January 26, 2023
While regulatory developments around climate remained in the headlines, both the SEC and the CFPB reached back in time a bit for important announcements this week.
The SEC voted unanimously to return to some unfinished business since the Dodd-Frank Act in 2010 (and a follow-up proposal in 2011) with its consideration of a rule to prohibit conflicts of interest in certain securitization transactions.
And the CFPB restated its strong position on “negative option” programs, specifically targeting subscription services that trick or mislead consumers. As CFPB Director Rohit Chopra put it, “The CFPB has made it clear that misleading consumers about products or subscription services they don’t want is not only dishonest, but also a violation of law.”
We also look at the UK's new rules on Packaged Retail and Insurance-based Investment Products and, thanks to our Tax colleagues, offer some insights on cryptocurrency tax reporting.
This makes for quite an eclectic issue, and I welcome you to drop me a note here if there is anything you want to discuss.
Daniel Meade
Editor, Cabinet News and Views
The Securities and Exchange Commission (“SEC”) unanimously voted yesterday to re-propose a rule to prohibit conflicts of interest in certain securitization transactions. The SEC previously proposed, but never finalized, this rule in 2011. The rule is required by section 27B of the Securities Act of 1933 as added by section 621 of the Dodd-Frank Act. Comments on the proposal are due by March 27 (or possibly later if not published in the Federal Register by February 25 or if the comment period is extended).
Section 621 of the Dodd-Frank Act was an amendment to the Dodd-Frank Act mainly sponsored by Sen. Carl Levin after the Senate Permanent Subcommittee on Investigations, which he chaired, issued a report that found certain instances of the appearance of conflicts of interest between the sponsors of certain securitizations and their investors. The fact that 12 years have elapsed since the SEC originally proposed this rule may provide some evidence of how difficult it is to actually implement a workable rule in this space.
The proposed rule is designed to “prohibit securitization participants from engaging in certain transactions that could incentivize a securitization participant to structure an asset-backed security (ABS) in a way that would put the securitization participant’s interests ahead of those of ABS investors.” The SEC’s proposal would do this by prohibiting a “securitization participant” (generally the sponsor, initial purchaser, underwriter or placement agent of the asset-backed securities) from engaging in a “conflicted transaction.” The proposal defines a “conflicted transaction” as having two components: (1) being adverse to the ABS (i.e., entering into transactions where the securitization participant would benefit from the poor performance of the ABS, such as short sales of the ABS or purchase of credit default swaps on the ABS), and (2) being material to the investor in the ABS (i.e., whether the reasonable investor would consider the relevant transaction effected by the securitization participant important to the investor’s investment decision). As required by the statutory text, the proposed rule would exempt risk-mitigating hedging activities, bona fide market-making activities, and certain liquidity commitments.
Although the vote to issue the proposed rule for comment was unanimous, the Commissioners do not appear to have unanimity as to whether the proposed rule can strike the right balance. Commissioner Hester Peirce suggested that the proposed rule may be too vague, noting, for example, that the proposed rule’s definition of “sponsor” includes “entities that do not fit within the traditional definition of ‘sponsor’” and that the proposed rule is unclear regarding the type of activity that would constitute taking “substantial steps” for the purposes of becoming a securitization participant. Commissioner Mark Uyeda emphasized the need to balance protecting investors from conflicts of interest with “ensuring that market participants can engage in transactions that do not cause such harm.” Commissioner Uyeda expressed concern that the proposed rule does not strike this balance.
The Democratic appointees to the SEC − Chair Gary Gensler and Commissioners Caroline Crenshaw and Jaime Lizárraga − all expressed more support but await public comment. Commissioner Crenshaw, in a possible preemptive move, expressed skepticism at the use of information barriers, noting that commenters to the 2011 proposed rule opposed the use of information barriers given their limited utility and the difficulties associated with implementing, monitoring, and enforcing such information barriers.
We will have more to say on the SEC’s conflicts of interest proposal as we dig deeper into the proposal, so please be on the lookout for a more in-depth commentary from Cadwalader.
This week, the Consumer Financial Protection Bureau issued a Consumer Financial Protection Circular reminding financial institutions that are covered persons that negative option marketing, when not done correctly, can be a violation of the Consumer Financial Protection Act, pursuant to the CFPB’s authority to address unfair, deceptive or abusive acts or practices.
