Comment period on large SBS position reporting reopened

By Rodney F. Tonkovic, J.D.

The SEC has reopened the comment period for a proposed rule requiring position reporting of large security-based swap positions. New Rule 10B-1 would require anyone with a security-based swap position exceeding a certain threshold to file a schedule disclosing certain information about that position. The comment period has been reopened to allow comment on additional analysis and data contained in a staff memorandum. The comment period for the proposing release, No. 34-93784, is reopened for 30 days after publication in the Federal Register or August 21, 2023, whichever is later (Reopening of Comment Period for Position Reporting of Large Security-Based Swap Positions, Release No. 34-97762, June 20, 2023).

Proposed rule. The Commission proposed Rule 10B-1 on December 15, 2021, in Release No. 34-93784: Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers; Position Reporting of Large Security-Based Swap Positions. The proposing release contained additional rules which were adopted on June 7, 2023. The Commission noted that it was not finalizing Rule 10B-1 in that release because it was still continuing to consider comments received in connection with the proposed rule.

As proposed, Rule 10B-1 would require any person with a security-based swap position exceeding a certain threshold to promptly file with the Commission a new Schedule 10B disclosing, among other items:

• the applicable security-based swap position;
• positions in any security or loan underlying the security-based swap position; and
• positions in any other instrument relating to the underlying security or loan, or group or index of securities or loans.

The proposed rule includes different reporting thresholds for security-based swaps tied to debt securities and security-based swaps tied to equity securities. The filings received pursuant to proposed Rule 10B-1 would be made available to the public, with the goal of increasing transparency and oversight in the security-based swap market.

DERA memo. The staff of the Division of Economic and Risk Analysis has prepared a memorandum providing supplemental data and analysis related to the anticipated economic effects of the proposed rule. The memo notes in particular that at the time of the proposal, the Commission had access to only one month of security-based swap data reported to registered security-based-swap data repositories ("SBSDRs") pursuant to Regulation SBSR and that this data was not used in the proposal. The memo's analysis incorporates equity security-based swap data reported to SBSDRs and information from Schedule 13D filings from November 1, 2021, through November 25, 2022. Given the information in the memo, the Commission specifically seeks comment on whether the proposed rule's reporting threshold amounts should be higher or lower.

This is Release No. 34-97762.

Third Circuit grants SEC four months in Coinbase crypto rulemaking lawsuit

By Lene Powell, J.D.

The Third Circuit gave the SEC a breather in a closely watched lawsuit related to crypto assets, ordering the SEC to update the court on October 11 on how it is handling Coinbase’s petition for rulemaking on crypto assets. The court said it will retain jurisdiction in the meantime (In re Coinbase, Inc., June 20, 2023, Krause, C.).

Coinbase had asked the court for a writ of mandamus to force the SEC to respond to its petition. The SEC said this is unnecessary and it is considering the petition “in the ordinary course.”

The court’s order could help calm crypto industry turmoil, providing an outer bound on when the SEC will respond yea or nay on rulemaking to clarify how the securities laws apply to crypto assets. The order also gives space for the SEC as it pursues a major enforcement action against Coinbase.

Coinbase rulemaking petition. Crypto giant Coinbase filed a rulemaking petition with the SEC last July. Coinbase says regulatory clarity is overdue for the crypto industry and the SEC is engaging in “rulemaking by enforcement.”

In its Third Circuit petition for writ of mandamus, Coinbase contends the SEC has already decided to deny the petition but has not revealed this publicly. The crypto company points to statements by SEC Chair Gary Gensler that “the rules are already clear.” Coinbase also cites the SEC’s enforcement action against it as “smoking-gun evidence” that the SEC is not seriously entertaining the rulemaking petition.

The SEC says it has not decided what action to take on the petition and its ongoing consideration is reasonable.

A three-judge panel previously ordered the SEC to inform the court whether it has decided to deny the Coinbase petition, and to show cause why the SEC should not be ordered to submit periodic reports.

SEC enforcement action. Coinbase’s action in the Third Circuit is playing out alongside an SEC enforcement action against Coinbase in the Southern District of New York. The SEC has charged Coinbase with operating as an unregistered securities exchange, broker, and clearing agency, as well as the unregistered offer and sale of securities.

