Non-U.S. Entities Are Reminded of Stern U.S. Regulatory Regime, Contributed by Amy Kroll and Margaret Blake, Bingham McCutchen LLP
As 2011 drew to a close, the U.S. Securities and Exchange Commission (SEC) continued to assert its jurisdictional reach and the application of U.S. securities laws to non-U.S. entities engaging in securities activity in the United States. Specifically, in October 2011, the SEC published an order instituting administrative and cease-and-desist proceedings (Order) against a Portuguese bank, Banco Espirito Santo S.A. (Bank or Banco Espirito Santo), in connection with the Bank’s alleged violations of U.S. securities laws.1 Specifically, the SEC’s Order referenced laws requiring broker-dealer and investment adviser registration as well as laws requiring that certain securities be registered prior to being sold to the public in the United States. The Bank, without admitting or denying the allegations, settled this matter with the SEC and agreed to terms that included ceasing and desisting from committing or causing any violations or future violations of the relevant securities laws, and payment of disgorgement of $1.65 million, prejudgment interest of $363,518, and a civil monetary penalty of $4.95 million.
The SEC’s action serves as a reminder that the SEC staff firmly believes that the U.S. securities laws require a non-U.S. entity (e.g., bank, broker-dealer, investment adviser) to comply with U.S. regulatory requirements, including registration of securities offerings and registration of non-U.S. entities such as a broker-dealer and/or investment adviser, unless the U.S. rules or laws provide an exemption from such regulation and registration.
Summary of the Order
In its Order, the SEC alleged that Banco Espirito Santo engaged in extensive activities with U.S. resident individuals from outside the United States without the appropriate broker-dealer or investment adviser registration or applicable exemptions therefrom. Specifically, the SEC alleged that the Bank:
- Mailed marketing materials to persons in the United States;
- Operated a customer service call center outside the United States with dedicated employees servicing U.S. customers and offering financial products, including securities, to U.S. residents;
- Had personnel offering securities services who were not associated with, or registered with, a U.S. registered broker-dealer;
- Offered broker-dealer services through a U.S.-based affiliate that was not registered as a broker-dealer and the employees of which were not associated persons of or registered with a U.S. registered broker-dealer;
- Used from time-to-time a U.S.-based affiliate that was not a registered broker-dealer to act as point of contact for the Bank’s investment activities with U.S. residents;
- Offered securities and provided advice regarding investments in securities to 225 affluent U.S. residents through a dedicated division in Portugal, none of the employees of which were registered as investment adviser representatives or as representatives of a broker-dealer, or associated with a U.S. registered broker-dealer or investment adviser; and
- Had personnel who were members of the dedicated division and who conducted annual visits to the United States for two to three weeks at a time meeting with U.S.-resident clients and also servicing these clients in the U.S. by telephone, facsimile, and email. The Bank personnel allegedly discussed the U.S. client’s accounts and financial products, including securities; helped to effect transactions in financial products; and urged the clients to buy, sell, or hold certain financial products.
In addition to the above, the SEC alleged that the Bank offered and sold a variety of securities to U.S. residents and provided investment advice to approximately 3,800 U.S. residents. Registration statements were not filed or in effect for securities that were issued or sponsored by the Bank or its affiliates and sold to U.S. residents. (The SEC described the securities as debt and other group-guaranteed securities issued by the Bank and its affiliates as well as interests in Portuguese analogs to mutual funds sponsored by the Bank and affiliated entities). There is no discussion in the Order about whether the purchasers of these securities were accredited investors or qualified purchasers.
The Bank received fees and commissions from the accounts and transactions of approximately $1.65 million. This is the amount that the Bank agreed to disgorge in its settlement, plus prejudgment interest on this amount. In addition to these payments and the civil monetary penalty of $4.95 million to be paid to the U.S. Treasury, the Bank agreed to pay each U.S. resident interest on securities purchased through the Bank, less any payments, other than principal payments, received pursuant to the terms of the securities, and to compensate each U.S. resident for any realized or unrealized losses with respect to securities purchased through the Bank, plus interest until maturity or sale.
A year prior to the Banco Espirito Santo Order, the U.S. Supreme Court ruled in Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010), that Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder—the antifraud provisions of the Exchange Act—only apply to cases involving either the purchase or sale of securities listed on U.S. securities exchanges or the purchase or sale of any other security in the United States. While Morrison seemed to limit the SEC’s presumed jurisdiction over non-U.S. entities acting completely outside the United States, the Order demonstrates that the Morrison case does not appear to have dampened the SEC staff’s view as to the scope of its enforcement authority regarding securities activities involving U.S. investors and the use of U.S. jurisdictional means.
The SEC’s Order against Banco Espirito Santo and the Morrison case are reminders that non-U.S. financial institutions should take the time to structure carefully their activities that touch the United States. While the up-front costs may seem significant, they pale in comparison to the back-end cost and potential reputational harm of defending an SEC investigation and incurring disgorgement, interest, penalties, and restitution deemed necessary to conclude a matter with the SEC.