So-called negative option programs are those that have “a term or condition under which the seller may interpret a consumer’s silence, failure to take an affirmative action to reject a product or service, or failure to cancel an agreement as an acceptance or continued acceptance of the offer.” In other words, any program that has an automatic renewal feature is considered a negative option program. To pull in the dark patterns aspect, the CFPB focuses upon how such “dark patterns can be particularly harmful when paired with negative option programs, causing consumers to be misled into purchasing subscriptions and other services with recurring charges and making it difficult for consumers to cancel and avoid such charges.” In addition, the CFPB focuses upon negative option marketing plans that include a trial period, where “consumers receive products or services for free (or for a reduced fee) for a trial period” and then are automatically charged a fee on a recurring basis until they affirmatively cancel.
While the CFPB has brought enforcement actions that include negative option marketing issues, the Federal Trade Commission, the CFPB’s sister consumer protection federal agency, has been most active in the space, issuing this Policy Statement Regarding Negative Option Marketing in 2021. While neither agency forbids negative option marketing, both emphasize that the programs must be set up in a manner that is consistent with these principles:
- clear and conspicuous disclosure of the material terms of the negative option offer to the consumer;
- consumer’s informed consent is obtained (i.e., the consumer has affirmatively checked or clicked something to accept the trial period, or recurring charge), and
- cancellation methods are easy for the consumer to utilize, without unreasonable barriers to cancellation, or anything that would “[impede] the effective operation of promised cancellation procedures.
Specifically, the CFPB calls out the following material terms of a negative option offer that must be disclosed clearly and conspicuously:
- a statement “that the consumer is enrolling in and will be charged for the product or service”;
- the amount (or range of amounts) that the consumer will be charged.
- information that charges will occur on a recurring basis unless the consumer takes affirmative steps to cancel the product or service; and
- the period of time for any trial period, and the date on which charges will begin (or increase) after the trial period.
In terms of cancellation methods, conservative advice is that there should be symmetry between the medium through which the consumer signs up and the medium through which the consumer is required to cancel. In other words and for example, if consumers can sign up for the negative option program online, then consumers should be able to cancel online; if they can sign-up for the negative option program through the mobile app, then they should be able to cancel through the mobile app. Failure to have symmetry in this fashion is not immediately an unfair, deceptive or abusive act or practice, but it will cause the regulator to look more closely at the program.
On January 23, the Chairman of the Commodity Futures Trading Commission (“CFTC”), Rostin Behnam, announced in his keynote speech at the Commodity Markets Council’s annual conference that the CFTC “can play a role in voluntary carbon markets.” This is not the first time that the CFTC has publicly stated that it is considering its role vis-a-vis regulation of voluntary carbon markets (“VCMs”) or compliance carbon markets (“CCMs”), but it is the first time that the CFTC Chair has articulated a clear action plan for regulation. According to Chairman Behnam, carbon markets "must have integrity and adhere to basic market regulatory requirements."
Chairman Behnam’s comments are significant for a number of reasons.
First, the comments confirm the CFTC's authority to “play a role” in VCMs because carbon itself, as well as carbon and other environmental offsets, credits and allowances, generally are considered “commodities” as defined in § 1a(9) of the Commodity Exchange Act of 1936 (“CEA”) and as explained in CFTC and Securities and Exchange Commission (“SEC”) guidance. As a “commodity,” transactions involving carbon or carbon offsets as VCMs are subject to CFTC’s anti-fraud and anti-manipulation enforcement jurisdiction.
Second, because VCMs and CCMs are commodities markets, the CFTC not only “can” but is bound to police these markets pursuant to the CEA. In fact, a group of U.S. senators wrote to the CFTC in October 2022 directing the CFTC to take “concrete steps to implement rules governing the voluntary carbon offsets market, also referred to as carbon credits.”
Third, commodities originating in VCMs and CCMs are now also traded as listed futures and options contracts on CFTC-regulated designated contract markets – i.e., commodity exchanges. For example, the CME Group lists futures on California carbon allowances as well as Regional Greenhouse Gas Initiative CO2 allowances, and the ICE and Nodal exchanges list futures on commodities also traded on VCMs and CCMs in the U.S. and globally. Because futures and options on commodities qualify as contracts for future delivery (such as derivatives), the CFTC under the CEA not only has a role but also exclusive enforcement authority in these markets. Indeed, Chairman Behnam states that in these markets the CFTC’s “responsibility is real.”
Fourth, in light of recent COP27 announcements, as well as the goals of the White House National Climate Task Force, the U.S. government will have to become more actively involved in further development of VCMs and CCMs, and the CFTC would have to play a key role in these efforts, especially if there will be some form of a national cap-and-trade scheme. The CFTC has already taken steps to define its regulatory role in these markets.