Court grants four months. For now, the panel declined to rule on Coinbase’s petition for writ of mandamus, though it retained jurisdiction.

The panel cited the SEC’s indication that staff expects to submit a final recommendation to the Commission on the rulemaking petition within 120 days.

The court ordered the SEC to update the court on its status on October 11, 2023.

This is case No. 23-1779.

Petition asks SEC to amend protections from prohibited personnel practices

By Rodney F. Tonkovic, J.D.

The National Treasury Employees Union has submitted a petition to the SEC to extend the protection afforded to federal employees. Federal law protects most federal employees from "prohibited personnel practices." The NTEU's petition would have the SEC extend that protection to two categories of employees not covered by the current regulations.

Prohibited practices. Federal law, under 5 U.S.C. Section 2302, protects federal employees from "prohibited personnel practices." This means protection from personnel actions motivated by discrimination, reprisal, political coercion, improper influence, or obstruction of rights. There is, however, a category of employees who fall outside the statute's coverage. The NTEU's proposal would extend coverage to these employees: those who are excepted from the competitive service because (1) their position is of a confidential, policy-determining, policy-making, or policy-advocating character; or (2) their position is excluded from the competitive service by a President based on a determination that such exclusion is necessary and warranted by conditions of good administration (see 5 U.S.C. Section 2302(a)(2)(B)(i)-(ii)).

Proposed protection. Subpart M of 17 CFR part 200 contains regulations concerning the conduct of members and employees and former members and employees of the Commission. The NTEU proposes to add a new subsection (i) to 17 C.F.R.200.735-3, which contains general provisions about conduct. Among other directives, Section 200.735-3 provides that Commission personnel comply with conduct requirements broadly applicable to all public servants. There are also Commission-specific provisions, such as prohibitions against engaging in business transactions for personal profit and divulging Commission documents before their release.

Proposed new Subsection 200.735-3(i) would apply to "covered employees," meaning those excepted service employees in 5 U.S.C. Section 2302(a)(2)(B)(i)-(ii). If adopted, the provision would prevent the SEC from taking personnel action against covered employees based on the same prohibited personnel practices that apply to other federal employees. The new subsection also sets out the process by which a claim may be raised.

The proposal notes that the SEC has broad authority to promulgate regulations and that nothing restricts the agency from extending protection against prohibited personnel practices to additional groups of employees. The NTEU also observes that President's Trump's administration explicitly expanded prohibited personnel practice protections to the very category of excepted service employees that NTEU’s proposal covers, but this order was rescinded by the next administration. Some agencies, however, have already promulgated the types of regulations proposed by the NTEU.

The petition is No. 4-805.

SIFMA voices opposition to SEC’s plan to extend Reg. SCI to broker-dealers

By John Filar Atwood

The Securities Industry and Financial Markets Association (SIFMA) strongly opposes the SEC’s proposed extension of Reg. SCI to broker-dealers, a group for which the regulation was not originally designed. In a comment letter to the Commission, SIFMA outlined multiple objections, including that entities subject to Reg. SCI serve different roles in the markets than broker-dealers and operate under different regulatory expectations regarding their availability and accessibility.

Reg. SCI was adopted in 2014 to strengthen the technology infrastructure of the securities markets, and applies to certain self-regulatory organizations such as stock and options exchanges, registered clearing agencies, FINRA, and the MSRB. It also applies to alternative trading systems that trade NMS and non-NMS stocks exceeding specified volume thresholds, disseminators of consolidated market data, and certain clearing agencies.

In March, the SEC proposed to expand and update Reg. SCI by, among other things, extending it to registered security-based swap data repositories, all clearing agencies that are exempt from registration, and certain large broker-dealers that exceed a total assets threshold or a transaction activity threshold in national market system stocks, exchange-listed options contracts, U.S. Treasury securities, or Agency securities.

SIFMA’s managing director noted that the proposed expansion of Reg. SCI does not address the distinctions the Commission recognized when originally setting the scope for the regulation. In addition, he argued that SIFMA’s members have already developed robust technological resiliency as a result of the various existing regulatory obligations to which they are subject, and have done so without the imposition of the requirements of Reg. SCI.

Thresholds. In its comment letter, SIFMA argues that the proposed asset and trading thresholds to capture broker-dealers are not the appropriate means by which to impose Reg. SCI’s requirements, especially where the SEC has not explained how the proposed thresholds are an appropriate proxy for operational risk.

