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New Jersey Bureau of Securities Proposes New Rule to Create State-Level Fiduciary Duties For Broker-Dealers, Associated Persons, Investment Advisers and Investment Adviser Representatives

On April 15, 2019, the New Jersey Bureau of Securities, within the Division of Consumer Affairs, proposed a new state-level rule requiring all registered financial services professionals to act in accordance with the fiduciary duty to their customers when providing investment advice or recommending to a customer an investment strategy, the opening of or transfer of assets of any type of account, or the purchase, sale, or exchange of any security. Under the proposed rule, any conduct falling short of this fiduciary duty would constitute a “dishonest and unethical practice.”

Under current federal standards, only investment advisers subject to the Investment Advisors Act of 1940 and their representatives operate subject to a fiduciary duty standard. Among other differences from their investment adviser counterparts, broker-dealers and their associated persons typically receive only commissions for transactions they facilitate and for selling financial products – not compensation for financial planning, discretionary trading or investment portfolio advice and management. New Jersey proposes a substantial expansion of regulatory requirements on broker-dealers and their associated persons conducting business within the State of New Jersey.

The Proposed Rule

Dishonest or Unethical Practices

The proposed regulation, N.J.A.C. 13:47A-6.3 and N.J.A.C. 13:47A-6.4, seeks to impose a uniform, state-level duty of care and loyalty for both investment advisers and their representatives as well as broker-dealers and their associated persons doing business within the State. The State’s proposal is a product of its dissatisfaction with the pace of meaningful change to the federal regulatory framework following the United States Department of Labor’s failed Fiduciary Rule* and the scope of the United States Securities and Exchange Commission’s proposed Regulation Best Interest**, to promulgate a new, uniform federal interest ahead of the customer’s interest; (ii) act with diligence, care, skill and prudence; and (iii) disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendation. Regulation Best Interest does not apply a fiduciary standard to broker-dealers or its associated persons. In addition, Regulation Best Interest allows some duty of loyalty conflict of interests to be mitigated through disclosure to the customer.

Expanded Reach and Duration

As proposed, the fiduciary duty would apply to recommendations to purchase, sell or hold securities and to recommendations about investment strategy, the opening of an account or the transfer of assets to any type of account. Further, the new duty would also apply to contractual and discretionary fiduciaries in addition to investment advice fiduciaries. Moreover, if investment advice is provided, the new fiduciary duty rule would impose an ongoing fiduciary duty for the entire relationship. In other words, dual registered persons who provide both brokerage recommendations and investment advice to a retail customer would be subject to the fiduciary duty for the life of the relationship***

Creating New and Rejecting Old Presumptions

The proposed rule also creates a new presumption that the investment adviser, its representative, the broker-dealer or its associated person breaches the duty of loyalty for any recommendation concerning the opening of, or transfer of assets to a specific type of account, or the purchase, sale or exchange of a specific security “that is not the best of the reasonably available options.” According to the State, the payment of transaction-based fees to broker- dealers or associated persons will not itself be deemed a breach of fiduciary duty, however, so long as “the fee is reasonable and is the best of the reasonably available fee options and the duty of care is satisfied.”

The regulation, if adopted in current form, disallows a presumption that disclosing a conflict of interest satisfies the duty of loyalty.

The proposed regulation applies to retail customer only, i.e., not banks, savings and loan associations, insurance companies, investment advisers, broker-dealers, fiduciaries to employee benefit plans, its participants or beneficiaries, or individuals with at least $50 million in assets.

Books and Records Requirements

Ostensibly to avoid federal preemption, the State’s proposal does not require any new or additional capital, custody, margin, financial responsibility, making and keeping of records, bonding or financial or operational reporting requirements on broker-dealers beyond those already required by federal law.

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If you have any questions about the issues addressed in this Broker-Dealer Regulation Alert, if you would like a copy of any of the materials mentioned in it or if you would like to continue to receive Broker-Dealer Regulation Alerts, please do not hesitate to call or email Securities and Commercial Litigation and Securities Regulatory Practice Partner Daniel Scott Furst at (646) 810-2185 or sfurst@srf.law ****

*The Department of Labor’s rule was to be implemented starting April 10, 2017, however, on or about June 21, 2018, the United States Fifth Circuit Court of Appeals vacated the rule, effectively killing it.

