Regulation of the capital markets in the United States is principally conducted by federal government agencies, particularly the Securities and Exchange Commission (SEC).
The Securities Act of 1933 (Securities Act) requires that all offers and sales of securities in the United States be made either pursuant to an effective registration statement or an explicit exemption from registration. Any class of securities listed on a US exchange must be registered under the Securities Exchange Act of 1934 (Exchange Act), and the issuer of the relevant class is required to file annual and other reports with the SEC. Exchange Act registration and reporting also apply to unlisted equity securities, including securities of companies traded and organised outside the United States, held by a sufficiently large population of US record-holders. Companies with securities registered under the Exchange Act are also subject to the SEC's rules on ownership reporting and tender offers.
The perspective of the SEC statutes is that persons making investment decisions in regulated transactions should have complete and reliable information. The detailed disclosure requirements that apply to such transactions are found in the rules promulgated by the SEC under the securities laws.
In addition to the SEC, other federal and state regulators and self-regulatory organisations, such as the Financial Industry Regulatory Authority, have important roles in the oversight of the securities activities of banks, insurers and broker-dealers, in particular. Finally, the Commodity Futures Trading Commission (CFTC) continues to adopt and propose important rules relevant to the securities industry and the capital markets.
Although the SEC proposes and adopts rules under the federal securities laws every year, particularly wide-ranging rule changes were adopted in recent years as a result of the financial crisis, including those mandated by the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank Act). The thrust of the Dodd–Frank Act, which sought to increase investor protection through substantive market regulation, was somewhat at odds with the SEC's previous efforts to reduce the regulatory burden on issuers, and many argue that the Dodd–Frank Act reforms have gone so far as to have had a chilling effect on the capital markets. Reflecting these concerns, the administration of President Trump has rolled back some, and announced plans to further roll back other, Dodd–Frank Act reforms. While the deregulatory stance of the Trump administration is clear, so far the changes relevant to the capital markets and the US financial system have been limited.
This chapter summarises some of the more important rule changes and proposals during the past year, and important litigation, tax and other developments likely to be of interest to capital markets practitioners outside the United States.
II THE YEAR IN REVIEW
The SEC, Congress and various administrations have long wrestled with the challenge of updating the requirements of the Securities Act, the Exchange Act and other federal securities laws to keep pace with changes in market practice and technology. There has also been the ever-present challenge of simplifying disclosure to ensure an appropriate balance between the quantity and quality of the information furnished to investors. Each of these challenges was addressed again in 2019 in the SEC rule changes and proposals discussed below. In addition, the SEC has continued to provide guidance to the market both in relation to areas of focus and the interpretation of its existing rules and regulations.
i Developments affecting debt and equity offerings
On 6 December 2018, SEC Chairman Jay Clayton outlined the SEC's priorities for the year ahead.2 He also referred to the SEC's recently published four-year strategic plan.3 Under the heading 'Significant Initiatives for 2019', Chairman Clayton has identified several more immediate priorities. As well as identifying key market risks, these include completing the SEC's work on standard of conduct rules for investment professionals; facilitating capital formation and access to investment opportunities for retail investors, including by streamlining, harmonising and improving the 'patchwork' of securities offering exemptions currently in place; assessing the continued need for quarterly reporting by domestic reporting companies, and other efforts to encourage long-term investment; and addressing investor protection concerns in relation to distributed ledger technology, digital assets and initial coin offerings. Over the past year, the SEC has made tangible progress in relation to most of these issues.
Addressing Brexit, LIBOR, cybersecurity and other risks in SEC filings
In his December 2018 remarks, SEC Chairman Clayton identified three market risks the SEC staff was monitoring: Brexit, LIBOR and cybersecurity.
Chairman Clayton has indicated that he had requested that SEC staff focus on the disclosures companies are making about Brexit, having noted considerable variations of disclosures, even within the same industry. Having directed the staff to monitor whether Brexit-related information and material risks are being effectively communicated to investors, he indicated he would like to see fewer generic disclosures and more thoughtful and appropriately detailed disclosures about how management are considering Brexit and its potential impacts on companies and their operations. The SEC continues to work with its domestic and non-US counterparts to identify and plan for potential Brexit-related impacts.
Chairman Clayton referred to the significant risks faced by many market participants in how to manage the transition from LIBOR to a new rate (such as SOFR, the recommended alternative rate for US dollar LIBOR), particularly with respect to those existing contracts that will still be outstanding when LIBOR is phased out in 2021. In terms of the documents governing LIBOR-based instruments, questions to be addressed include whether fallback language exists and, if it exists, whether it will work correctly in such a situation. If not, will consents be needed to amend the documentation, bearing in mind that consents can be difficult and expensive to obtain?
Chairman Clayton's remarks were expanded upon by the SEC staff in a 12 July 2019 staff statement on LIBOR transition.4 Beyond the implications for registrants on their existing contracts, the statement noted the potential impact on their businesses more broadly, such as on strategy, products, processes and information systems. It suggested that 'prudent risk management may necessitate the establishment of a task force to assess the impact of financial, operational, legal, regulatory, technology, and other risks'.5 Supplementing these broader remarks, various divisions of the SEC's staff set out more specific guidance for affected market participants, with the Division of Corporation Finance encouraging companies to consider the following guidance in deciding what disclosures are relevant and appropriate:
- since the evaluation and mitigation of risks related to the expected discontinuation of LIBOR may span several reporting periods, reporting companies should consider disclosing the status of company efforts to date and the significant matters yet to be addressed;
- when a company identifies a material exposure to LIBOR but does not yet know or cannot yet reasonably estimate the expected impact, it should consider disclosing the uncertainty; and
- disclosures that allow investors to see this issue through the eyes of management are likely to be the most useful for investors, which may entail sharing information used by management and the board in assessing and monitoring how the transition from LIBOR to an alternative reference rate may affect a company. This could include qualitative disclosures and, when material, quantitative disclosures, such as the notional value of contracts referencing LIBOR and extending past 2021.
The Division noted that LIBOR risks were being highlighted most by larger companies in the real estate, banking and insurance industries, but recommended increased focus on the issue by other registrants as well.