So what does this all mean? There are two likely outcomes for the immediate future: (a) the CFTC’s division of enforcement will become more active in prosecuting fraud and manipulation in commodity or cash VCMs and CCMs (e.g., greenwashing, or fraud in claiming reduction in carbon capture or reduction), as well as in related exchange or OTC-traded derivatives markets, and (b) the CFTC will become more involved in regulation of these markets in the U.S. in coordination with other regulators and global initiatives (e.g., IOSCO).
Last week, the Federal Reserve Board (“FRB”) announced additional details on its pilot climate scenario analysis (“CSA”) involving six of the largest U.S. banks. The additional details include a Participant Instructions Document that calls for submissions by the participating banks by July 31, 2023. The FRB anticipates that it will publish insights and aggregate data from the exercise at the end of 2023. The FRB stated: “[t]his pilot CSA exercise will support the Board’s responsibilities to ensure that supervised institutions are appropriately managing all material risks, including financial risks related to climate change.”
As noted in the FRB’s announcement, the “CSA exercise comprises two separate and independent modules: a physical risk module and a transition risk module. Physical risks represent the harm to people and property that may result from climate-related events, while transition risks represent stresses that may result from the transition to a lower carbon economy.”
In the physical risk module, the FRB set a severe hurricane hitting the northeast of the United States as the common shock scenario. Each of the participating banks also were directed to select an idiosyncratic shock. The banks will apply those shocks to their residential and commercial real estate loan portfolios and analyze the direct and indirect impacts of such a shock on those portfolios. In the transition risk module, the FRB instructed banks to consider “the impact on corporate loans and commercial real estate portfolios using a scenario based on current policies and one based on reaching net zero greenhouse gas emissions by 2050.”
The FRB made clear that the “climate scenarios are neither forecasts nor policy prescriptions and do not necessarily represent the most likely future outcomes or a comprehensive set of possible outcomes.” The FRB went on to highlight the difference between this exercise and regulatory stress tests, noting that the CSA exercise “is exploratory in nature and does not have consequences for bank capital or supervisory implications.”
Notwithstanding the additional details the FRB has provided on the CSA exercise, the Federal Reserve continues to emphasize that, as Chairman Powell said last week, the FRB is not a climate policymaker. Vice Chair of Supervision Michael Barr was quoted in the press release reiterating those sentiments, stating that “[t]he Fed has narrow, but important, responsibilities regarding climate-related financial risks – to ensure that banks understand and manage their material risks, including the financial risks from climate change. . . . The exercise we are launching today will advance the ability of supervisors and banks to analyze and manage emerging climate-related financial risks.”
(This article originally appeared in Cadwalader Climate, a twice-weekly newsletter on the ESG market.)
The transitional period for the implementation of new scope rules and amendments to regulatory technical standards for Packaged Retail and Insurance-based Investment Products (“PRIIPs“) came to an end on 31 December 2022, meaning that the new rules and guidance set out in Policy Statement PS22/2 by the Financial Conduct Authority (“FCA”) are now in force. PRIIPs rules, guidance and technical standards are aimed at protecting retail investors in these packaged products, largely through the prescription of the content and form of pre-investment disclosures, which has proved problematic for product providers and distributors.
The changes chiefly address:
- a perceived lack of clarity of scope as to what is and is not a PRIIP − in particular, to make it clearer that certain features of corporate bonds make it unlikely that they will amount to PRIIPs;
- guidance on what it means for a PRIIP to be “made available” to retail customers, which may cause issuers to amend selling restrictions for packaged products that are not intended for the retail market but would otherwise be categorised as PRIIPs;
- problems in the methodologies for producing the required performance scenarios for the pre-investment disclosure Key Investor Document (“KID”) as well as the use of inappropriately low summary risk indicators and issues with the calculation of transaction costs; and
- an extension of time for regulated retail (UCITS) funds to continue to use the existing Key Investor Information Document (“KIID”) to 2026.
While it remains up to issuers to determine whether or not what they are producing is a PRIIP, guidance on bonds does describe some distinctions between PRIIP and non-PRIIP debt securities by setting out certain indicative and certain neutral criteria. In the former category, linkages or material dependencies on levels of interest, conditionality of principal repayment or issuer default risk to fluctuations in reference indices or benchmarks, reference asset value or performance, or the performance or value of investments held by an issuer or a connected person (such as a pool of receivables) look like PRIIPs’ features. In the neutral camp, though, are features such as fixed, floating or variable coupons and put or call options.
(This article was originally published in BrassTax, Cadwalader's monthly tax newsletter.)