In SIFMA’s opinion, the actual experience of how the market operates undercuts any potential Commission justification for imposing Reg. SCI on broker-dealers, including that broker-dealers are generally easily substitutable for one another in the market and that buyside firms routinely diversify using multiple broker-dealers and sources of liquidity. In addition, SIFMA believes the SEC should address the fact that the proposed thresholds impose burdens on certain broker-dealers and not others, and consider how the proposed thresholds would impose significant compliance burdens on brokers.

SIFMA also warns that the by expanding Reg. SCI from systems facilitating trading to include systems that do the trading itself, the proposal creates a requirement that proposed SCI broker-dealers engage in trading by committing capital and taking on principal risk. The Commission offers no rationale for this fundamental change and fails to analyze its consequences, SIFMA said.

Not designed for brokers. SIFMA points out that Reg. SCI was originally designed to cover vital systems of entities that represent the critical trading infrastructure, including certain trading venues, entities essential to providing real-time market data, and entities that clear and settle securities transactions. Systems failures of these entities are what prompted Reg. SCI, SIFMA notes. In its view, when Reg. SCI is applied to broker-dealers, many of the core concepts and obligations of the original rule are unsuitable and unworkable.

SIFMA also objects to the compliance costs that will be imposed by the proposed changes. The association believes that the proposal does not justify the costs and cites no evidence that Reg. SCI is needed to solve an existing regulatory gap or that it would produce any net improvement in systems integrity for broker-dealers.

Third-party providers. SIFMA argues that its members already maintain robust third-party management programs and require the contracted service provider to adhere to applicable legal and regulatory obligations. A principles- and risk-based approach is crucial to ensure such programs are efficient and sustainable, SIFMA said, but the proposal would take a prescriptive approach that may disincentivize the use of third-party providers or limit the provision of certain valuable services.

On the issue of third-party relationships, SIFMA recommends that the Commission adopt a similar approach to the federal prudential regulators’ interagency guidance. That guidance acknowledges potential limitations and challenges in negotiating certain rights or gaining access to certain information, and grounds its expectations in the adoption of a risk-based approach throughout the entire third-party relationships lifecycle, according to SIFMA.

SIFMA also recommends that the SEC examine the experience and costs of Reg. SCI entities since its adoption and apply that knowledge before expanding the scope of Reg. SCI or adding additional requirements. The proposal lacks any concrete examples, SIFMA notes, where current Reg. SCI requirements have provided the Commission or the public with beneficial information that it has received and found actionable in any real-time way.

In reality, SIFMA said, Reg. SCI requirements have caused entities to divert resources from addressing potential issues merely to meet the arbitrary timeframe for certain reporting requirements. Nevertheless, the proposal seeks to prioritize reporting speed over system resiliency and recovery, in SIFMA’s opinion.

Former directors could not rely on Schnell’s equitable principles to delay annual shareholders’ meeting date

By Mark S. Nelson, J.D.

A group of former directors on the board of Cano Health, Inc. were not entitled to a preliminary injunction requiring the company to waive its advance notice bylaw regarding its changed annual shareholder meeting date because, under a subset of cases applying the Schnell doctrine, the accelerated meeting date did not constitute a radical change of position by the company or a material change in circumstances. The former directors had sought to oust the company’s CEO and force the sale of the company. Ultimately, several Cano directors resigned, an action the company disagreed with via press release as focusing too much on short-term goals and too much on actions alleged to have been taken by the company’s CEO/Chair. The company did eventually split the CEO and Chair roles and, upon winning in the Chancery Court, proceeded to hold its annual shareholders’ meeting (Sternlicht v. Hernandez, June 14, 2023, Fioravanti, P.).

Focus on CEO and selling Cano. The several former directors, one of whom whose term would have expired at the 2023 annual meeting, objected to how Cano co-founder and CEO/Chair Dr. Marlow Hernandez conducted himself regarding a pledge of securities and several loan arrangements involving Hernandez and Hernandez’s wife. Cano became a public company via a de-SPAC transaction with JAWS Acquisition Corp. in June 2021. The former directors held 35.7 percent of Cano’s voting power.