***Broker-dealer associated persons who act in a broker-only capacity, however, would be subject to the fiduciary duty only through the transaction’s execution.

**The final rulemaking of Regulation Best Interest was approved in a 3-to-1 vote by the Commission on June 5, 2019. Regulation Best Interest is effective 60 days after publication in the Federal Register, and the anticipated implementation date is June 30, 2020. Regulation Best Interest would create a national, heightened standard of conduct for broker-dealers. Regulation Best Interest provides that when a broker- dealer or its associated person recommends securities transaction or investment strategy, the broker-deal or associated person must: (i) act in the customer’s best interest, without placing its financial or other standard applicable to investment advisers and broker-dealers. Specifically, the proposed regulation would define a “dishonest or unethical practice” to include: recommending to a customer, an investment strategy, the opening of, or transfer of any assets to, any type of account, or the purchase, sale, or exchange of any security or securities without reasonable grounds to believe that such strategy, transaction, or recommendation is suitable for the customer based upon reasonable inquiry concerning the customer’s investment objectives, financial situation, and needs, and any other relevant information known by the broker-dealer[.]

****This Broker-Dealer Regulation Alert is for general information purposes only of interest to New Jersey broker-dealers and is not intended to advertise our services, solicit clients or represent our legal advice.

Will The Murky Marijuana Banking Picture Finally Get Clearer?

Federal Reserve Chairman Jerome Powell, while testifying before Congress yesterday, Tuesday, February 26, 2019, explicitly acknowledged the uncertainty and tension surrounding the access of a company engaged in marijuana or marijuana-related business to banking because of conflicting state and federal laws.  When asked about the topic, the Chairman said, “I think it would be great to have clarity,” adding, “Financial institutions and their regulators and supervisors are in a difficult position with marijuana being illegal under federal law and legal under some state laws.”

Further, last week, the House Financial Services Committee made history by holding its first ever hearing on marijuana and financial services. Up for discussion at that hearing was a new draft of the Secure and Fair Enforcement (SAFE) Banking Act.  Last year, Congress introduced the SAFE Act of 2017, which stalled and went nowhere.  Colorado Rep. Ed Perlmutter, a prime sponsor of the bill, has been introducing a version of this bill for almost six years, but has failed to get a hearing until now. This year, not only is the bill going to be discussed, but the bill is even more robust, specifically adding protections for ancillary businesses providing products and services to marijuana-related businesses.

As Treasury Secretary Steven Mnuchin made clear while testifying before Congress last year, he too would like to see marijuana businesses able to access banking services.  “I assure you that we don’t want bags of cash,” he said before a House Committee last year.  “We want to find a solution to make sure that the businesses that have large access to cash have a way to get them into a depository institution for it to be safe.”

Today, while 10 states and the district of Columbia have legalized recreational marijuana, marijuana remains illegal on the federal level, listed as a Schedule 1 drug, along with heroin and LSD.  And, while an increasing number of financial institutions are willing to bank marijuana and marijuana-related businesses, there still is a predominant, industry-wide reluctance to get involved, whether because of the added compliance that is required, or because of the unclear restrictions that are promulgated, by the Department of the Treasury.

Marc J. Ross, Esq.

Marc J. Ross is a founding partner representing clients (public and private companies, brokerage firms, registered representatives, high net-worth individuals, and hedge funds) throughout the United States, North America, Asia, Europe and Israel. Mr. Ross advises clients on securities, corporate, regulatory and litigation/arbitration matters.
Marc J. Ross, Esq.

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    Client Alert: U.S. Senate and House of Representatives Approve 2018 Farm Bill

    The long-awaited resurgence of the Agriculture Improvement Act of 2018, colloquially referred to as the 2018 Farm Bill, became more promising yesterday as its latest iteration received overwhelming bipartisan approval as it decidedly passed through the Senate on Tuesday, by a vote of 87-to-13, and easily passed through the House of Representatives, by a vote of 369-to-47. Now, the reality of the 2018 Farm Bill awaits the hand of President Donald Trump, who is expected to sign it into law before the end of the month.