Chairman Clayton noted that investors are entitled to be informed about the material cybersecurity risks and incidents affecting the companies in which they invest, and referred to the extensive interpretative guidance published by the SEC earlier in 2018.6 The SEC's seriousness of purpose in relation to this issue was made clear in its 24 July 2019 US$100 million settlement with Facebook (the largest penalty ever imposed by the SEC in a disclosure-related case) in relation to the inadequacy of its risk factor disclosure concerning data losses and related failings in disclosure controls and procedures mandated under the Exchange Act. Although Facebook had a generic risk factor about data that 'may' be improperly accessed, it had access to enough information to know that was more than a theoretical possibility. As the SEC stated: 'Public companies must identify and consider the material risks to their business and have procedures designed to make disclosures that are accurate in all material respects, including not continuing to describe a risk as hypothetical when it has in fact happened'.7
Risk identification and categorisation
On 8 August 2019, the SEC proposed amendments to Regulation S-K of relevance to foreign private issuers filing on Forms F-1, F-3 and F-4 (the Securities Act forms used by them in connection with most capital raisings).8 The proposed amendments would require:
- summary risk factor disclosures if the risk factor section exceeds 15 pages, with the summary to consist of a bullet point list summarising the principal risk factors, to appear at the front of the registration statement under an appropriate heading;
- disclosure of the material rather than the most significant risks facing the company to encourage companies to disclose the risks to which a reasonable investor would attach importance in making investment decisions; and
- organisation of risk factors under relevant headings (already a common practice) and, if a company discloses generic risks that could apply to any company or offering (which continues to be discouraged), they will be required to appear at the end of the risk factor section under the caption 'General Risk Factors'.
The overall effect would be to align US risk factor disclosures more closely with recent changes in Europe under the EU Prospectus Regulation, which became effective in July 2019.
Partly because Form 20-F (the Exchange Act form for annual reporting by foreign private issuers) has for some time been already aligned with the IOSCO requirements for disclosure in cross-border security offerings, the SEC has not proposed corresponding amendments to Form 20-F. However, it has solicited comment from market participants as to whether such further amendments (as well as amendments to business and legal proceedings disclosure) would be appropriate.
Modernisation and simplification of existing disclosure requirements
On 20 March 2019, the SEC adopted rule amendments to modernise and simplify Securities Act and Exchange Act disclosure requirements applicable to both domestic and foreign private issuers9. The amendments, which are reflected in Regulation S-K and various SEC forms (including Form 20-F), implemented several of the recommendations in the SEC staff's Report on Modernisation and Simplification of Regulation S-K,10 which was submitted to Congress in November 2016.
Among the more noteworthy amendments are the following:
Reducing the burden on filing exhibits
The SEC amended Regulation S-K and related SEC forms (including Form 20-F) to allow registrants to:
- redact confidential information from material contracts without having to first submit a confidential treatment request to the SEC, so long as such information is not material and would be likely to cause competitive harm to the registrant if publicly disclosed;
- omit immaterial schedules and attachments from all exhibits; and
- omit personally identifiable information.
SEC examiners may question omissions from exhibits and request a company's justification for a claim. It also limits to newly reporting registrants the requirement to file material contracts that were entered into within two years of the applicable registration statement or report.
Streamlining management discussion and analysis disclosure by excluding discussion of the earliest year of the financials
The SEC amended Regulation S-K and related SEC forms (including Form 20-F) to allow registrants, when financial statements included in a filing cover three years, to eliminate management discussion and analysis (MD&A) discussion of the earliest year if such discussion was already included in any other of the registrant's prior filings on EDGAR. Where the discussion of the earliest year is omitted, there must be a cross-reference to the prior filing in which the discussion may be found. The amendments add an instruction that emphasises that registrants have discretion to use any form of MD&A presentation that would enhance investors understanding (and are not limited to using year-to-year comparisons).
The SEC has adopted amendments to Regulation S-K and related SEC forms (including Forms F-1, F-3 and F-4) to streamline the information required on a prospectus cover page by explicitly allowing registrants to state that the offering price will be determined by a particular method or formula that is more fully explained in the prospectus (with a cross-reference to such disclosure) and exclude the portion of the legend relating to state law for offerings that are not prohibited by state blue-sky laws.
Other significant amendments
- the amendments clarify that a description of property is required only to the extent physical properties are material to the registrant and may be provided on a collective basis, if appropriate. However, this clarification does not apply to companies in the mining, real estate and oil and gas industries.
- the amendments require that a brief description of the registrant's registered capital stock, debt securities, warrants, rights, American depositary receipts (ADRs) and other securities must be filed as an exhibit to Form 10-K or Form 20-F rather than limiting this disclosure to registration statements (as is currently the case). The required descriptions may be incorporated by reference to other hyperlinked filings;
- the amendments require the disclosure of trading symbols for each class of the registrant's registered securities on the cover pages of the SEC forms specified, including Form 20-F; and
- the amendments require registrants to tag all – rather than some as currently required – of the data on the cover pages of the SEC forms specified, including Form 20-F, using Inline XBRL.
Most of the amendments to the rules are now effective, except for the cover page data tagging requirements (which are subject to a three-year phase-in). Taken together with the rule amendments adopted by the SEC in August 2018,11 which eliminated numerous redundant or obsolete disclosure requirements, these latest amendments represent an important step in the SEC's efforts to improve its disclosure framework.
SEC concept release on securities offering exemptions
Although foreign private issuers and other registrants routinely register public offerings of securities with the SEC, many still prefer to access the US capital markets on the basis of available exemptions from SEC registration requirements. Many non-US readers will be familiar with Rule 144A and Regulation S, but the broader exempt offering framework, and the interplay between the various exemptions, is complex and less well understood.
On 18 June 2019, the SEC published a concept release soliciting public comment on 'possible ways to simplify, harmonize, and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections'.12 Although the concept release does not propose specific rule changes, input provided to the SEC by industry participants will likely play a significant role in shaping future proposed rulemaking.
The SEC's concept release covers seven broad themes as follows:
The exempt offering framework
The SEC wants to determine if the exempt offering framework, as a whole, is consistent, accessible and effective for both companies and investors, or whether the SEC should consider changes to simplify, improve or harmonise the exempt offering framework.
