The new changes imposed by the Bipartisan Budget Act of 2015 established new rules for how partnerships will be audited and how they are assessed liability for federal taxes due after an examination. These new rules require that every entity that could be treated as a partnership to examine, and when needed, revise its governing documents to be able to comply with the rules. This article delves further into the new BBA rules and how partnerships may opt-out to avoid the full effects of the new consolidated partnership audit rules and push-out the adjustments to income, gain, loss, deduction, or credit to each partner of the partnership for the reviewed year by following a prescribed process. For those considering purchasing or selling partnership interests should be aware of the current responsibilities implemented by these new rules and review their partnership agreements.
Tag: Joseph Pastore
Initial Coin Offerings: The New (Controversial) Way to Raise Capital
With Bitcoin exploding in market value to over $19,000 per coin at the close of 2017, investors are intrigued by the alluring concepts of cryptocurrency, blockchain, and the decision of whether to invest in startup companies utilizing cryptocurrency.[1] Recently, initial coin offerings (ICOs) have been the primary way for cryptocurrency startup companies to raise capital, and most notably, avoid the high costs associated with the traditional initial public offering (IPO). In 2017, over $4 billion was raised through the use of initial coin offerings, and that figure was forecasted to rise significantly.[2] This article will summarize what an initial coin offering is, why it is controversial, and what the near future may hold regarding regulation for this method of raising capital.
What is an Initial Coin Offering?
An initial coin offering is a means for cryptocurrency startup companies to raise capital through crowdfunding. There are two primary reasons to create an initial coin offering: first, to create a new kind of cryptocurrency (different from Bitcoin) that has its own blockchain, or, second, to fund a project that requires a new unique currency to be effective. Most ICOs involve the second type, known as token generation events (TGE). To begin the process of an ICO, the issuing company publishes a whitepaper detailing their company business model, projections, fundraising goals, what type of currency is accepted in the offering, company timelines, and other information to incentivize investors. Upon making the decision to participate in the ICO, investors use cryptocurrency (or fiat currencies like U.S. dollars (hereinafter, “cash”), in some cases) to purchase coins, or “tokens,” from the coin issuing company. Bitcoin is the most commonly used form of cryptocurrency by investors in ICOs. Tokens purchased by the investor do not necessarily represent shares of ownership in the company, but they are similar in varying respects. Technically, they reflect a percentage of the total amount of the initial cryptocurrency produced and can be redeemed or sold on secondary markets for cash value (or Bitcoin) once the issuing company meets its funding benchmarks and launches the venture.
In a nut shell, investors are simply being offered the opportunity to “get in on the ground floor” and purchase coins for a significantly lower price than the coin is projected to reach in the whitepaper. Should the company not meet its funding benchmarks, these tokens are supposed to be refunded for the principle price paid in the currency used by the investor. Ultimately, the decision to invest in an ICO depends on the investor’s prediction on whether the issuing company will successfully attain funding milestones to produce a viable cryptocurrency that will increase in value over time, or at least will be able to return all investments made by the investor should the benchmarks not be reached.
Ethereum is an example of a successful ICO that generated a substantial return on investment for those who participated. Ethereum uses Ether as its cryptocurrency, which was issued in 2014 at $.40 per Ether, translating to roughly $18 million in Bitcoin at the time.[3] Ethereum’s project went live in 2015, and as of today the cryptocurrency trades at $873.72 per Ether, and is the second most successful cryptocurrency to date behind Bitcoin.[4] Returns like Ethereum make headlines across the nation, and are a focal point in driving investors to take a hard look into the “cryptocurrency bubble.”
Securities Regulation of ICOs
ICOs are quite similar to a traditional IPO, save for one major aspect: enforced regulation. On July 25th, the SEC issued its first sweeping statement (a “21(a) Report”) regarding the transfer and sale of digital currency like “tokens” sold in ICOs, declaring that the federal securities laws may apply to ICOs after its investigation into The DAO.[5]
The DAO was a decentralized autonomous organization (“dao”) that used distributed ledger or blockchain technology to operate as a virtual entity, and sold tokens representing interests in the company to investors in exchange for cryptocurrency. In the 21(a) Report, the SEC confirmed that cryptocurrency in the form of tokens or “coins” sold in ICOs can be a security, and that ICO issuers and ICOs may be subject to federal securities regulation law.[6] How these laws will be applied and when further enforcement will go into effect are uncertain at this time, but the signs of SEC movement on the issues of cryptocurrency transactions are present.