While it is clear that non-U.S. financial institutions must focus on compliance with U.S. securities laws overall, based on the SEC’s Order and the authors’ recent experience, the following items are of particular concern to U.S. regulators:
- Broker-dealer definition. Non-U.S. entities must remember, regardless of how their business is characterized in their home jurisdictions, if the activities they engage in touch U.S. persons or use U.S. jurisdictional means and would be deemed brokerage activities under U.S. securities laws, they will be considered “broker-dealers” for U.S. securities law purposes. As a result, such non-U.S. entities will be required to register as broker-dealers under U.S. securities laws or operate pursuant to Rule 15a-6, adopted by the SEC under the Exchange Act as described in more detail below.
- Pre-existing relationships. Where a non-U.S. bank or other financial services entity opens accounts outside the United States for non-U.S. persons who subsequently move or relocate to the United States, those customers become U.S. residents and their accounts must be serviced by a U.S.-registered broker-dealer or a non-U.S. broker-dealer operating pursuant to an exemption. Regardless of whether the non-U.S. entity had a pre-existing relationship with the customer, once the account holder moves to the United States, it is very difficult to avoid the use of U.S. jurisdictional means to maintain the investor relationship, and thus, the U.S. laws likely will apply.
- Marketing to individual investors. As noted below, Rule 15a-6 only allows transactions with U.S. individual investors on an unsolicited basis. Following an unsolicited transaction, there may not be any ongoing investment relationship established between the non-U.S. entity and U.S. individual investors. A non-U.S. entity may not market to individuals in the United States or otherwise pursue individual investors living in the United States without becoming subject to the SEC’s jurisdiction. The SEC particularly is attuned to the solicitation and marketing efforts of non-U.S. entities as it pertains to individual investors.
- Regulation of securities offerings. Any offering of securities in the United States is subject to the Securities Act of 1933 (Securities Act) and rules thereunder as well as relevant state law requirements applicable to securities offerings. That is, in addition to requiring the use of a registered broker-dealer when conducting a securities business using U.S. jurisdictional means, a non-U.S. entity must offer securities only in a manner that complies with relevant laws, rules, and regulations.
- Investment adviser registration requirements. Non-U.S. entities engaging in securities activity with U.S. persons or using U.S. jurisdictional means also must be aware that certain activities may cause them to cross into the investment adviser regulatory regime under the Investment Advisers Act of 1940 (Advisers Act). While the core definition of “investment adviser” has not changed, the Dodd–Frank Wall Street Reform and Consumer Protection Act significantly changed the exemptions from investment adviser registration and added one exclusion to the definition.2 Therefore, investment adviser status and applicable exemptions must be considered when engaging in advisory activity on behalf of U.S. persons or when using U.S. jurisdictional means to conduct such activity.
How to Maintain Compliance
In considering potential broker-dealer activity in the United States or with U.S. investors, a non-U.S. firm must either register as a broker-dealer in the United States or conduct its activity pursuant to Exchange Act Rule 15a-6. However, Rule 15a-6 only provides a safe harbor from the broker-dealer registration requirements under certain circumstances with specific parties. In general terms, Rule 15a-6 applies to, among other things, isolated unsolicited transactions effected for U.S. investors, including individuals; transactions with certain defined classes of persons deemed not to require intermediation at any point by a U.S. broker-dealer; and solicitation of and effecting of brokerage transactions with “Major U.S. Institutional Investors” and “U.S. Institutional Investors.”3
More specifically, pursuant to Rule 15a-6(a)(1), a foreign broker-dealer may effect transactions in securities with or for U.S. investors on an unsolicited basis without being required to register as a U.S. broker-dealer. This safe harbor is viewed very narrowly by the SEC, as permitting a foreign broker-dealer contacted by a U.S. client on an unsolicited basis, to execute the requested transaction without triggering the U.S. registration requirements and related regulation regardless of whether the U.S. client contacts the broker-dealer from the U.S. or abroad. However, continued communications with the U.S. person, whether solicited or not, is viewed by the SEC as establishing a regular brokerage relationship such that registration of the broker-dealer entity is required. Furthermore, the SEC’s action against Banco Espirito Santo illustrates that transactions with individuals are fraught with danger, because the SEC may seek to find a basis for determining that it should have regulatory jurisdiction over any such activities in the name of investor protection.
Rule 15a-6(a)(4) also provides an exemption for foreign broker-dealers engaging in transactions with certain classes of persons. For example, pursuant to this exemption, registration requirements would not apply to a foreign broker-dealer outside the U.S. dealing with (1) registered brokers and banks acting in a broker-dealer capacity; (2) certain international organizations, regardless of their location; (3) foreign persons temporarily present in the U.S. with whom the foreign broker-dealer had a bona fide, pre-existing relationship before the foreign person entered the U.S.; (4) foreign agencies or branches of U.S. persons; and (5) U.S. citizens residing abroad, as long as the transactions occur outside the United States and the foreign broker-dealer does not direct selling efforts to identifiable groups of U.S. persons (e.g., military personnel).