The capital raising exemptions within the framework
The SEC is considering whether there should be any changes to improve, harmonise or streamline any of the capital raising exemptions, specifically the private placement exemption and Rule 506 of Regulation D, Regulation A, Rule 504 of Regulation D, the intrastate offering exemptions and Regulation Crowdfunding.
Potential gaps in the framework
The SEC is seeking to determine if there are gaps in the SEC's framework that make it difficult, especially for smaller companies, to rely on an exemption from registration to raise capital at key stages of their business cycle.
The SEC wishes to determine whether the limitations on persons eligible to invest in certain exempt offerings, or the amount they can invest, provide an appropriate level of investor protection (i.e., whether the current levels of investor protection are insufficient, appropriate or excessive) or pose an undue obstacle to capital formation or investor access to investment opportunities, including a discussion of the persons and companies that fall within the accredited investor definition. Historically, the SEC has given little consideration to investors' opportunity costs in its rulemaking deliberations.
The SEC wants to determine if it can and should do more to allow companies to transition more easily from one exempt offering to another and, ultimately, to a registered public offering.
Pooled investments funds
The SEC wants to determine whether it should facilitate capital formation in exempt offerings through pooled investment funds, including interval funds and other closed-end funds, and whether retail investors should be allowed greater exposure to growth-stage companies through pooled investment funds in light of the advantages and risks of investing through such funds.
The SEC wishes to determine whether it should revise its rules governing exemptions for resales of securities to facilitate capital formation and to promote investor protection by improving secondary market liquidity.
The concept release reviews the existing securities law framework for each of these topics and follows with a series of questions. The number (138 in total) and tenor of the questions, ranging from very open-ended, broad questions to very specific questions, suggest that the SEC is conducting a very thorough, fundamental inspection of the overall framework. The deadline for comments to the SEC in relation to the concept release was 24 September 2019.
Other SEC initiatives relevant to debt and equity markets
The SEC and its staff routinely adopt more targeted rule changes of relevance to issuers and underwriters and also provide guidance to the market as to the manner in which it interprets its existing rules and regulations. Notable recent examples include the following:
On 26 September 2019, the SEC adopted a new Rule 163B that permits issuers (or any person authorised to act on their behalf) to gauge market interest in a possible initial public offering or other registered securities offering through discussions with specified institutional investors prior to, or following, the filing of a registration statement with the SEC. The new rule extends the SEC's 'test-the-waters' accommodation made available to emerging growth companies following the enactment of the JOBS Act. The new rule extends to permitted oral and written communications made to persons reasonably believed to be qualified institutional buyers within the meaning of Rule 144A or institutions that are accredited investors within the meaning of Regulation D. The are no SEC filing or legending requirements triggered by use of the Rule.
Framework for analysis of digital assets
On 3 April 2019, the SEC's new Strategic Hub for Innovation and Financial Technology released its much-anticipated guidance to assist market participants in their assessment of whether a distribution of digital assets amounts to an offering of securities required to be registered under the Securities Act.13 The framework is based on an amalgamation of sources, including federal court decisions, SEC enforcement activities, public statements and speeches. It amounts to an interpretation of the US Supreme Court's longstanding Howey test for finding an investment contract cognisable as a security under the SEC statutes. The test is whether there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived by the efforts of others.14 Simultaneously with the publication of the framework, the SEC's Division of Corporation Finance issued a no-action letter to TurnKey Jet, Inc enabling it to offer and sell its tokens without registration under the Securities Act.
Effectiveness of Inline XBRL requirements
On 20 August 2019, the SEC published guidance in the form of compliance and disclosure interpretations to clarify the new Inline XBRL requirements.15 Foreign private issuers will be required to comply with the Inline XBRL requirements based on their filer status and basis of accounting. For a foreign private issuer that prepares its financial statements in accordance with US GAAP, the phase-in of the Inline XBRL requirements is determined based on its filer status. Large accelerated filers, including foreign private issuers that prepare their financial statements in accordance with US GAAP, will be required to comply with Inline XBRL for financial statements for fiscal periods ending on or after 15 June 2019. Accelerated filers, including foreign private issuers, that prepare their financial statements in accordance with US GAAP will be required to comply with Inline XBRL for financial statements for fiscal periods ending on or after 15 June 2020. All other filers, including foreign private issuers that prepare their financial statements in accordance with IFRS, will be required to comply with Inline XBRL for financial statements for fiscal periods ending on or after 15 June 2021. The guidance also clarified that Form 20-F filers will be required to comply with Inline XBRL beginning with the first filing on a form for which Inline XBRL is required for a fiscal period ending on or after the applicable compliance date.
ii Developments affecting derivatives, securitisations and other structured products
In recent years, US regulatory changes in relation to derivatives, securitisations and other structured products have been focused on rule changes mandated by the Dodd-Frank Act, including Section 619, commonly known as the Volcker Rule. During 2019, the SEC and such other regulatory authorities have continued to both implement and refine these rules, and have proposed additional rule changes for consideration.
Interagency amendment of the Volcker Rule
In September 2019, the SEC, the CFTC, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board approved amendments to the Volcker Rule.16 The Rule restricts banks from engaging in proprietary trading and from owning hedge funds and private equity funds. Distinguishing between what qualifies as proprietary trading and what does not has proven to be extremely difficult. In addition, banks that do relatively little trading have been required to go through substantial compliance exercises to ensure that activities that have long been regarded as traditional banking activities do not violate the Volcker Rule.
Among other things, the final Rule will:
- tailor the Rule's compliance requirements based on the size of a firm's trading assets and liabilities, with the most stringent requirements applied to banking entities with the most trading activity;
- clarify that banking entities that trade within internal risk limits set under the conditions in the final Rule are engaged in permissible market making or underwriting activity;
- streamline the criteria that apply when a banking entity seeks to rely on the hedging exemption from the proprietary trading prohibition;
- limit the impact of the rule on the foreign activities of foreign banking organisations; and
- simplify the trading activity information that banking entities are required to provide to the agencies.
The final Rule is scheduled to become effective from 1 January 2020.
SEC adopts requirements for security-based swap dealers and major security-based swap participants and amends capital and segregation requirements for broker-dealers
On 21 June 2019, the SEC took another significant step towards establishing the regulatory regime for security-based swaps dealers by adopting a package of measures under the Dodd-Frank Act.17 These and other rules previously adopted by the SEC are designed to enhance the risk mitigation practices of firms that stand at the centre of the security-based swap market, thereby protecting their counterparties and reducing risk to the market as a whole.