The former directors, in addition to the various dealings of Hernandez, also were concerned that Cano could not be effectively sold because they believed Hernandez had told two potential suitors that Cano was not for sale. As a result, the former directors planned a two-phase strategy: (1) in phase I they would demand an auction coupled with the removal of Hernandez as CEO; if this approach failed, they would engage in a “noisy resignation” aimed at getting the remainder of the Cano board to back them; (2) in phase II, the former directors would conduct a proxy contest, threaten litigation, sell their shares to a buyer interested in conducting a proxy contest, or some combination of these alternatives.

At the heart of the former directors’ preliminary injunction suit was the fact that Cano moved up the date of its annual shareholders’ meeting by several weeks and set a new record date. The former directors eventually began the process of planning for a proxy contest but abided by several self-imposed delays amounting to several weeks before seeking to nominate their own slate of directors. The Chancery Court held expedited proceedings and ruled in favor of Cano shortly before the mid-June 2023 annual shareholders’ meeting date.

Schnell and radical business changes. The legal aspects of the case turned on an application of the equitable doctrine announced in the well-known case of Schnell v. Chris-Craft Industries, Inc. (Del. 1971). That doctrine holds that equity may enjoin corporate activities (oftentimes involving changed shareholder meeting dates) even if the action would be legal because the effect of the action is somehow unfair (i.e., “…inequitable action does not become permissible simply because it is legally possible.”). Here, the vice chancellor set aside other potential theories not properly raised by the parties and focused solely on the former directors’ reliance on a subset of legal principles that are part of the Schnell doctrine.

Specifically, the former directors relied on Hubbard v. Hollywood Park Realty Enters., Inc. (Del. Ch. Jan. 14, 1991), dealing with the right to nominate a competing slate of directors, a corollary to the more general and fundamental corporate right to vote. The process of conducting director nominations is, under Delaware law, typically addressed by companies through the adoption of advance notice bylaws. The court in Hubbard concluded that a company would have to waive its advance notice bylaw per the Schnell doctrine if, once the nomination deadline had elapsed, there was a “radical shift in position, or a material change in circumstances” regarding the company’s business.

To obtain a preliminary injunction, Cano’s former directors would have to show a reasonable probability of success on the merits of their claims, irreparable harm if no injunction is issued, and that the balance of harms tips in their favor. The Chancery Court easily found that the last two requirements were not satisfied because the only harm to the former directors was “self-imposed,” and the balance of harms tipped in favor of the corporate defendants. As result, the vice chancellor emphasized the various permutations of Hubbard and how the former directors failed to show they could win on the merits.

In making this latter determination, the court said multiple factors ran against the former directors. For one, the former directors knew of a committee chairs meeting before the February 2023 deadline. Claims that four Cano directors formed a “Shadow Board” were insufficient because the claimed failings did not involve board action and the claims were otherwise speculative. The formation of a post-deadline special committee was not a radical shift in position, or a material change in direction, added the court. Likewise, a March 2023 decision by the company to retain Hernandez as CEO but not as Chair was not a radical shift in position or a material change in direction of the business. Moreover, the appointment of a new chair did not materially change the company’s operations and management, nor did the various dealings of Hernandez’s wife change the company’s path.

For these reasons, the court concluded that the former directors were not entitled to a preliminary injunction to forestall Cano’s annual shareholders’ meeting. In reaching this conclusion, the court further determined that the former directors’ multiple, self-imposed delays in seeking relief were unreasonable.

The case is No. 2023-0477-PAF.

Small business capital formation panel weighs economic impact of high rates, regional banking, startup funding

By Suzanne Cosgrove

Addressing a meeting Wednesday of the SEC’s small business advisory committee, Chairman Gary Gensler enumerated the group’s discussion priorities: providing feedback on the effect of rising interest rates and the challenges of regional banks on small businesses, looking at the increased use of predictive data analytics and how these technologies are changing funding practices and availability, and addressing funding gaps for underrepresented startups.

“That input, formal and informal, helps us advance our mission-- including with regard to capital formation for small businesses,” Gensler said.

Exploring legal obstacles. SEC Commissioner Mark Uyeda also asked committee members to weigh in on whether small business owners, especially those located in more rural areas, have access to the quality legal services necessary to help them understand their capital raising options.