At the Senate Committee on Banking, Housing, and Urban Affairs hearing on February 9, 2018, SEC Chairman Jay Clayton was quoted as saying, “You can call it a coin, but if it functions like a security, then it’s a security,” and, most notably, “A note for professionals in these markets: those that engage in semantic gymnastics … are squarely within the crosshairs of our Enforcement Division.”[7] In most types of ICOs listed today, if one were to apply the “Howey test” (from the landmark 1946 U.S. Supreme Court decision that helped clarify what defines an “investment contract,” which itself is part of the definition under the Securities Act of 1933 of a “security”), the tokens offered would most likely be interpreted by the SEC to be securities, in that they are “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[8]
Clayton’s comments in February echo the sentiments of his statement from December 11, 2017regarding cryptocurrency’s treatment under the Howey test and the 21(a) Report, in which he stated, “In the 21(a) Report, the Commission applied the longstanding securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, we concluded that the token offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
Recently, there has been a growing number of public statements from prominent figures regarding online market trading regulation, which indicates a possible regulatory turf war between the SEC and the CTFC. On March 7, 2018, the SEC published a statement detailing considerations both investors and market participants should assess regarding online market exchanges for ICO-based coins and tokens.[9] In addressing investor considerations, the SEC urged investors to utilize national exchanges, broker dealers, or other traditional platforms that are heavily regulated. Specifically, the SEC made it clear that even though many of these online trading markets call themselves “exchanges,” they are, in fact, not as heavily regulated at this present time the same way as traditional national exchanges. Regarding whether or not all online trading exchanges shall be subject to regulation, the SEC states:
“Some online trading platforms may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offer trading or other services related to digital assets that are securities. For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities. These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things. In addition, a platform that offers digital assets that are securities may be participating in the unregistered offer and sale of securities if those securities are not registered or exempt from registration.” (Id.)
This statement suggests that certain circumstances and types of transactions occurring in the online market platforms will determine what kinds of regulation requirements will be enforced, but most importantly, that there will be forthcoming enforcement on a large scale.
The SEC’s statement was issued on the heels of an opinion from the District Court for the Eastern District of New York, which on March 6, 2018 held that the CTFC had standing to bring a lawsuit for fraud and to oversee cryptocurrency (including Bitcoin and the similar Litecoin, but not necessarily including ICO-based coins and tokens), for it is within the plain language definition of a “commodity.”[10] The CTFC initially determined in 2015 that cryptocurrency was a commodity, and this Federal District Court holding strengthens the CTFC’s claim to regulatory jurisdiction over cryptocurrency.
Both the SEC and the CTFC will issue regulations on cryptocurrency, and the turf war over this hot topic will ensue for the foreseeable future as the market for virtual currency continues to grow. On March 14, Congress held its first hearing on ICOs, where “House Financial Services Committee members asked questions about such topics as hacking, use of digital currencies by criminals, defining securities, and protecting investors.”[11] Also of note, the Governor of the Bank of England gave a statement in which he said, “The time has come to hold the crypto asset ecosystem to the same standards as the rest of the financial system. Being part of the financial system brings enormous privileges, but with them great responsibilities…In my view, holding crypto asset exchanges to the same rigorous standards as those that trade securities would address a major underlap in the regulatory approach.”[12]
This regulatory crackdown by the SEC and the CTFC comes as no surprise, as there are numerous market factors that triggered the initial SEC and CFTC investigations and that continue to command the regulators’ attention, including the explosion of token offering companies and investors participating in ICOs, the exponential increase in value of cryptocurrencies, and ICO scams that defraud investors.[13]
ICO Scams Defraud Investors
ICO scams are of particular concern to the SEC, as the underlying premise of the federal securities laws are to protect investors from being deceived, by mandating public companies to file numerous types of disclosures for investor transparency. These scams occur when news spreads that startup cryptocurrency companies forecasting massive growth are preparing to launch an ICO, which prompts scammers into setting up fake website domains and portals that deceive investors. The scammers will utilize social media sites like Facebook and Twitter to quickly capture non-sophisticated investors who are researching the ICO. Once the investor submits their cryptocurrency investment into the scammer’s system, any effort to try and reclaim that investment is futile as it recedes into the dark web.
