[Editor’s note: The following post is from Davis Polk’s April 2013 Dodd-Frank Progress Report, generated using the Davis Polk Regulatory Tracker.]
Firm Advice: Dodd-Frank Progress Report, April 2013
Social Media and the SEC’s Disclosure Regulations: Netflix
According to Netflix CEO Reed Hastings’ Facebook post in July 2012, “Netflix[‘s] monthly viewing exceeded 1 billion hours for the first time ever in June.” This 15-word sentence might involve Netflix in a lengthy dispute with the SEC, which believes that the posting may be in violation of the SEC’s Regulation FD. The regulation requires public entities to make full and fair public disclosure of material non-public information. Though it is unclear whether disclosing company information through social media is a violation of SEC regulations, Hastings has implied that the SEC intended such announcements to be made through a press release or a regulatory filing.
The SEC notified Hastings and Netflix of the violation through a Wells Notice. A Wells Notice indicates that a securities regulator has concluded an investigation, found infractions, and will recommend enforcement action of either a cease-and-desist action and/or a civil injunction against Netflix and Hastings. The notice gives the respondent the opportunity to explain why such an action is not needed.
Hastings has responded that he does not believe the post revealed material information. However, analysts have pointed out that Netflix’s share price increased 13 percent after the posting. Hastings also wrote that posting to his Facebook page, where many of his 200,000+ friends who are reporters can see the posting, is public disclosure.
The broader question, however, is to what extent can public companies release information through social networks without violating SEC regulations? There is no clear answer, but the SEC’s response to Netflix may give an indication of how the agency will regulate social media.
The Week in Review: SEC Litigation, Sequester Countdown and AT&T
In a unanimous opinion yesterday, the Supreme Court limited the SEC’s ability to pursue civil penalties. The Court held that the five-year statute of limitations begins to run at the moment a fraud is committed, not when regulators become aware if it. In the case at issue, Gabelli v. SEC, the agency sued in 2008 for alleged violations occurring between 1999 and 2002. Chief Justice Roberts noted practical difficulties in determining when a large governmental agency first discovers a fraud, concluding that Congress had not intended to permit the SEC to bring such actions so late. Read the opinion here. For more, see Reuters.
Two days until the sequester. Congressional leaders are meeting at the White House this morning, but both sides appear to be bracing for $85 billion in across-the-board cuts on Friday, March 1. While yet another short-term bill might resolve immediate funding concerns, the parties thus far remain gridlocked on tax reform proposals, which both recognize as an important bargaining chip. House Speaker John Boehner has recently appeared more willing to tackle a comprehensive tax deal this Congress, but a solid democratic majority in the Senate is unlikely to concede to his current “no tax increases” position. For more, see NYTimes, BBC and Politico.
AT&T has announced plans to expand into Europe with new lines of business, including wireless home-monitoring and automation. The company will license its new Digital Life product to more than 30 companies worldwide, exceeding anticipated demand. The move shows that AT&T, the U.S.’s largest phone provider, is transitioning to become a more general technology company, as consumers are increasingly seeking around-the-clock wireless connectivity and product integration. For more, see Bloomberg.
From the Bench: Dichter-Mad Family Partners v. United States
The Ninth Circuit recently affirmed a judgment – from the Central District of California – that the victims of Bernard Madoff’s Ponzi scheme lack subject matter jurisdiction to sue the Securities and Exchange Commission as an agency of the United States under the Federal Tort Claims Act.
The SEC compiled a 450-page public report highlighting its failure to uncover Madoff’s problematic investment activities. The allegations posed by the victim plaintiffs centered on decisions made by the SEC which the district court acknowledged “should have and could have been made differently” and “reveal[ed] the SEC’s sheer incompetence.” Nevertheless, the court held that the United States was protected from suit because the Securities and Exchange Commission was engaged in a discretionary function. An exception is set aside in the Federal Tort Claims Act (“FTCA”) whereby employees of the Government cannot be held liable for failures relating to purely “discretionary” functions of that employee.