    Most notable, the 2018 Farm Bill is set to legalize hemp, a plant that’s nearly identical to marijuana and is a key source of the highly popular health and wellness ingredient cannabinoid, or CBD. If signed into law, the 803-page Bill would be the most significant change to the Controlled Substances Act (the “CSA”) since 1971, which is illustrative of the federal government’s recognition that outdated federal regulations do not sufficiently distinguish between hemp, including CBD derived from hemp, and CBD derived from marijuana.

    In contrast to its predecessor, the voluminous 2018 Farm Bill expressly and unambiguously provides that the definition of “marihuana” under the CSA would be amended to exclude “hemp”, which, in turn, is defined as “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3 percent on a dry weight basis.” Succinctly, if signed into law, the 2018 Farm Bill would be the first piece of federal legislation that explicitly carves out certain permutations of CBD containing tetrahydrocannabinol (“THC”), the active ingredient that causes the psychoactive effect of marijuana, from the CSA.

    Against this backdrop, financial institutions that have been reluctant to establish relationships with hemp-related business because of the inclusion of “hemp” in the CSA’s definition of “marihuana” and the February 14, 2014 guidance from the Department of the Treasury Financial Crimes Enforcement Network, may now turn a new leaf and embrace the estimated $1 billion industry.

    Relatedly, and in furtherance of the federal government’s progressive initiative toward the proliferation of the rapidly increasing hemp market, the 2018 Farm Bill also places far-reaching limitations on the States’ abilities to prevent the transport of hemp across interstate commerce. Specifically, the 2018 Farm Bill states, in relevant part, that “No State or Indian Tribe shall prohibit the transportation or shipment of hemp or hemp products,” so long as such hemp or hemp products are produced in accordance with discrete guidelines set forth elsewhere in the 2018 Farm Bill.

    Notwithstanding, this monumental shift in cannabis reform should not be misconstrued as a blanket legalization of hemp at the state level. Conversely, the 2018 Farm Bill provides a roadmap for states and Indian tribes to become the “primary regulators” of hemp production by submitting “a plan under which the State or Indian tribe monitors and regulates” the production of hemp within its borders. In this regard, those interested in getting involved in the hemp industry, in any capacity, are cautioned to review the applicable state law, which may carry more stringent restrictions than the 2018 Farm Bill, as well as any other pertinent federal authority.

    Finally, it is worth noting that nothing in the 2018 Farm Bill implicates the status quo of marijuana or CBD derived from marijuana, both of which remain illegal under federal law. And while the legal landscape remains somewhat hazy, bipartisan agreement of the 2018 Farm Bill marks a long-overdue, massive step forward for the U.S. hemp industry.

    About the authors

    S. Ashley Jaber

    S. Ashley Jaber is an associate in the firm’s Corporate and Securities practice group. Ms. Jaber represents both public and privately-held clients in a broad range of corporate and securities matters. She also assists clients in the filing of registration statements and in complying with their ongoing SEC reporting obligations.
    S. Ashley Jaber

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      Robert Volynsky

      Robert Volynsky is an associate in the firm’s Litigation Department. Mr. Volynsky engages in securities and general commercial litigation in both state and federal courts and before regulatory agencies, including the Securities and Exchange Commission and the Financial Industry Regulatory Authority.
      Robert Volynsky

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        California’s New Commercial Financing Disclosure Legislation

        Introduction

        On August 31, 2018, the California State Senate passed novel legislation, Senate Bill 1235, which requires new disclosures for certain commercial financing, such as loans, factoring transactions, and, potentially, merchant cash advances (MCAs). California Governor Jerry Brown has until September 30 to sign this legislation, and it appears likely that he will. continue reading >>

        Under new tax law, sales by foreign partners of U.S. partnership interests are once again taxable.