“Has the Securities Act’s regulatory framework for registration exemptions become too complicated, and if so, how can it be simplified?” Uyeda asked in prepared remarks. “What are the common foot faults in compliance – before, during, and after the offering?”

Challenges for underrepresented founders are widely recognized, Uyeda said. “As we search for ways to address these challenges, how can the Commission ensure that its future regulations do not exacerbate the problem?” he asked. For example, would increasing income and net worth thresholds in the “accredited investor” definition, as the SEC has discussed, make it even more challenging for underrepresented founders to obtain funding?

Capital access limits. Commissioner Jaime Lizárraga, who also spoke to the committee, noted a recent report by the Small Business Advocate, stating that 78 percent of the entrepreneurs surveyed reported that access to capital limits their day-to-day operations, 89 percent said that barriers to accessing capital limit their business growth potential, and 73 percent of owners sought support in preparing to apply for and use business financing.

Bridging gaps between entrepreneurs and investors remains the biggest challenge for early-stage startups when raising capital, Lizárraga said, with 40 percent of entrepreneurs finding it challenging to find a lead investor.

But Lizárraga said he remains optimistic. “New and innovative solutions can help address funding gaps for the 94 percent of small businesses that are in need of access to growth capital but have not sought to do so through equity investments,” he said.

“While many of the solutions may take time to develop, there is also low-hanging fruit that can easily be harvested right now,” he added. That includes basics like making information about how disadvantaged businesses can benefit from the securities law framework more available to owners, Lizárraga said.

Proposed expanded definition of ‘exchange’ draws ire from crypto commenters

By Suzanne Cosgrove

The SEC’s reopening of the comment period for its proposal to amend its definition of an exchange drew a flood of responses this week ahead of its closing. Numerous individuals and crypto industry firms weighed in with sharp criticism of the SEC’s amendment reopening and supplemental information, and a group of U.S. House members charged the SEC with attempting to “front-run” Congress while House committee members worked on crypto legislation.

“Last year, the Committee on Financial Services sent a letter to Chair Gensler expressing our concern that the Commission’s attempt to expand the definition of an exchange to include ‘Communication Protocol Systems’ exceeded its statutory authority,” wrote Patrick McHenry (R-N.C.), chairman of the House Committee on Financial Services, and French Hill (R-Ark.), the committee vice chairman. “With this re-opening, it is clear that the Committee’s initial concerns were valid,” they said.

“Given the questions included in the Proposed Rule, it is incredibly problematic that the SEC is attempting to propose amendments on a topic that it is still seeking to understand without direction from Congress. … we respectfully request that the SEC withdraw this rulemaking,” the congressmen concluded.

Industry response. In a letter dated June 13, the Crypto Council for Innovation noted it had previously requested that the Commission clarify whether its original proposal covered crypto and DeFi protocols, and, if it did, to re-propose it in accordance with the Commission’s statutory requirements under the Administrative Procedure Act (APA), the Exchange Act, and the Paperwork Reduction Act.

“However, we remain very strongly of the view that the Re-Proposal (the subsequent amendment submitted this year) continues to suffer from significant, and even potentially fatal flaws under the APA and the Exchange Act,” the Council stated. The group called the re-proposal “impermissibly vague,” neglecting to provide clarity for crypto trading platforms and market participants. In particular, the Council said the re-proposal failed to give fair notice of what conduct is subject to liability and did not provide sufficient guidance on when a person would be a member of a group operating an exchange.

Keeping pace. Amid a wave of criticism from the crypto industry, the SEC’s proposal found support from the non-profit organization Better Markets. “We believe the Commission has developed a strong proposal that would represent another important enhancement and incremental step in the oversight of exchanges and ATSs,” Better Markets said. “If adopted, it will help the Commission’s regulatory framework keep pace with the increased use of electronic trading venues and innovations in facilitating the purchasing and selling of securities in our markets.”

Further, Better Markets noted the proposal reiterates the standing position of the Commission, “expressed on numerous occasions,” that trading systems that bring together multiple buyers and sellers of cryptocurrency securities using established, non-discretionary methods meet the definition of an “exchange” under Section 3(a)(1) of the Exchange Act and Exchange Act Rule 3b-16(a) and are subject to the exchange regulatory framework.