The district court, considering the legislative history of the FTCA, noted that Congress “repeatedly and explicitly suggested” that the SEC should be shielded by the discretionary function exception. The FTCA only allows a claim where statutory language mandates a particular course of action. By contrast, the duties and functions of the SEC allow it discretion in choosing who to investigate and when to bring enforcement proceedings. Because the plaintiffs could not demonstrate that the SEC violated a specific and mandatory policy directive that related to the investigation, the court held they failed to overcome an FTCA claim’s threshold requirement.
Proprietary Data Feeds and the SEC’s Regulatory Approach to High Frequency Trading
Earlier this year the Securities Exchange Commission (“SEC”) levied its first monetary fine against an exchange as part of a $5 million dollar settlement against the New York Stock Exchange (“NYSE”). The SEC found that the NYSE delivered stock-price quotes and other data to subscribers of so called proprietary data feeds seconds before transmitting the same data to the broader market. This gave certain traders an improper head start to act on important market information. Proprietary data feeds had been a favorite resource of high frequency trading (“HFT”) firms whose business model depends on split-second informational advantages. The SEC’s attack on proprietary feeds represents an episode in the struggle to regulate HFT.
HFT firms use computer-based algorithms and ultra-fast processing speed to steer daily trading activity. They derive profits by obtaining information about the market and executing trades much faster than non-HFT competitors. Typically, HFT firms would have to wait for public disclosure of market data before trading on such information because U.S. exchanges are required to submit market data to a centralized network for public dissemination. However, proprietary feeds, like the ones offered by NYSE, allowed firms direct access to information a few seconds before public disclosure. According to Gibson Dunn Partner Barry Goldsmith, permitting access to these NYSE feeds gave HFT firms “potentially unfair advantages.”
Some critics go further than Goldsmith and question whether HFT should be allowed at all. These critics argue that HFT creates two-tiered markets where firms with fast computers trade ahead of market orders to the detriment of all other investors. Even without the NYSE feeds, HFT firms use sophisticated infrastructure to routinely access market data before non-HFT firms. Some strategies include issuing thousands of “immediate or cancel” orders and dark pool pinging. Furthermore, proliferation of HFT practices has been recognized as a cause of the 2010 “Flash Crash” and other market embarrassments like the Knight Capital “Trading Glitch.”
Despite evidence of HFT’s negative impact on markets, the practice does have support. HFT’s proponents claim that the practice has positive effects. Cameron Smith, General Counsel for Quantlab Financial, argues that HFT increases liquidity by increasing trading volumes, thus making it easier to find buyers and sellers of securities. This increased liquidity also lowers trading costs by reducing risk for market makers. Accordingly, Smith believes that HFT firms should not be inhibited by regulation.
The SEC appears content with an intermediate position, allowing HFT firms certain privileges, like server collocation, while directly attacking certain methods it deems as abusive informational advantages, like flash trading and utilization direct data feeds. Though the NYSE settlement and fines may curb the aggressive marketing of data feeds to HFT, unbalanced informational advantages for HFT and market failure risks still remain. The SEC must make difficult decisions in considering what types of advantages it will allow to HFT. As European regulators move to halt HFT completely, it remains to be seen whether the SEC will change its regulatory approach.
Firm Advice: Your Weekly Update
Federal Reserve Governor, Daniel Tarullo, recently discussed an upcoming proposal to alter the regulation of foreign banks in the U.S. The proposal would require large foreign banks to establish “a separately capitalized top-tier U.S. intermediate holding company.” The holding company would be “required independently to meet all U.S. capital and liquidity requirements as well as other enhanced prudential standards required by the Dodd-Frank Act.” In a recent Client Memorandum, Davis Polk suggests that the proposal “could have profound negative consequences” for both foreign banks in the U.S. and U.S. banks abroad by adding “fuel to the growing trend toward regionalization of global banking.” The proposal is still under consideration and more details are anticipated “in the coming weeks.”
The Dodd-Frank Act amended the Commodities Exchange Act to require clearing of certain swaps through a derivatives clearing organization. This includes fixed-to-floating swaps, basis swaps, forward rate agreements, and overnight index swaps. The CFTC recently issued final rules to implement this requirement and issued two no-action letters “that provide time-limited relief from the clearing requirement for certain swaps.” In a recent Legal Alert, Bingham McCutchen details the requirements, the timing of their implementation, and safe harbors provided by the no-action letters.