        In an August 2017 posting we reported that the U.S. Tax Court had held that, notwithstanding an IRS revenue ruling to the contrary, the sale by a foreign partner of his interest in a U.S. partnership was not a taxable transaction to him (assuming he was not otherwise a U.S. taxpayer), just as the sale of stock in a U.S. corporation is not a taxable transaction to a foreign shareholder. (“Tax Court: Foreign investors not taxable on sales/liquidations, of U.S. partnership interests.”)

        continue reading >>

        Sichenzia Ross Ference Kesner’s Jodi Zimmerman Conducts Q&A on “What You Should Know About Creating A Last Will & Testament”

        Press Release – New York, NY – July 26, 2017 – Jodi B. Zimmerman, Esq. of Sichenzia Ross Ference Kesner LLP participated in a Q&A blog post hosted by eSignatureGuarantee Group, to share “What You Should Know About Creating A Last Will & Testament.” The Q&A outlines the reasons for planning ahead, what to be aware of, and most importantly — the impact on your family and community.

        Read the entire post here.

        FAST Act Includes Changes to Securities Laws

        By Avital Perlman

        President Obama signed the Fixing America’s Surface Transportation Act, or FAST Act, into law on December 4, 2015.  The FAST Act, which is aimed at improving the country’s surface transportation infrastructure, also contains several sections that amend securities laws to ease regulatory burdens for smaller companies.

        Improving Access to Capital for Emerging Growth Companies, or EGCs continue reading >>

        Why Go Public?

        This blog post is the first installment of our "Going Public" blog series; a collection of blog articles dedicated to educating readers on the legal and financial considerations companies need to have when and if they decide to go public. Next week, we'll be covering the different ways a company can go public so please stay tuned. 

        Why Go Public?

        continue reading >>

        23 States Legalized Marijuana – Bankruptcy Courts Remind Us That It’s Legal in None of Them

        “There was a time a few years ago when the United States was spoken of in the plural number.
        Men said ‘the United States are’ — ‘the United States have’ — ‘the United States were.’ But the war changed all that.”   The Washington Post, April 24, 1887.   The phrase “United States” became a singular noun after the Civil War. continue reading >>

        Rule 144 : How Officers, Directors and Large Shareholders Can Navigate Affiliate Sale Requirements

        Introduction

        The resolution of tension between two desires of a subset of powerful investors—to sell, and to govern well—is the impetus behind the affiliate sale provisions as drafted in the amended Rule 144.

        Rule 144 is the main avenue open to affiliates to sell un-registered securities in the public market. An “affiliate” of an issuer is defined as a “person” who directly or indirectly controls the issuer, generally any executive officer, director or shareholder beneficially-owning 10% or more of the issued and outstanding shares.[1] Volume limitations, reporting obligations and manner of sale provisions, as well as a definition of “person” that responds to the concept of “indirect control,” are among the measures incorporated into Rule 144, in view of the SEC’s understanding that, absent limitations, those in control of a company could be liable for significant abuses in sales of un-registered securities.[2]

        Affiliates should know who they are, and what their obligations under the rule are in order to plan efficient sales with reduced liability potential. Additional benefits may be gained at the point of negotiating director or officer compensation. Negotiators may better gauge the value of un-registered compensation shares if they understand the workings of the Rule 144 affiliate sale process.

        [1] An affiliate of the issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer. See 17 CFR 230.144(a)(1). Factors the SEC has indicated as relevant to the determination of “control” include an individual’s status as a director, officer, or 10% shareholder. See American Standard, October 11, 1972.
        [1] 2007 Proposal, p. 20.

        Affiliate Sale Rules

        Part I: Who is an “Affiliate”?

        The navigation of affiliate sale requirements begins with a substantive analysis: Is a given security-holder an “affiliate” for the purpose of Rule 144? The answer is complicated by the broad definition of “person,” which responds to the possibility of “indirect control” of an issuer.