The rules address four key areas:
- they establish minimum capital requirements for security-based swap dealers and major security-based swap participants for which there is not a prudential regulator non-bank security-based swap dealers (SBSDs) and major security-based swap participants MSBSPs). They also increase the minimum net capital requirements for broker-dealers that use internal models to compute net capital (ANC broker-dealers). In addition, they establish capital requirements tailored to security-based swaps and swaps for broker-dealers that are not registered as an SBSD or MSBSP to the extent they trade these instruments;
- they establish margin requirements for non-bank SBSDs and MSBSPs with respect to non-cleared security-based swaps;
- they establish segregation requirements for SBSDs and stand-alone broker-dealers for cleared and non-cleared security-based swaps; and
- they amend the SEC's existing cross-border rule to provide a means to request substituted compliance with respect to the capital and margin requirements for foreign SBSDs and MSBSPs, and provide guidance discussing how the SEC will evaluate requests for substituted compliance.
SEC proposes to align margin requirements for security futures with requirements for similar financial products
On 3 July 2019, the SEC proposed to align the minimum margin required on security futures with other similar financial products.18 The proposal, made jointly with the CFTC, would set the minimum margin requirement for security futures at 15 per cent of the current market value of each security future.
In 2002, the SEC and CFTC adopted rules establishing margin requirements for unhedged security futures products at 20 per cent. In light of lower margin requirements that have been established for comparable financial products and the resulting asymmetry, the SEC and CFTC have determined that it is appropriate to reexamine the minimum margin required for security futures.
SEC proposes actions to improve the cross-border application of security-based swap requirements
On 10 May 2019, the SEC proposed a package of rule amendments and interpretive guidance to improve the framework for regulating cross-border security-based swap transactions and market participants.19
The proposals are intended to improve the regulatory framework by pragmatically addressing implementation issues and efficiency concerns, and in some cases further harmonising the regulatory regime governing security-based swaps administered by the SEC with the regulatory regime governing swaps administered by the CFTC.
The proposing release addresses four key areas:
- the use of transactions that have been arranged, negotiated, or executed by personnel located in the US as a trigger for regulating security-based swaps and market participants;
- the requirement that non-US resident security-based swap dealers and major security-based swap participants certify and provide an opinion of counsel that the SEC can access their books and records and conduct onsite inspections and examinations;
- the cross-border application of statutory disqualification provisions; and
- the questionnaires or employment applications that security-based swap dealers and major security-based swap participants must maintain with regard to their foreign associated persons.
iii Bankruptcy and other US cases of relevance to the capital markets
During 2019, US federal courts have rendered judgments in relation to several cases of interest to capital markets practitioners, some of which are discussed below. Very often the issue in question has been the extraterritorial application of US laws and the jurisdictional reach of US courts.
US Supreme Court denies certiorari in Stoyas v. Toshiba Corporation20
After the Supreme Court's 2010 decision in Morrison v. National Australia Bank,21 US courts have typically held that foreign issuers whose securities are traded in the US via ADRs or American depositary shares (ADSs) cannot be sued under Section 10(b) of the Securities Exchange Act and Rule 10b-5 by purchasers or sellers of a company's stock traded abroad, but can be sued by buyers or sellers of ADRs22 if the suit is based on a purchase or sale on a US exchange or that otherwise takes place in the US (such as an over-the-counter (OTC) trade or private placement in which the parties commit to the trade within the US). However, those cases have typically addressed sponsored ADR facilities, in which there could be no question of the issuer's involvement. In 2016, the decision of the US District Court in Stoyas was the first to expressly rule on how Morrison applies to unsponsored ADR facilities. The Stoyas court held that a foreign issuer's lack of involvement in the unsponsored facility means it cannot be sued for statements it made to the markets overseas. On appeal, in 2018, the Ninth Circuit reversed, holding that an issuer can be sued by purchasers of ADRs through an unsponsored facility, although it left open some questions.23 Toshiba petitioned the Supreme Court to hear the case, which it declined to do.
After Morrison held that Section 10(b) applies only to transactions in the United States, most of the decisions on the territorial application of Section 10(b) have focused on where off-exchange transactions take place. For example, the Southern District of New York, in Satyam Computer Services Ltd Securities Litigation, held that Section 10(b) did not cover the exercise of employee stock options to buy NYSE-listed ADSs in an Indian corporation because the terms of the options (as written by the company) deemed them to be exercised only when notice was received in India.24 The fact that the company did not consent to options on its ADSs being transacted in the United States, regardless of the listing of the underlying security, was thus important in Satyam, but the court was still addressing securities with which the company was involved. By contrast, the Second Circuit's decision in ParkCentral Global Hub Ltd v. Porsche Automobile Holdings found that US trading alone was not sufficient if the company had no connection to the security – but ParkCentral involved swaps, not ADRs, and an unusual fact pattern in which the defendant was not the issuer but a potential acquirer.25
Stoyas presented the question squarely: the defendant, Toshiba, has only stock listed on the Tokyo and Nagoya exchanges and ADRs traded on US OTC markets – specifically, OTC Link – pursuant to an unsponsored ADR facility set up without the involvement of the company; it did not list or trade any securities in the United States.26 The plaintiffs in Stoyas argued that it was enough that the issuer had complied with Rule 12g3-2's disclosure requirements (an exemption from Exchange Act registration) 'and never objected to the sale of its securities in the United States'.27 The Ninth Circuit described the unsponsored ADR issuance as 'without Toshiba's 'formal participation' and possibly without its acquiescence'.28
The District Court concluded that an OTC market is not a US exchange for purposes of Morrison's rule that securities traded on US exchanges are covered, given that the Exchange Act treats national securities exchanges and OTC markets as distinct.29 The District Court further concluded that 'Plaintiffs have not argued or pled that Defendant was involved in th[e ADS] transactions in any way . . . nowhere in Morrison did the Court state that US securities laws could be applied to a foreign company that only listed its securities on foreign exchanges but whose stocks are purchased by an American depositary bank on a foreign exchange and then resold as a different kind of security (an ADR) in the United States'.30
On appeal, the Ninth Circuit disagreed on both points. First, as to Morrison's reference to Section 10(b) covering domestic exchanges,31 the Ninth Circuit declined to decide whether OTC Link is a domestic exchange, but disagreed with the District Court that only national securities exchanges, as defined in the Exchange Act, qualify under Morrison. Second, the Ninth Circuit criticised the Second Circuit's reasoning in ParkCentral and concluded that the Exchange Act covers any ADR transaction in the United States regardless of whether the facility is sponsored.32 However, that was not the end, because the Ninth Circuit concluded that a claim could be stated only if there were sufficient facts pleaded to show a sufficient connection between the issuer and the transaction – a requirement that may in practice insulate some issuers who had no involvement in an unsponsored ADR facility.33 The Ninth Circuit sent the case back to let the plaintiffs plead more facts on this point.34 It did not, however, suggest that investors other than ADR purchasers could ever sue.
