons[….]”x

Finally, on April 8, 2016, the U.S. Department of Labor adopted a new, expanded definition of “fiduciary” to include those who provide investment advice or recommendations for a fee or other compensation with respect to assets of an ERISA plan or IRA (in other words, certain “brokers”) (the “DOL Fiduciary Rule”). Many brokerage firms and others (such as insurance companies) made operational and licensing adjustments to prepare for the DOL Fiduciary Rule while various lawsuits were filed in attempts to invalidate the controversial rule. Most recently, the United States Court of Appeals for the Fifth Circuit vacated the DOL Fiduciary Rule on March 15, 2018.xi

“Suitability” Standard vs. “Fiduciary” Standard

The “suitability” standard of a broker is a far cry from the “fiduciary” standard of an investment adviser.  As the SEC has stated, “Like many principal-agent relationships, the relationship between a broker-dealer and an investor has inherent conflicts of interest, which may provide an incentive to a broker-dealer to seek to maximize its compensation at the expense of the investor it is advising.”xii  Put more bluntly, “there is no specific obligation under the Exchange Act that broker-dealers make recommendations that are in their customers’ best interest.”xiii

FINRA (including under its former name, NASD) has certainly striven to close that gap via its own interpretations and disciplinary proceedings, and has succeeded to a point.  Specifically, a number of SEC administrative rulings have confirmed FINRA’s interpretation of FINRA’s suitability rule as requiring a broker-dealer to make recommendations that are “consistent with his customers’ best interests” or are not “clearly contrary to the best interest of the customer.”xiv However, the SEC has highlighted that these interpretations are “not explicit requirement[s] of FINRA’s suitability rule.”xv

This lower duty of care for brokers (as opposed to investment advisers, who have a fiduciary duty) has had and continues to have purportedly large and definitive financial consequences for retail investors:

Conflicted advice causes substantial harm to investors. Just looking at retirement savers, SaveOurRetirement.com estimates that investors lose between $57 million and $117 million every day due to conflicted investment advice, amounting to at least $21 billion annually.xvi

A 2015 report from the White House Council of Economic Advisers (CEA) estimated that –

[…]conflicts of interests cost middle-class families who receive conflicted advice huge amounts of their hard-earned savings. It finds conflicts likely lead, on average, to:

  • 1 percentage point lower annual returns on retirement savings.
  • $17 billion of losses every year for working and middle class families.
SEC”S NEWLY-PROPOSED “REGULATION BEST INTEREST”

Despite the controversy over the DOL Fiduciary Rule and its recent, apparent defeat, the SEC has been working under the guidance of Chairman Jay Clayton since 2017 to finally rectify the confusion among investors as to the different standards of care applicable to brokers versus investment advisers.xvii

The latest development in that regard has been the proposal by the SEC of “Regulation Best Interest” (“Reg. BI”) on April 18, 2018.xviii  The proposed rule is significant in its proposed breadth. Subparagraph (a)(1) of the proposed rule would provide as follows:

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.xix

This is a sea change in the duty of care owed by brokers to their retail clients, as it would effectively enhance a broker’s duty of care to approximate that of an investment adviser’s (at least in regard to retail clients).xx

To satisfy the “best interest” obligation in subparagraph (a)(1), subparagraph (a)(2) of Reg. BI would impose four component requirements: a Disclosure Obligation, a Care Obligation, and two Conflict of Interest Obligations.xxi

For the “Disclosure Obligation,” subparagraph (a)(2)(i) of Reg. BI would require the broker to –

reasonably disclose[] to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation.xxii

For the “Care Obligation,” subparagraph (a)(2)(ii) of Reg. BI would require the broker to “exercise[] reasonable diligence, care, skill, and prudence to” do the following:

(A) Understand the potential risks and rewards associated with the recommendation, and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;

(B) Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and

(C) Have a reasonable basis to believe that a series of recommended transactions, even if in the retail customer’s best interest when viewed in isolation, is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.xxiii

Finally, for the two “Conflict of Interest Obligations,” subparagraph (a)(2)(iii) of Reg. BI would require the following:

(A) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all material conflicts of interest that are associated with such recommendations.

(B) The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations.xxiv

Furthermore, Reg. BI would expand the SEC’s records requirement rules (i.e., Rules 17a-3 and 17a-4) to  provide that “[f]or each retail customer to whom a recommendation of any securities transaction or investment strategy involving securities is or will be provided,” a broker obtain and maintain for six years “[a] record of all information collected from and provided to the retail customer pursuant to [Reg. BI].”xxv

CONCLUSION

The SEC’s proposed “Regulation Best Interest” is a significant proposal that could have far-reaching impact across the securities brokerage and other segments of the financial services industries. Whether this latest regulatory effort to establish a more consistent standard of care for brokers and investment advisers will succeed is unknown, but the proposed rule is certainly an aggressive step in that regard.

All those interested will have until approximately July 23, 2018 to file a public comment on the proposed rule. Meanwhile, investors should take this opportunity to educate themselves on the current differences between “brokers” and “investment advisers,” including the different standard of care that each owe their clients.

ENDNOTES

i   The specific date will be established once the proposed rule is published in the Federal Register.

ii   Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (“Study”), at iii, available at www.sec.gov/news/studies/2011/913studyfinal.pdf.

iii  Study at iv.

iv  FINRA Rule 2111(a), available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=15663&element_id=9859&highlight=2111#r15663, as of April 23, 2018.

v   Study at 96.

vi  Study at 97.

vii Study at 98.

viii Study at i.

ix  See Request for Data and Other Information: Duties of Brokers, Dealers and Investment Advisers, Exchange Act Release No. 69013 (Mar. 1, 2013), available at http://www.sec.gov/rules/other/2013/34-69013.pdf.

x   Regulation Best Interest, Exchange Act Release No. 34-83062 (April 18, 2018) (“Reg. BI Proposal”), at 20, available at https://www.sec.gov/rules/proposed/2018/34-83062.pdf.

xi  Reg. BI Proposal at 27.

xii     Reg. BI Proposal at 7.

xiii Reg. BI Proposal at 8.

xiv Reg. BI Proposal at 14, fn. 15.

xv Reg. BI Proposal at 8, fn. 6.

xvi Reg. BI Proposal at 20, fn. 28, quoting Letter from Marnie C. Lambert, President, Public Investors Arbitration Bar Association (Aug. 11, 2017) (“PIABA Letter”).

xvii    Chairman Jay Clayton, Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers, Public Statement, June 1, 2017, available at https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31.

xviii   See Reg. BI Proposal.

xix Reg. BI Proposal, at 404.

xx In a related SEC proposal regarding investment advisers that was also dated April 18, 2018, the SEC stated that “[a]n investment adviser’s fiduciary duty is similar to, but not the same as, the proposed obligations of broker-dealers under Regulation Best Interest,” and that “we are not proposing a uniform standard of conduct for broker-dealers and investment advisers in light of their different relationship types and models for providing advice[….]” See Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. IA-4889 (April 18, 2018), available at https://www.sec.gov/rules/proposed/2018/ia-4889.pdf.

xxi Reg. BI Proposal, at 404.

xxii Reg. BI, subparagraph (B), Reg. BI Proposal, at 404.

xxiii   Reg. BI Proposal, at 404-405.

Subparagraph (b)(2) of Reg. BI would define “retail customer’s investment profile” as including, but not be limited to, “the retail customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the retail customer may disclose to the broker, dealer, or a natural person who is an associated person of a broker or dealer in connection with a recommendation.” Reg. BI Proposal, at 406.

xxiv   Reg. BI Proposal, at 405.

xxv      Reg. BI Proposal, at 406-407