Telegram is a current example of immense market backlash from scammers hijacking ICO market anticipation. Telegram is hosting a widely anticipated ICO beginning in March, but already has faced a prominent scam that stole millions of dollars worth of cryptocurrency from investors who thought they were buying into Telegram’s ICO. English and Russian versions of the actual whitepaper were leaked, and hosted by these scammer websites, of which Gramtoken.io was the most prominent. Gramtoken.io posted project road maps, copies of the whitepaper, and information regarding the ICO to trick investors into depositing their cryptocurrency into their system. Once Gramtoken.io reached its fundraising goal of $5 million dollars, the website went dark, and the investments through Gramtoken.io cannot be located.
The difficulty in protecting cryptocurrency investments is the driving force behind these scams and is a serious concern for investors. Cryptocurrency transactions are tremendously hard to track for several reasons. First, traditional financial institutions are not involved with cryptocurrency transactions, making traceability of the flow of currency unusual. Second, cryptocurrency transactions are happening on an international scale, which restricts what information the SEC, CFTC and/or other federal and state regulators can compile on the transactions, depending on where the issuing entity is located. Third, there is no central authority or market for cryptocurrency transactions and collection of user information at this time. Finally, law enforcement has no current ability to freeze any cryptocurrency transactions, as cryptocurrency is encrypted and cannot be held by a third-party custodian like a traditional security. Together, these factors significantly impede federal, state and private legal actions and remedies for investors in cryptocurrency transactions.
Celebrity ICO Endorsements and Differing Perspectives
On February 27th, Microsoft founder Bill Gates was asked for his opinion on cryptocurrency during a question and answer session on the popular website Reddit, and responded with, “The main feature of cryptocurrencies is their anonymity. I don’t think this is a good thing. The government’s ability to find money laundering and tax evasion and terrorist funding is a good thing. Right now, cryptocurrencies are used for buying fentanyl and other drugs, so it is a rare technology that has caused deaths in a fairly direct way. I think the speculative wave around ICOs and cryptocurrencies is super risky for those who go long.”[14] Other high-profile individuals have made public statements that appeared to be endorsing specific ICOs, especially pop culture celebrities. Floyd Mayweather, DJ Khaled, Paris Hilton, Jaime Foxx, and other celebrities have made public social media endorsements of a variety of ICOs.[15] These endorsements are problematic and could potentially lead to violations of securities law regarding proper disclosures and solicitations of investors if these celebrities are interpreted to be promoters of the ICO.
Conclusion
Initial coin offerings have become the most prevalent way for cryptocurrency companies to raise capital. With the advent of cryptocurrency (including ICO-based coins and tokens) taking markets by storm, it appears they are here to stay for the foreseeable future as well. The SEC’s statements are clear that securities regulation law will be applied to coins and tokens arising out of ICOs, but numerous investor rights issues regarding traceability, jurisdiction, and lack of central authority over all cryptocurrency render enforcement challenging. While ICOs in their current form are a hot ticket item for now, a massive legal and regulatory overhaul for United States cryptocurrency transactions is undoubtedly in the works.
[1] Coindesk, Bitcoin (USD) Price (last visited Feb. 26, 2018) https://www.coindesk.com/price/
[2] Forbes, ICOs In 2017: From Two Geeks And A Whitepaper To Professional Fundraising Machines (Dec.18, 2017) https://www.forbes.com/sites/outofasia/2017/12/18/icos-in-2017-from-two-geeks-and-a-whitepaper-to-professional-fundraising-machines/#40e99c4e139e
[3] Investopedia, Breaking Down Initial Coin Offerings (ICO) (Feb 26, 2018) https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp
[4] EthereumPrice, Ethereum (USD) Price, (last visited Feb 26, 2018) https://ethereumprice.org/
[5] Divisions of Corporation Finance and Enforcement, Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO (July 25, 2017) https://www.sec.gov/news/public-statement/corpfin-enforcement-statement-report-investigation-dao
[6] Id.