On 14 January 2019, the Supreme Court invited the Solicitor General to file an amicus brief in the Stoyas case to express the views of the United States.35 The Solicitor General submitted the amicus brief in May 2019, urging the Supreme Court to deny certiorari. In its brief, the Solicitor General argued that the Ninth Circuit's holding in Stoyas was correct because the Section 10(b) claim at issue originated from a domestic transaction under Morrison.36 Therefore, in the Solicitor General's opinion, Stoyas did not represent 'an impermissible extraterritorial application of Section 10(b)' because neither party disputed that the purchases of the unsponsored ADRs took place in the United States.37 The Solicitor General also agreed with the Ninth Circuit, however, that the case should be remanded to allow for factual development. On 24 June 2019, the Supreme Court denied certiorari in the Stoyas case, allowing the Ninth Circuit's decision to stand and the case to be remanded for further development of the facts.38 Accordingly, unless and until there are further decisions on the question, issuers of stock that is traded through ADR facilities in the United States, even if unsponsored, should consider the possibility that they will face liability to US purchasers of those ADRs.
Second Circuit rules that presumption against extraterritoriality and international comity principles do not limit recovery of fraudulent transfer
In February 2019, in In re Picard,39 the Second Circuit addressed the question of whether the presumption against extraterritoriality or international comity principles limit a trustee's ability to recover property under Bankruptcy Code Section 550(a)(2) from a foreign subsequent transferee. In this case, the trustee sought to avoid an initial asset transfer made by a US debtor as an intentional fraudulent conveyance, and recover the asset from a foreign transferee that received the asset from a foreign initial transferee. The Second Circuit concluded that neither doctrine precludes the trustee from recovering against the subsequent transferee. This decision provides guidance for the lower courts, which have been split on the extent to which the Bankruptcy Code's avoidance and recovery provisions apply extraterritorially.40
In Picard, the trustee administering the liquidation of Bernard L. Madoff Investment Securities LLC (Madoff Securities) commenced actions to avoid payments made by Madoff Securities to non-US investment funds as intentional fraudulent transfers, and recover the subsequently transferred payments from the funds' non-US investors under Bankruptcy Code Section 550(a)(2).41 In a prior decision in the Madoff liquidation, the District Court held that the presumption against extraterritoriality would prevent a trustee from recovering property under Section 550(a)(2) if the transaction was determined to be a foreign transaction, and that international comity principles similarly limited the scope of Section 550(a)(2).42 On remand, the Bankruptcy Court concluded that the factors relevant to determining whether the transactions were domestic or foreign were the locations from which the transfers were sent and the location or residence of the initial and subsequent transferee.43 The Bankruptcy Court then made a factual determination that certain transactions between foreign initial transferees and foreign subsequent transferees did not have a nexus to the US, and dismissed the trustee's recovery actions under the presumption against extraterritoriality.
Rather than focusing on the domestic or foreign nature of the subsequent transfer between the fund and its investors, the Second Circuit focused on the initial transfer that was the subject of the fraudulent transfer claim, and concluded that the regulatory focus of the Bankruptcy Code's avoidance and recovery provisions was the transfer of property that depleted the estate. As a result, the Court held that the US debtor's fraudulent transfer of property from the US was a domestic activity, and therefore the presumption against extraterritoriality did not prohibit the trustee from recovering the fraudulent property under Section 550(a), regardless of the location of any initial or subsequent transfer.
With respect to principles of international comity, the Court considered whether, as a matter of statutory interpretation, a court should presume that Congress intended to limit the application of US law on a given set of facts out of respect for foreign sovereigns. The Court determined that the US has a compelling interest in allowing a US estate to recover fraudulently transferred property to assure its creditors will receive a fair share of the estate's property in a bankruptcy. The Court acknowledged that when a debtor in the US courts is also in liquidation proceedings in a foreign court, the foreign jurisdiction has at least some interest in adjudicating property disputes. However, in this case Madoff Securities was not subject to a parallel proceeding in a foreign jurisdiction. The Court determined that the fact that certain transferees were subject to foreign liquidation proceedings did not present a compelling interest to prevent the US estate from recovering fraudulently transferred property. The Second Circuit determined that the Bankruptcy Code provided no indication that trustees seeking to recover property in US proceedings should defer to a foreign transferee's liquidation proceeding, particularly where Section 550(a)(2) permits a trustee to recover fraudulently transferred assets from even remote subsequent transferees.
The Court did emphasise that the allegation that the initial transfer was an intentional fraudulent transfer was relevant to its decision, as were the facts that the debtor was a domestic entity and that the alleged fraudulent transfer occurred when property was transferred from US bank accounts. The Court noted that it was not expressing an opinion as to whether the regulatory focus of Section 550(a) would similarly be the initial transfer if it did not involve an intentional fraudulent transfer, or whether the residence of the debtor or the location of the transfer, standing alone, would support a finding that the transfer was domestic in nature. The Court further noted that whether the US adjudication would conflict with a foreign adjudication may depend on different facts in different cases. As a result, the Court left open the possibility that the extraterritoriality and international comity analysis could vary under different factual circumstances.
Bankruptcy court extends application of safe harbours in Chapter 15 proceedings
In December 2018, the Bankruptcy Court for the Southern District of New York held in In re Fairfield Sentry Limited that the Bankruptcy Code safe harbours for qualified financial contracts apply to actions brought by a foreign representative in a Chapter 15 case seeking to avoid foreign transfers under foreign insolvency laws.44 This decision further highlights the complexities regarding how avoidance laws and safe harbours may apply when non-US parties or non-US assets are involved.