The cryptocurrency industry may be breathing a sigh of relief following the release of recent IRS guidance on cryptocurrency tax reporting, which effectively postpones the January 1, 2023 effective date of the digital asset broker rules and reporting obligations enacted by the 2021 Infrastructure Investment and Jobs Act (the “Act”) under Sections 6045 and 6045A. See Announcement 2023-2 (the “Announcement”) linked here. While this effective delay may be good news for cryptocurrency market participants potentially subject to these reporting rules, retail cryptocurrency investors may not receive IRS Form 1099-Bs covering their cryptocurrency investments this tax season and so may need to continue to make do with the improvised system that the cryptocurrency industry has implemented in past years.
Prior to the Act, cryptocurrency market participants struggled with how the tax reporting rules of Sections 6045 and 6045A applied to cryptocurrency, as these rules were not drafted with cryptocurrency in mind. Thus, the cryptocurrency industry has been left to its own devices to answer such basic questions as (1) who must report (e.g., exchanges, miners, stakers, and others), (2) what must be reported (e.g., gross proceeds, tax basis, and other information), and (3) to whom must the reports be provided (e.g., IRS, customers, and others). With the delay of reporting rules, cryptocurrency tax reporting remains muddled, and the reporting itself will be a crazy quilt of ad hoc interpretations of existing law.
As amended by the Act, Sections 6045 and 6045A impose mandatory tax reporting requirements for brokers of certain digital asset transactions entered into after December 31, 2022. Section 6045 requires brokers to report on IRS Form 1099-B certain information about taxpayers, including names and addresses, as well as certain information about the property underlying the transaction, including the sale date and gross proceeds of a sale (and for so-called covered securities, the adjusted basis of the property sold and the character of any gain or loss) as well as furnish payee statements to customers. For transactions between brokers, Section 6045A further requires transferors of covered securities to furnish transfer statements to transferees. The Act expanded Section 6045’s definition of “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” Additionally, the Act provides that digital assets, defined as “any digital representation of value which is recorded cryptographically,” could be treated as covered securities.
Concern has been expressed that the Act’s broad definition of “broker” could subject many cryptocurrency market participants not traditionally viewed as brokers (e.g., miners, stakers, etc.) to reporting requirements as discussed here and in the legislative history to the Act linked here. As included in the Announcement, Treasury plans to provide further guidance on what constitutes a broker for purposes of Sections 6045 and 6045A, address the application of Sections 6045 and 6045A to digital assets, and provide forms for broker reporting. The Announcement provides interim relief in advance of the January 1, 2023 effective date and provides that until final regulations are published, digital asset brokers may rely on the law in effect as of the date of the Announcement, December 23, 2022 (i.e., prior law).
Pursuant to the Announcement, digital asset brokers may report the gross proceeds of certain sales and adjusted basis of property and may furnish statements on transfers of covered securities but will not be required to provide additional information with respect to dispositions of digital assets, issue additional statements, or file returns with the IRS on digital asset transfers. The Announcement does not, however, address the extent to which certain digital asset transactions may otherwise be subject to Sections 6045 and 6045A absent additional guidance. Thus, cryptocurrency market participants are left to decipher their reporting obligations under prior law. The IRS has provided no guidance to date on the applicability of existing regulations under Sections 6045 and 6045A to cryptocurrency specifically. As a result, the cryptocurrency industry and specifically cryptocurrency exchanges have been left to review the existing guidance under Sections 6045 and 6045A, which was not specifically designed to address cryptocurrency transactions, in order to ascertain their reporting obligations, if any. Accordingly, the reporting provided by cryptocurrency exchanges is not uniform in the marketplace, and many exchanges do not provide IRS Form 1099-Bs to their customers.
Clarity may be coming soon as a draft of proposed regulations is currently under review by the Office of Management and Budget. While the content of these regulations remains uncertain, it seems plausible that the regulations may narrow the definition of “broker” as Treasury indicated in a letter to various U.S. senators in February 2022 that ancillary parties such as stakers or miners, persons selling storage devices, and persons writing code should not be subject to reporting requirements. The regulations will also likely address issues inherent in cryptocurrency reporting − namely, the decentralized nature of cryptocurrency, that may make compliance with the broker reporting rules onerous. That is, in many cryptocurrency transactions, it is unlikely that either party may have the requisite information (e.g., names or addresses) or access thereto as the ledger does not provide this information. If Treasury’s earlier statements are any indicator, it is likely that future guidance will provide some comfort for the cryptocurrency industry.
Until these regulations are finalized, some cryptocurrency customers currently receiving IRS Form W-2s for wages and IRS Form 1099-INTs for interest may not be receiving IRS Form 1099-Bs for their cryptocurrency investments. For now, it is status quo ante for cryptocurrency tax reporting.