The group also observed the 2023 proposal acknowledged that the amendments to Regulation ATS in the 2022 proposal would potentially require additional cryptocurrency securities exchanges to register as national exchanges, specifically those that “offer the use of non-firm trading interest and provide non-discretionary protocols to bring together buyers and sellers of crypto assets securities.”

Criticism redux. While the SEC’s amendments drew fire from crypto affiliates, other groups took issue with elements of the Commission’s initial focus. Market maker and stock exchange member Virtu Financial, for example, said the Commission failed to consider the economic consequences of the proposal – both the benefits and the costs – in the original amendment and in its recent supplement. Virtu called the proposed amendments to Reg ATS and Reg ATS-N “unwarranted,” and alleged the changes would harm the marketplace.

As reported in January 2022, the Commission re-proposed amendments to Regulation ATS that would include significant Treasury market platforms within the regulation's coverage. Amendments eliminating the Regulation ATS exemption for alternative trading systems trading U.S. government securities were first proposed in September 2020.

Mixed review. The Securities Industry and Financial Markets Association (SIFMA) said it supported the SEC’s goal of ensuring that its rules keep pace with technological and market developments, and its proposal to extend existing regulatory requirements to government securities ATSs.

But SIFMA added that the group and its members continued to have significant concerns with aspects of the proposal, especially the far-reaching implications of the proposed amendments to Rule 3b-16 and the inclusion of the amorphous term “communication protocol systems” within the definition of “exchange.”

SIFMA also said it opposes requiring ATSs operated by the same or affiliated broker-dealers to aggregate their transaction volume for purposes of calculating fair access volume thresholds.

The proposed rule presents “significant” compliance challenges for newly designated ATSs that cross certain volume thresholds, and for some existing government securities ATSs, the group said. “Moreover … the Commission has indicated that there may be additional changes in store for the Regulation SCI regime, which will have further consequences for the ability of affected entities to come into and remain in compliance with this challenging set of requirements.”

According to the SEC, Regulation SCI aims to reduce the occurrence of systems issues, improve resiliency when systems problems occur, and enhance the Commission’s oversight of securities market technology infrastructure. Reg SCI applies to the systems of SCI entities—SROs, stock and options exchanges and alternative trading systems—that support any one of six securities market functions: trading, clearance and settlement, order routing, market data, market regulation and market surveillance.

SEC, NASAA, FINRA to hold joint educational session on financial exploitation on June 15

By Lene Powell, J.D.

On June 15, the SEC, North American Securities Administrators Association (NASAA) and FINRA will cohost a webinar on the financial exploitation of senior citizens and other vulnerable adults. The event builds on SEC, NASAA and FINRA’s joint training released in 2021.

The Senior Safe Act Webinar: Identifying and Reporting Suspected Exploitation will include a Q&A portion and is open to the public.

Senior Safe Act. The Senior Safe Act was signed into law on May 24, 2018. The act protects covered financial institutions from civil liability for reporting potential exploitation of a senior citizen to a covered agency.

NASAA, the SEC, and FINRA released a training program in June 2021, “Addressing and Reporting Financial Exploitation of Senior and Vulnerable Adult Investors,” to assist securities firms in implementing the act’s training requirements.

June 15 webinar. The webinar will be held on World Elder Abuse Awareness Day. It serves as a resource for firms implementing the requirements of the Senior Safe Act and Connecticut state training requirements, and satisfies state training requirements in Florida, Nevada, New Mexico, Puerto Rico, and Washington.

Registration details are available on the FINRA website.

Attorney to disgorge $180,000 for helping board chairman hide stock ownership

By Anne Sherry, J.D.

An attorney settled SEC charges of violating the ’33 and ’34 Acts by helping a public-company chairman sell restricted stock into the markets. The attorney (and the chairman) violated disclosure rules requiring them to report their beneficial ownership of the stock. For these violations, and in light of his cooperation, the attorney was ordered to disgorge $182,000, cease and desist from future violations, and be barred from practicing before the Commission or participating in any penny-stock offering (In the Matter of Daniel V. Martinez, Esq., Release No. 33-11203, June 8, 2023).

Beginning in 2011, the chairman arranged with the respondent to hold and sell millions of shares in the penny-stock companies he chaired. The respondent formed an LLC for this purpose and then signed a stock purchase agreement on the LLC’s behalf. This agreement falsely represented that the LLC was acquiring the shares as principal for its own account and that no one else had a beneficial interest in the shares. In fact, though, the shares were acquired primarily for the chairman, who shared beneficial ownership with the respondent.