In a Chapter 15 case under the Bankruptcy Code, a debtor or its representative seeks to have a foreign insolvency or restructuring proceeding recognised by the a US bankruptcy court, which enables the foreign debtor to, among other things, protect and administer assets located in the United States and seek certain relief from the US court under the Bankruptcy Code.45 Notably, a foreign representative is not permitted to pursue preference or fraudulent conveyance actions under Sections 544, 547, 548 or 550 in a Chapter 15 case.46
In Fairfield Sentry, foreign representatives acting as liquidators of investment funds subject to liquidation proceedings in the British Virgin Islands (BVI) commenced a Chapter 15 proceeding in the United States, and sought to recover redemption payments made to US clients under the avoidance provisions of the BVI's Insolvency Act. The redemption payments were settlement payments made in connection with securities contracts, and the defendants took the position that such payments could not be avoided under Bankruptcy Code Section 546(e)'s safe harbour.47 The liquidators argued that the Bankruptcy Code's safe harbours did not apply extraterritorially, and therefore did not apply to an action brought by a foreign representative under foreign law to recover foreign asset transfers. The Bankruptcy Court determined that the extraterritoriality issue was not relevant, because Bankruptcy Code Section 561(d) specifically provides that a foreign representative or US bankruptcy court cannot interfere with a non-debtor counterparty's enforcement of closeout rights under a qualified protected contract, regardless of whether the collateral is within or outside of the United States; and the safe harbours limit avoidance powers in a Chapter 15 case to the same extent as in a Chapter 7 or Chapter 11 case.48
The liquidators argued that, because Section 546(e) would not apply if the proceeding was a Chapter 7 or Chapter 11 case due to the presumption against extraterritoriality, the safe harbour could not apply to the transfers as issue, which involved a foreign debtor, foreign law and transfers occurring outside of the United States. The Court rejected this argument, and concluded that Section 561(d) extends the safe harbours for qualified protected contracts in the context of a Chapter 15 case, regardless of whether the collateral was located within or outside of the United States. Because the Bankruptcy Code would not permit a foreign representative to bring an avoidance action under Sections 544, 547, 548 or 550, the Court determined that Section 561(d) necessarily refers and applies to avoidance actions brought under non-US law. As such, if the defendants were able to establish that the subject transactions were entitled to protection under Section 546(e),49 the Bankruptcy Code would prevent the foreign representative from avoiding the transfers under foreign law in the Chapter 15 case.
iv US tax law changes of relevance to the capital markets
During 2019, there have been several developments in US tax law of relevance to capital markets practitioners.
FATCA guidance on gross proceeds withholding and foreign pass-through payments
In December 2018, the US Treasury Department (Treasury) and the US Internal Revenue Service (IRS) issued proposed regulations providing guidance with respect to Sections 1471 through 1474 of the US Internal Revenue Code (Code), commonly referred to as FATCA).50 The preamble to the proposed regulations states that taxpayers may generally rely on the rules therein until final regulations are issued.
Generally, FATCA requires US and non-US withholding agents (including foreign financial institutions (FFIs)) to identify who their payees are and the FATCA status of those payees. US withholding agents must withhold tax on certain payments (including gross proceeds received with respect to certain sales or other dispositions) to FFIs that do not agree to report certain information to the US regarding their US accounts and on certain payments to non-financial foreign entities that do not provide information about their substantial US owners to withholding agents. Withholding is also required with respect to foreign pass-through payments, a term that was largely undefined in previous IRS guidance. The US has entered into intergovernmental agreements with many non-US governments that have the effect of minimising the impact of FATCA on the financial institutions located in those countries.
The proposed regulations make a number of changes with respect to the FATCA regime. Significantly, because the IRS has now determined that withholding on gross proceeds is no longer necessary in light of current global compliance with FATCA, the proposed regulations remove this requirement.
Furthermore, the proposed regulations further extend the time for withholding on foreign pass-through payments. Withholding on a foreign pass-through payment will not be required before the date that is two years after the date of publication of final regulations defining the term foreign pass-through payment. The preamble reiterates that the IRS still considers such withholding to serve an important purpose, but requests comments on alternative approaches that might serve the same compliance objectives.
Removal of US tax impediments to credit support from foreign subsidiaries
Foreign subsidiaries of a US parent issuer have not historically provided credit support for the parent's debt because doing so could subject the foreign subsidiary's earnings to US tax. Section 956 of the Code deems a US parent to receive a distribution from its controlled foreign corporation (CFC) that provides credit enhancement for the parent's debt, such as guarantees or pledges. These tax consequences led to a market practice that US issuers of debt securities did not provide guarantees or security from their foreign subsidiaries, domestic holding companies that solely own foreign subsidiaries or any domestic subsidiaries of their foreign subsidiaries; and limited pledges of equity interests in their foreign subsidiaries to 65 per cent of the voting equities in their first-tier foreign subsidiaries or in such domestic holding companies of foreign subsidiaries.
This deemed distribution for credit support reflected how a US parent was taxed on actual repatriations of earnings of its foreign subsidiaries. However, the tax treatment of actual distributions changed in 2017. The Tax Cuts and Jobs Act created a deduction for actual distributions by certain foreign corporate subsidiaries to their 10 per cent US corporate shareholders under Section 245A of the Code. The deduction, however, did not extend to earnings deemed distributed by the foreign subsidiary providing credit support.
In May 2019, the IRS and Treasury published final regulations to harmonise the taxation of deemed repatriations by CFCs from credit support to their US corporate shareholders with the taxation of actual repatriations.51 The new regulations reduce the amount of the deemed distribution to the extent the US corporate shareholder could deduct it under Section 245A if the deemed distribution were an actual distribution. In many circumstances, the deemed distribution under Section 956 can be reduced to zero.