In a recent Corporate Finance Alert, Skadden provides guidance on how to avoid prohibited communications when contemplating a securities offering. Section 5 of the Securities Act prohibits “activities intended to stimulate interest in a securities offering prior to the filing of registration statement.” Violations of this prohibition are commonly referred to as “gun jumping.” The Alert outlines the types and timing of permitted and prohibited communications, as well as suggestions for a company policy on relevant social media communications.
Financial Services Providers Race (Cautiously) to Conquer Social Media
The first of this month Goldman Sachs announced that it would be hiring a new “social media community manager.” This report comes on the heels of Morgan Stanley’s announcement in March that it was launching a new social media program designed to enable its nearly 17,800 financial advisers to use Twitter and LinkedIn to disseminate investment information and insights. The moves by these two giants are sure to trigger a race in Wall Street to conquer the social media landscape for financial and investment services.
But why has the financial services industry been so slow to join the social media frenzy? For one, it worries about the legal pitfalls of letting their legions of advisers loose into unchartered territory. And their unease is not totally unfounded. As posted previously on The Network, the Financial Regulatory Authority (FINRA) brought an action last year to suspend and fine a California-based broker $10,000 for promoting certain investments in “a series of ‘misrepresentative and unbalanced’ messages” to her 1,400 Twitter followers. And as recently as a few months ago, the Securities and Exchange Commission (SEC) charged an Illinois-based investment adviser with securities fraud for offering to sell “more than $500 billion in fictitious securities through various social media websites.” These regulatory actions precede a set of notable guidance letters from both the SEC and FINRA, briefly discussed in the prior post, but reviewed in more depth below.
The SEC’s Limit Up – Limit Down Rule Can Help Markets, But Does It Go Far Enough To Address High-Frequency Trading?
The BATS IPO was an ironic disaster. BATS, a stock exchange that billed itself as the future of stock trading, botched the IPO of its own stock, which was supposed to be listed on the BATS exchange beginning March 23rd. According to the company, the failure was caused by a software bug, and not by high-frequency trading algorithms, as some have speculated. Not only did the failure cause BATS to abandon its own IPO, it also rattled shares of Apple, mirroring the events of the 2010 Flash Crash.
While the IPO was an embarrassment for BATS, it put the SEC’s regulatory response to the Flash Crash on display. The 2010 Flash Crash was a series of events that caused the Dow Jones Industrial Average to plummet more than 700 points in a matter of minutes, only to recover within a half hour. In response to the Flash Crash, single stock circuit breakers were established to curb the effects of extreme market volatility. By most accounts, single stock circuit breakers have been effective in restoring order to markets after numerous test runs during other “mini flash crashes,” hitting a high of 51 in December of 2011.
The Impact of the JOBS Act on Silicon Valley: Engine of Growth or License for Scam Artists?
On March 27, 2012, Congress passed the final version of the Jumpstart Our Business Startups Act (‘JOBS Act’), aimed at increasing American job creation and economic growth by making it easier for startup companies to raise funds. As a Kauffman Foundation report posits, “Startups aren’t everything when it comes to job growth. They’re the only thing.”
The package of measures in the JOBS Act are intended to promote more initial public offerings (‘IPOs’) through provisions permitting crowdfunding, redefining the divide between “public” and “private” firms, creating a special IPO “on-ramp” for ‘emerging growth companies’, reducing restrictions on advertising of new securities offerings and permitting more analyst reports of companies undergoing an IPO. However, how much of a help are these measures to the tech entreprenuers of Silicon Valley?
Second Circuit Set to Reign in Rakoff
On March 15, the Second Circuit stayed proceedings in the now notorious case of SEC v. Citigroup. The case hit headlines last November when District Court Judge Rakoff refused to accept a $280 million settlement agreement between the SEC and Citigroup. Judge Rakoff’s decision was outlined in great detail in a previous post on the Network.
By granting a stay in the proceedings, the Second Circuit is allowing the SEC and Citigroup to avoid having to proceed with the trial litigation while appealing Judge Rakoff’s decision. The appeal is scheduled to be heard in September, though the dicta in the March 15 decision appears to support the position that the Second Circuit is prepared to overturn Judge Rakoff’s decision.