Finally, Rule 15a-6(a)(2) sets forth an exemption for non-U.S. broker-dealers providing research to Major U.S. Institutional Investors, while Rule 15a-6(a)(3) allows a non-U.S. broker-dealer to induce or attempt to induce the purchase or sale of a security by U.S. Institutional Investors or Major U.S. Institutional Investors (neither of which include individual investors) pursuant to the strict terms set forth in the rule (and as supplemented by SEC interpretive letters).
— Securities Offerings
Often, a non-U.S. issuer offering its securities in the United States does so pursuant to a private placement by a registered broker-dealer to existing contacts and not by a general solicitation to the public. There are limitations on the number of investors that may partake in such an offering, unless all investors meet the definition of “accredited investor” under the Securities Act4 (and even then the number must remain below 500 investors or otherwise the issuer is deemed to have made a public offering and becomes subject to Exchange Act reporting requirements).5 Depending on the basis for the private placement (e.g., the safe harbor under Regulation D), the SEC and some states require a filing regarding the offering to be made on Form D. In addition, where securities products are proprietary products of the selling entity or an affiliate, regulatory scrutiny will be greater, as recent FINRA guidance has shown.6
A non-U.S. issuer or broker-dealer should engage U.S.-qualified counsel and a reputable U.S.-registered broker-dealer to collaborate on any securities offering to U.S. investors in the United States in order to ensure that the offering and related communications comply with the requirements of the Securities Act. All communications and offering activity should be managed by the U.S. broker-dealer either directly on behalf of the issuer or pursuant to a Rule 15a-6 agreement with a non-U.S. broker-dealer such that the non-U.S. broker-dealer is in compliance with the requirements of the Rule 15a-6 safe harbor(s). This should prevent both a non-U.S. issuer and its non-U.S. broker-dealer from finding themselves, like Banco Espirito Santo, the subject of an SEC action alleging violations of the Securities Act and the Exchange Act.
— Investment Adviser Activity
An investment adviser generally is any person who, for compensation, provides advice as to the value of securities or the advisability of buying or selling securities, or that issues reports or analyses regarding securities.7 Such a person is deemed to be an investment adviser and may be subject to the registration requirements under the Advisers Act.
If a non-U.S. entity meets the definition of an investment adviser, it must register as such or consider if and how the exemptions/exclusions might apply to its activities. The following activities generally are exempt or excluded from adviser registration if all of the elements of the particular exemption/exclusion are met:
- Any foreign private adviser, which is defined as an adviser with no place of business in the United States; having fewer than 15 clients and aggregate assets under management attributable to clients in the United States and investors in the United States in private funds of less than $25 million; and which does not hold itself out as an adviser and does not advise a registered investment company or business development company;8
- A private fund adviser with its principal office and place of business outside the United States that acts as an adviser to U.S. qualifying funds, attributes all assets managed in the United States to private fund assets and has a total value of such private fund assets of less than $150 million;9
- A family office with no clients, other than family clients, that is wholly owned and exclusively controlled by family clients and does not hold itself out to the public as an investment adviser;10
- An adviser to one or more venture capital funds;11 and
- An adviser registered with the Commodity Futures Trading Commission as a commodity trading adviser whose business does not consist primarily of acting as an investment adviser and who does not advise a registered investment company or business development company.12
Note that although a foreign adviser may be exempt from registration under the Advisers Act, certain filings, recordkeeping, and/or examination requirements likely will apply to its activity effective March 30, 2012.13
Registration and regulation of investment advisers is separate and distinct from that of broker-dealers. As in the case of Banco Espirito Santo, a non-U.S. entity can engage in activities that require both broker-dealer and investment adviser registration and, as a result, risk finding itself in violation of both the Exchange Act and the Advisers Act.
We have seen the SEC take an active interest in the operations of non-U.S. entities over the past several years. The recent SEC action against Banco Espirito Santo reiterates the SEC’s view that its jurisdiction extends outside the United States when non-U.S. entities engage in transactions with U.S. investors using U.S. jurisdictional means. However, we do note that Morrison leaves open the question whether the SEC’s jurisdiction is in fact as broad as the SEC traditionally has asserted.
Now, more than ever, non-U.S. financial entities should evaluate their activities and any potential nexus of their activities to the United States. To the extent a non-U.S. financial entity is using U.S. jurisdictional means to conduct a securities business with or for U.S. investors, it should cease any such activity immediately until an infrastructure is in place to guard against SEC assertions of potential violations of the U.S. securities laws.
Amy Kroll is a partner in the Washington, D.C. office of Bingham McCutchen LLP. She counsels U.S. and non-U.S. broker-dealers on U.S. regulatory requirements and best practices. Ms. Kroll has particular experience with issues related to the equity capital markets, such as research activities and research analysts, supervisory controls and internal controls, and cross-border trading. She can be contacted at 202.373.6118 or firstname.lastname@example.org.
Margaret Blake is of counsel in the Washington, D.C. office of Bingham McCutchen LLP. She focuses her practice on regulatory and compliance matters applicable to U.S. and non-U.S. broker-dealers under the Securities Exchange Act of 1934, as well as FINRA rules and the rules of other self-regulatory organizations. She can be contacted at 202.373.6296 or email@example.com.
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