[7] Joseph Young, SEC Hints at Tighter Regulation for ICOs, Smart Policies for “True Cryptocurrencies”(Feb. 9, 2018) https://cointelegraph.com/news/sec-hints-at-tighter-regulation-for-icos-smart-policies-for-true-cryptocurrencies
[8] “In other words, an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 1104, 90 L. Ed. 1244 (1946)
[9] Divisions of Enforcement and Trading and Markets, Statement on Potentially Unlawful Online Platforms (Mar. 7, 2018) https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading
[10] Brenden Pierson, Virtual currencies are commodities, U.S. judge rules, THOMPSON REUTERS (Mar. 6, 2018) https://www.reuters.com/article/us-usa-cftc-bitcoin/virtual-currencies-are-commodities-u-s-judge-rules-idUSKCN1GI32C
[11] Kia Kokalitcheva, Congress holds first hearing on initial coin offerings, AXIOS (Mar. 14, 2018) https://www.axios.com/crypto-ico-congress-1521059028-8807c852-22de-461a-8c9e-8a8a9f85d452.html
[12] John D’Antona Jr., BoE Push for Cryptocurrency Regulation Can Boost Markets, TRADERS (Mar. 14, 2018) http://www.tradersmagazine.com/news/cryptocurrencies/boe-push-for-cryptocurrency-regulation-can-boost-markets-117387-1.html?ET=tradersmagazine:e3646:1189431a:&st=email
[13] Jon Russell, Scammers are cashing in on Telegram’s upcoming ICO, TECHCRUNCH (Jan. 20, 2018) https://techcrunch.com/2018/01/20/telegram-ico-scammers/
[14] Reddit, I’m Bill Gates, Co-chair of the Bill and Melinda Gates Foundation. Ask Me Anything (Feb. 28, 2018) https://www.reddit.com/r/IAmA/comments/80ow6w/im_bill_gates_cochair_of_the_bill_melinda_gates/
[15] Jonathan Burr, The Bubble in Celebrity Cryptocurrency Endorsements, CBS NEWS (Nov. 6, 2017) https://www.cbsnews.com/news/bitcoin-celebrity-endorsements-cryptocurrency-sec-warning/
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 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
Pastore & Dailey Represented Mortgage Services Company in Financing Transaction
Pastore & Dailey represented a mortgage servicing company in a financing transaction designed to allow the company to service a multinational bank. The transaction required expert and careful drafting and negotiation as it involved affiliates as well. Goodwin Proctor’s San Francisco office represented the lender.
Private-Equity Firm Manaer Prevails in Federal District Court Against the Milstein Family
Private- equity firm manager Dean Barr, along with his attorneys at Carmody Torrance Sandak & Hennessey LLP, successfully defended claims brought against him by the Milstein Family, the founders of Burlington Coat Factory and investors in Mr. Barr’s firm. The Milsteins had invested several millions of dollars in the fund before its ultimate decline, and claimed that the risks associated with the investment were misrepresented to them. The Connecticut District Court disagreed, and ultimately found that the Milsteins were sophisticated investors, were aware of the risks related to their investment and dismissed the claims brought against Dean Barr. Mr. Barr has retained Pastore & Dailey to bring claims of his own in Connecticut State Court against the Milsteins as well as his former partners.
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Pastore & Dailey Successfully Represents Broker Dealer Regarding Errors in Filings
Pastore & Dailey successfully obtained a favorable stipulation and agreement with the Connecticut Department of Banking on behalf of a large national registered broker-dealer. The Department of Banking conducted an investigation into the broker dealer and concluded that the broker-dealer has failed to file a timely U5, included misinformation on a U4, and failed to renew its registration for the calendar year. Following our successful representation, the broker dealer was able to amend its filings and receive a favorable stipulation and agreement with the Department of Banking.
Pastore & Dailey Successfully Counters Motion to Set Aside Judgement
In February 2016, Pastore & Dailey successfully secured a permanent injunction against Defendant Felder for infringement of Van De Velde’s “PRIMADONNA” trademark via a default judgment. Van De Velde is a global retailer of luxury clothing with its headquarters in Belgium. The dispute, which occurred in the Southern District of Florida, resulted in the award of attorneys fees and costs to Van De Velde.
However, on September 29, 2017, more than a year after the judgment, Defendant Felder moved to set aside the default judgment. Pastore & Dailey countered Defendant’s motion as untimely. On March 12, 2018, the Southern District of Florida issued its decision on the motions denying Defendant’s motion to set aside the default judgment and reinforcing the award to Van De Velde. This victory was a collaborative effort between the attorneys at Pastore & Dailey.
Pastore & Dailey Wins Suitability Arbitration for Investor
A Pastore & Dailey client recently prevailed in a FINRA Arbitration against a broker dealer firm regarding compliance failures and unsuitable investments solicited by the broker. The arbitration took place in Houston, Texas. Pastore & Dailey was co-counsel with a well known former general counsel of a large securities firm. Our client asserted claims arising from oil and gas master limited partnerships for breach of fiduciary duty, negligence, failure to supervise, unsuitability, misrepresentation, violation of the Florida Securities and Investor Protection Act, Fla. Stat. § 517.301, and breach of contract. Our client was ultimately awarded both damages and attorneys fees.