While the new regulations address many cases where credit support from foreign subsidiaries raised tax issues, circumstances remain where such credit support may still raise issues. The new regulations only apply to US corporate issuers, so the treatment of non-corporate US issuers, such as real estate investment trusts or regulated investment companies, remains unchanged. A US partnership, such as a limited liability company, domestic private equity fund partnership or family investment partnership, may benefit from the new regulations if its beneficial owners are all corporate US shareholders. However, it will not benefit from the regulations to the extent its beneficial owners include non-corporate US entities. Section 245A also includes exceptions denying a deduction for actual distributions of a foreign subsidiary, which also apply despite the regulations. One exception requires a foreign subsidiary's stock to be held for more than 365 days in a two-year period for the subsidiary's actual distributions to be deductible.52 Therefore, credit support from a recently acquired foreign subsidiary may still raise tax issues. Issues may also arise if income of the foreign subsidiary is deemed to be effectively connected with a US trade or business, or if the foreign subsidiary's dividends to its US parent were deductible under foreign tax law.
The new regulations apply to taxable years of a CFC beginning on or after 22 July 2019. However, the new regulations may be applied to taxable years beginning after 31 December 2017 if the US parent and certain of its affiliates apply the regulations for the taxable years of each of their CFCs beginning after 31 December 2017.
Proposed and final global intangible low-taxed income regulations
Section 951A of the Code generally requires that a US shareholder of any CFC must include in gross income in the current taxable year its share of the CFC's GILTI. The amount of a US shareholder's GILTI inclusion generally reflects the sum, across all of its CFCs, of certain CFC income, offset by the sum of certain CFC losses, in excess of a 10 per cent return on a tangible asset investment (with the return reduced by certain interest expenses).
Significantly, the proposed regulations provide for a new election pursuant to which taxpayers can exclude certain high-taxed income from GILTI. High-taxed income is gross income subject to foreign income tax at an effective rate that is greater than 90 per cent of the US corporate rate (i.e., 18.9 per cent under the current US corporate rate of 21 per cent).
The proposed regulations also address the treatment of domestic partnerships for purposes of determining amounts included in the gross income of their partners under Section 951A with respect to CFCs owned by the partnership.
The final regulations provide guidance relating to the determination of a US shareholder's pro rata share of a CFC's Subpart F income and GILTI to be included in the shareholder's gross income, as well as certain reporting requirements relating to inclusions of Subpart F income and GILTI. The final regulations also include anti-abuse provisions that were included in earlier proposed regulations. In addition, the final regulations adopt an aggregate approach for purposes of determining the amount of GILTI to be included in the gross income of the partners of a domestic partnership with respect to CFCs owned by the partnership.
Proposed passive foreign investment companies regulations
Treasury and the IRS issued proposed regulations in July 2019 providing guidance with respect to passive foreign investment companies (PFICs).55 Specifically, the proposed regulations contain rules governing:
- the attribution of PFIC stock owned through partnerships;
- the look-through rules that apply to 25 per cent-owned corporations and the special look-through rules for 25 per cent-owned domestic corporations;
- the PFIC insurance rules; and
- the standards used to determine whether a PFIC satisfies the income and asset tests.
The proposed regulations clarify that the application of the attribution rules under Section 1298 of the Code to a tiered-ownership structure should be applied from the top down. The top down approach starts with a United States person that is a shareholder and determines what stock is owned at each lower tier on a proportionate basis. This approach is limited in its application to attribution through partnerships.
With respect to the look-through rules, the IRS proposed regulations that provide that where a tested foreign corporation does not own at least 25 per cent of the value of a partnership, such corporation's distributive share of income from the partnership will be treated as per se passive. Furthermore, the proposed regulations provide that dividends paid by a 25 per cent or greater subsidiary would be eliminated from income by the tested foreign corporation when applying the general look-through rule only if the subsidiary accumulated the earnings while it was a 25 per cent subsidiary of the tested foreign corporation.
The PFIC rules include an exception from those rules for certain qualifying insurance corporations (QICs) engaged in the active conduct of an insurance business. The proposed regulations provide standards for determining whether a foreign insurance company is a QIC and whether a QIC is engaged in the active conduct of an insurance business, including a proposal that would deny the insurance exception to companies that pay significant fees to outside service providers for underwriting and asset management.
The proposed regulations also provide guidance as to which Subpart F exceptions under Section 954 of the Code would apply for purposes of excluding income from passive income when determining if a foreign corporation is a PFIC.
The proposed regulations will apply to tax years of shareholders that begin on or after the date the final regulations are published in the Federal Register. However, prior to finalisation, the insurance rules may be relied upon for tax years beginning after 31 December 2017, and the remaining provisions may be relied upon for all open tax years.
III OUTLOOK AND CONCLUSIONS
The US capital markets continue to attract existing and first-time issuers of debt and equity securities, notwithstanding the continued rapid evolution of markets in Europe, Asia and elsewhere. The prospect of SEC, Department of Justice and other US regulatory oversight, although certainly a concern for many foreign private issuers, remains outweighed by the depth and liquidity of US institutional and retail markets. This is perhaps particularly the case for initial public offerings of equity by sector-specific industries, such as life sciences and technology companies, and by issuers of non-investment grade debt securities, where US investor participation is often viewed as integral to the success of a proposed transaction, but it also remains a key for the generally larger SEC registrants of long standing for whom a diversified global investor base is important. The overall thrust of current US regulatory developments appears likely to remain focused for the moment on easing the burdens associated with accessing these markets. At the same time, the SEC has expressed its intent to continue to regulate strictly capital raising initiatives, in respect of which it has well-known concerns.
1 Mark Walsh is a partner and Michael Hyatte is a senior counsel at Sidley Austin LLP. The authors would like to thank their colleague, Michele Luburich, for her assistance with this chapter. They would also like to thank their colleagues Daniel McLaughlin (litigation), Nick Brown and Michael Mann (tax), Dennis M Twomey and Allison Ross Stromberg (bankruptcy), and Alan G Grinceri and Dominic J T Nelson (high yield and leveraged finance).
3 SEC Strategic Plan Fiscal Years 2018-2022, available at https://www.sec.gov.files.SEC_Strategic_Plan_FY18-FY22_FINAL_0.pdf.
4 'SEC Staff Statement on LIBOR Transition', available at https://www.sec.govv/news/public-statement/libor-transitions (LIBOR Policy Statement).
5 LIBOR Policy Statement at page 3.
6 'Commission Statement and Guidance on Public Company Cybersecurity Disclosures' available at https://www.sec.gov/rules/interp/2018/33-10459.pdf.