Beginning in 2013, to induce brokerage firms to remove the shares’ restricted legends, the respondent falsely represented that he was the sole beneficial owner of LLC and not affiliated with the company. He eventually sold the shares, keeping 5 percent of the proceeds as his fee.

This scheme continued with another penny-stock company and a new LLC through 2017. At no time did the respondent file a Schedule 13D disclosing the agreements with the chairman or their combined holdings in the issuers. Similarly, he aided and abetted the chairman’s disclosure failures.

The SEC considered the respondent’s cooperation. The Commission ordered him to cease and desist from future violations, barred him from participating in any offering of a penny stock, and denied him the privilege of practicing as an attorney before the SEC. The order also imposed disgorgement of about $150,000 plus interest of $30,000.

This is Release No. 33-11203.

SEC adopts new rules on security-based-swap fraud and preventing interference with CCOs

By Rodney F. Tonkovic, J.D.

The SEC has adopted two new rules affecting security-based swaps. New Exchange Act Rule 9j-1 is meant to prevent fraud, manipulation, and deception in connection with security-based swap transactions. New Rule 15fh-4(c) prohibits personnel of an SBS entity from coercing, misleading, or otherwise fraudulently influencing the SBS entity's Chief Compliance Officer. The rules will be effective 60 days after publication in the Federal Register (Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition Against Undue Influence over Chief Compliance Officers, Release No. 34-97656, June 7, 2023).

The adoption of these two rules fulfills a mandate set out by Congress in Section 763 of the Dodd-Frank Act. Section 763(g) requires the Commission to adopt rules to prevent fraud, deception and manipulation in connection with security-based swaps. Chair Gensler pointed out that these new rules mark the completion of 28 rules related to the SBS market since Dodd-Frank passed 13 years ago. This leaves the Commission with two outstanding rulemakings related to Dodd-Frank authorities regarding security-based swaps, one of which relates to swap execution facilities.

The other remaining Dodd-Frank rulemaking involves new Rule 10B-1. The original proposal containing the newly adopted rules also included proposed new Rule 10B-1 requiring any owner of a security-based swap position exceeding the threshold amount set by the rule to file a statement on EDGAR containing the information required by Schedule 10B. The final release states that the Commission is not yet finalizing Rule 10B-1 because comments are still coming in on it.

According to the Commission, the SBS market, which in late 2022 had a gross notional amount outstanding of approximately $8.5 trillion, provides opportunities and incentives for misconduct. "Any misconduct in the security-based swaps market not only harms direct counterparties but also can affect reference entities and investors in those reference entities," said Chair Gensler. "Given these markets’ size, scale, and importance, it is critical that the Commission protect investors and market integrity through helping prevent fraud, manipulation, and deception relating to security-based swaps. Today’s set of rules will do just that."

Swaps antifraud rule. New Exchange Act Rule 9j-1 prevents fraud, manipulation and deception in connection with SBS transactions. Specifically, the rule includes prohibitions on categories of misconduct prohibited by Exchange Action Section 10(b) and Rule 10b-5 and Securities Act Section 17(a) when effecting a transaction or purchasing or selling any SBS. The rule is designed to account for the fundamental features of security-based swaps and includes a provision prohibiting the manipulating or attempted manipulation of the price or valuation of any security-based swap or any related payment or delivery.

The rule also provides that a person cannot escape liability for insider trading by communicating about or making purchases or sales in the security-based swap (as opposed to the underlying security) or vice versa: liability cannot be avoided by purchasing the underlying security in connection with a fraudulent scheme involving an SBS.

Rule 9j-1 also provides two affirmative defenses from liability: (1) if an otherwise prohibited action is taken in good faith in accordance with binding rights and obligations in written security-based swap documentation and the swap was entered into before the person became aware of the material nonpublic information; and (2) if an entity demonstrates that the individual at the entity making the investment decision was not aware of material nonpublic information and the entity had implemented reasonable policies and procedures to prevent violations of the rule.