        As stated above, an affiliate is defined as a person who directly or indirectly controls the issuer. “Indirect control” is determined in courts through a facts and circumstances analysis—it is a “know-it-when-we-see-it” idea. A director’s wife, for example, may exert indirect control on a company through influence, though she holds no formal position and may not own many shares. When does an ordinary filial relationship become a control relationship with the issuer? The question becomes more involved when determining when percentage-ownership, perhaps by an otherwise ordinary public investor, translates to having “control” of a company. Courts consider 10% beneficial ownership indicative of a control relationship, but not dispositive.

        Rule 144 gets in front of these questions by counting a range of people, entities and donees related to an individual security-holder as one “person.” Individuals or entities that constitute one affiliated “person” are individually subject to the affiliate sale rules, and their sales will be considered cumulatively as if they were one seller. An analysis of affiliate status can be done on a case-by-case basis where circumstances are vague or there are countervailing factors weighing against otherwise suspicious relationships. For this reason, determining whether one is an affiliate can be a rigorous point of investigation, and it must be done before sales can be planned.

        Part II: Affiliate Sale Requirements

        Rule 144 permits sales where an affiliate did not acquire shares with the intent to profit by distributing them, possibly at the expense of the issuer or the investing public. Volume limitations, manner of sale provisions and an obligation to report sales of a certain size, are factors the SEC believes demonstrate an affiliate assumed the economic risk of investment. Assumption of economic risk cleanses an affiliate’s intent in the eyes of the authorities.[3]

        Volume limitations control the rate at which securities may be sold. Quarterly sales of shares in an exchange-listed issuer are limited to the greater of 1% of the issued and outstanding shares of the same class being sold, or the average weekly trading volume during the preceding four weeks. An affiliate in a non-exchange listed issuer (such as an OTC Bulletin Board or OTC Markets company) must use the 1% measurement. Volume limitations present a significant, though straightforward, control on affiliate sales, and affiliates should consider them when planning sales on a timeline.

        Manner of sale provisions prescribe the appropriate relationship between an affiliate and a broker. They prevent sales from taking on the semblance of distributions, through commission structures or otherwise. Affiliates must sell equity securities in unsolicited broker’s transactions directly with a market maker, or in riskless principal transactions. A broker must do no more than execute an order to sell the securities as agent for the affiliate, and may receive no more than customary commission. Solicitation for buy orders is generally inappropriate. The SEC has cited the “gatekeeper” role of the broker to ensure compliance with Rule 144. By turn, affiliates should select brokers with care and construct healthy sale relationships with them in view of the manner of sale provisions.

        Finally, the SEC requests to be made aware of significant public securities transfers by affiliates. Affiliates must file Form 144 with the SEC in advance of sales of more than 5,000 shares or $50,000 aggregate dollar value. The sale must take place within three months of filing the form.

        Conclusion

        Officers, directors or large shareholders of an issuer should have a firm grasp of the affiliate sale rules under Rule 144, so they may plan sales efficiently, effectively and properly. This begins with knowing whether one is an affiliate, and how to count shares using the definition of “person” described above. Once affiliate status is determined, the obligation runs to sell in compliance with volume limitations, manner of sale provisions and Form 144 reporting. At the time of sale, this insulates affiliates from liability, and allows them to cultivate reputations as responsible controlling investors. At the time of employment contract negotiation, knowledge of the affiliate sale process can help an officer or director better gauge the value of compensation shares. Most importantly, being in compliance with Rule 144 enables an affiliate perform its duties to the issuer and the investing public, while participating actively in the market.

        [1] An affiliate of the issuer is a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer. See 17 CFR 230.144(a)(1). Factors the SEC has indicated as relevant to the determination of “control” include an individual’s status as a director, officer, or 10% shareholder. See American Standard, October 11, 1972.
        [2] 2007 Proposal, p. 20.
        [3] Barring other proof of a scheme to evade securities laws.

         

        The information in this blog post is for general, educational purposes only and should not be taken as specific legal advice.


        Written by Jennifer R. Rodriguez, Esq.

        JenniferRodriguez

        Selling Your LLC for Stock – The Tax Problem

        Entrepreneurs often choose limited liability companies to incubate their businesses. An LLC offers a simple entity structure, it lets the members claim start-up losses on their own tax returns, and it eliminates the double tax imposed on a corporate structure once the venture turns profitable.