8 'Modernisation of Regulation S-K Items 101, 103, and 105' available at https://www.sec.gov/rules/proposed/2019/33-10668.pdf.
10 The FAST Act Report is available at https://www.sec.gov/reports/sec-fast-act-report-2016.pdf.
12 'Concept Release on Harmonization of Securities Offering Exemptions' available at https://www.sec.gov/rules/concept/2019/33-10649.pdf.
13 'Framework for 'Investment Contract' Analysis of Digital Assets' available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digitalassets.
14 SEC v. W J Howey Co, 328 U.S. 293 (1946).
16 'Revisions to Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds', available at https://www.fdic.gov/news/board/2019/2019-08-20-notice-dis-a-fr.pdf.
17 'Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital and Segregation Requirements for Broker-Dealers', available at https://www.sec.gov/rules/final/2019/34-86175.pdf.
18 'Customer Margin Rules Relating To Security Futures', available at https://www.sec.gov/rules/proposed/2019/34-86304.pdf.
19 'Proposed Rule Amendments and Guidance Addressing Cross-Border Application of Certain Security-Based Swap Requirements', available https://www.sec.gov/rules/proposed/2019/34-85823.pdf
20 Stoyas v. Toshiba Corp, 191 F.Supp.3d 1080 (C.D. Cal. 2016) (Stoyas I), rev'd, 896 F.3d 933 (9th Cir. 2018).
21 Morrison v. Nat'l Australia Bank Ltd, 561 U.S. 247 (2010).
22 ADR and ADS are used interchangeably here, despite the distinct role of the two instruments in trading.
23 Stoyas v. Toshiba Corp, 896 F.3d 933 (9th Cir. 2018) (Stoyas II).
24 Satyam Computer Servs Ltd Secs Litig, 915 F. Supp. 2d 450, 474-75 (S.D.N.Y. 2013).
25 ParkCentral Global Hub Ltd v. Porsche Automobile Holdings SE, 763 F.3d 198, 215-16 (2d Cir. 2014).
26 Stoyas I, 191 F. Supp.3d at 1084 n. 1, 1089, 1091 (noting that the depositary bank had to purchase the stock on a foreign exchange); Stoyas II, 896 F.3d at 939.
27 Stoyas I, 191 F. Supp.3d at 1093.
28 Stoyas II, 896 F.3d at 941.
29 Stoyas I, 191 F. Supp.3d at 1090-91.
30 Stoyas I, 191 F. Supp.3d at 1094.
31 Morrison, 561 U.S. at 267.
32 Stoyas II, 896 F.3d at 950.
33 Stoyas II, 896 F.3d at 951.
35 Toshiba Corp v. Automotive Industries Pension Trust Fund, et al, 2019 U.S. LEXIS 680 (2019).
36 Brief for the United States as Amicus Curiae on Petition for a Writ of Certiorari to the United States Court of Appeals for the Ninth Circuit, Toshiba Corp v. Automotive Industries Pension Trust Fund, et al, 2019 U.S. LEXIS 680 (2019) (No. 18-496), 2019 U.S. S. Ct. Briefs LEXIS 1836, *15 (US Brief).
37 US Brief, 2019 U.S. S. Ct. Briefs LEXIS at *22.
38 Toshiba Corp v. Automotive Industries Pension Trust Fund, et al, 2019 U.S. LEXIS 4259 (2019).
39 In re Picard, 917 F.3d 85 (2d Cir. 2019), petition for cert. filed sub nom. HSBC Holdings PLC v. Irving H Picard (U.S. 30 August 2019) (No. 19-277).
40 See, e.g., La Monica v. CEVA Group PLC (In re CIL Ltd), 582 B.R. 46 (Bankr. S.D.N.Y. 2018) (concluding that fraudulent transfer and recovering provisions cannot apply extraterritorially to foreign transactions); Weisfelner v. Blavatnik (In re Lyondell Chem Co), 543 B.R. 127 (Bankr. S.D.N.Y. 2016) (concluding that Congress did intend to extend the scope of the Bankruptcy Code's avoidance powers to recover assets transferred abroad).
41 To the extent that a transfer is avoided, Section 550(a)(1) enables the trustee to recover the transferred property from the debtor's initial transferee, and Section 550(a)(2) permits a trustee to recover property from any subsequent transferee.
42 Sec Inv'r Prot Corp v. Bernard L Madoff Inv Sec LLC, 513 B.R. 222 (S.D.N.Y. 2014), as supplemented by 2014 WL 3778155 (S.D.N.Y. July 28, 2014).
43 Sec Inv'r Prot Corp v. Bernard L Madoff Inv Sec LLC, 2016 WL 6900689 (Bankr. S.D.N.Y. Nov. 22, 2016).
44 In re Fairfield Sentry Limited, 596 B.R. 275 (Bankr. S.D.N.Y. 2018).
45 See 11 U.S.C. §§ 1501 -1532.
46 See 11 U.S.C. § 1521(a)(7) (listing certain relief that may be grated to a debtor upon recognition of a foreign proceeding, including 'granting any additional relief that may be available to a trustee, except for relief available under sections 552, 544, 545, 547, 548, 550, and 724(a)'.
47 Section 546(e) of the Bankruptcy Code prohibits a debtor or bankruptcy trustee from avoiding margin payments or settlement payments, or transfers in connection with a securities contract, commodity contract, or forward contract, in each case 'made by or to (or for the benefit of)' a qualified entity. For purposes of Section 546(e), a qualified entity may be a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency.
48 11 U.S.C. § 561(d).
49 The parties did not dispute that the redemption payments fell within the scope of transactions covered by Section 546(e), but the Bankruptcy Court determined that it had inadequate evidence to determine whether either the transferor or transferee was a qualified entity under the safe harbour, particularly in light of the Supreme Court's ruling in Merit Management.
50 Reg-132881-17 (13 December 2018).
51 84 Fed. Reg. 23716 (23 May 2019).
52 Sections 245A(1)(A) and 246(c)(5) of the Code.
53 Reg-101828-19 (21 June 2019).
54 Treasury Decision 9866 (21 June 2019).
55 84 Fed. Reg. 33120 (11 July 2019).