        But an LLC has a tax defect that its owners frequently don’t understand until it’s too late: because it is not a corporation an LLC cannot participate in a tax-free corporate reorganization. So when the owners sell their LLC interests to another company for stock, the transaction is a taxable event to them but they don’t get cash to pay the tax on any gain.

        If the stock trades publicly the owners can sell some of it to raise cash for the taxes. But they may not want to do that, and there may be SEC- or deal-driven lockups that prohibit them from selling before the tax is due. If the stock doesn’t trade publicly, they may need to find cash somewhere else.

        The buyer may have a number of reasons for wanting to acquire membership interests of an LLC using its stock as currency: it may not have the cash itself, or want to use it, or it may want the sellers to continue to have an equity interest in the company and be motivated to help it succeed. The buyer may propose a stock-for-stock exchange, a stock-for-assets exchange, or a merger. All of these transactions could be tax-free to the sellers who own the target – but only if the target is a corporation.

        There are solutions to this problem, but each solution carries tax risks. The sellers can incorporate their LLC (or elect to have it treated as a corporation for tax purposes) before the acquisition and then exchange their stock in the new corporation for stock in the buyer. But this approach will usually generate a so-called “step-transaction” analysis: if the IRS decides that the conversion of the LLC into a “C” corporation and the subsequent stock exchange were all part of the same transaction, and that there was no non-tax reason for the conversion, it will disregard the first step – the conversion – and treat the transaction as a taxable sale of the LLC interests. The closer the conversion occurs to the acquisition, the more likely the step-transaction doctrine will be applied.

        Another solution is to structure the exchange as a tax-free “Section 351 transfer”. Section 351 transfers can involve property (as opposed to just stock). In a section 351 transfer the seller contributes his LLC interests (or the LLC’s assets) to a new corporation, and the buyer contributes stock (or other property) to the new corporation, and if together the seller and the buyer control more than 80% of the new corporation, then the transfer is tax-free.

        But this solution has its drawbacks, as well. For one thing the stock that the seller now owns is not stock in the buyer but in a corporation that is a subsidiary of the buyer. That stock probably won’t be sellable. After a decent interval (which could be as long as a year) the parties could liquidate the subsidiary into the buyer and distribute stock in the buyer, but if they do that too soon then — you guessed it — the step-transaction analysis is applied once again. And if the buyer uses treasury stock to capitalize the subsidiary, there is an unsettled legal question as to whether the transfer is still tax free to the seller. In any event, the section 351 transfer forces the buyer to hold the target’s business in a subsidiary company, something it may not wish to do.

        There are also non-tax solutions: the deal might require the buyer to provide enough cash consideration for the seller to pay the tax, but then the amount of cash becomes a negotiating point and chances are the seller gives up something in return for it.

        The best solution to the LLC problem is to plan ahead. Way ahead. Do you need an LLC in the first place – will the tax benefits of the losses justify the potential tax problem on a sale for stock? Would an S corporation serve as an alternative to an LLC? (It’s not an alternative if there are foreign, corporate or (in some cases) trust owners, more than 100 owners, or more than one class of equity.) If you plan to sell the business before it turns a profit (and then there would be no benefit to the tax flow-through) should you just start with a corporation in the first place? There are no boiler-plate answers to these questions; the alternatives need to be analyzed in the context of the business and the exit strategy.

        If you already have an LLC and plan to sell, the best solution is still to plan ahead. If today you foresee a sale of your company in a year or so, now may be the time to convert it to a corporation. The further in advance of the sale that you do so, the more likely you are to avoid the step-transaction doctrine. (LLCs can usually be converted to corporations tax-free.) Again, there is no one-solution-fits-all, but you will have more options if you address the problem well in advance of the sale.

        The corporate tax-free exchange rules of the tax laws are among the most complicated in the Internal Revenue Code, but people have been dealing with them for decades and a solution is often available, as long as you leave yourself enough time and flexibility to find it.


        Written by Michael Savage, Esq.

        The information in this article is for general, educational purposes only and should not be taken as specific legal advice.