Commissioners Peirce and Uyeda, who voted against the rules, both took issue with the final Rule 9j-1. Commissioner Peirce said that the final rule did not address any of the concerns she raised about the proposed version. Among other concerns, Peirce said that the rule is overly broad and that the affirmative defenses do not provide market participants with sufficient clarity. Firms will have to guess what the Commission feels is relevant, she said.

Commissioner Uyeda remarked that the rule does not in fact sufficiently take into account the special features of security-based swaps. The release should have been, but was not, crystal clear about what Rule 9j-1 covers that is not already covered by the existing antifraud provisions. Uyeda noted that a violation of the rule depends on the "facts and circumstances," but there are not sufficient specifics about what a fraudulent act is in the SBS context.

Compliance officers. New Exchange Act Rule 15fh-4(c) will prohibit any SBS personnel from taking any action to manipulate or otherwise interfere with the SBS entity's CCO in the performance of their duties. While recognizing that the ultimate responsibility for compliance rests with the SBD entity itself, this rule highlights the important role CCOs play in preventing fraud and manipulation by SBS entities and their personnel. While commenters argued that certain ambiguities in the scope of the rule could have a chilling effect on communications between the CCO and SBS personnel, the Commission declined to make any revisions in the proposed rule, stating that the rule must be broad enough to apply to any actions that might undermine the independence and responsibilities of the CCO.

The release is No. 34-97656.

PCAOB proposes increasing requirements for auditor vigilance

By Anne Sherry, J.D.

Amendments proposed by the PCAOB would increase auditor vigilance against fraud and other noncompliance with laws and regulations. The proposal would strengthen auditors’ requirements to identify, evaluate, and communicate possible or actual noncompliance, even if the effect on the financial statements is only indirect. Comments on the proposal are due August 7 (Amendments to PCAOB Auditing Standards related to a Company’s Noncompliance with Laws and Regulations, PCAOB Release No. 2023-003, June 6, 2023).

Current PCAOB standards require the auditor to identify noncompliance with laws and regulations that have a direct and material effect on the financial statements, but they don’t say much about identifying other noncompliance that only indirectly affects the financial statements. The proposed amendments do away with this distinction between “direct” and “indirect” effects. Even so-called indirect effects like violating anti-money-laundering or environmental regulations can lead to substantial fines and penalties, ultimately harming investors, the Board reasoned.

The Board believes that improving auditing standards can both protect investors and improve audit quality: “By catching and communicating noncompliance sooner, auditors can help companies course correct and better protect investors from risk,” said PCAOB Chair Erica Y. Williams. The proposal aims to achieve this by shoring up PCAOB rules in three respects:

• Identify. The proposal would require auditors to inquire and otherwise proactively identify applicable laws and regulations that could have a material effect on the financial statements. Financial statement fraud is explicitly called out as a type of noncompliance.
• Evaluate. The amendments would strengthen requirements for evaluating whether noncompliance has occurred and, if so, the possible effects. An auditor would be required to consider if specialized skill or knowledge is needed to assist the auditor in making this evaluation.
• Communicate. The proposal would make it clear that the auditor must communicate with management and the audit committee as soon as the auditor is aware of the potential or actual noncompliance. The amendments would create a new requirement that the auditor communicate the results of the auditor’s evaluation of this information, specifically addressing which matters are likely noncompliance and the effect on the financial statements.

If the Board does adopt the proposed amendments, it will ask the SEC to make a JOBS Act determination that it is in the public interest to apply the new rules to audits of emerging growth companies.

Affected provisions. The proposal would replace AS 2405, Illegal Acts by Clients, and retitle it A Company’s Noncompliance with Laws and Regulations. Some auditing and related professional practice standards would be amended, including AS 2110, Identifying and Assessing Risks of Material Misstatement. Finally, the amendments would rescind AS 6110, Compliance Auditing Considerations in Audits of Recipients of Governmental Financial Assistance; AI 13, Illegal Acts by Clients: Auditing Interpretations of AS 2405; and AI 21, Management Representations: Auditing Interpretations of AS 2805.

This is PCAOB Release No. 2023-003.

SEC amendments remove credit ratings from Regulation M

By Jay Fishman, J.D.

The SEC has adopted rule amendments to federal Regulation M that replace credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities with a default probability for nonconvertible debt securities and nonconvertible preferred securities. Additionally, the Commission has adopted a record preservation provision for broker-dealers who rely on the new amendments. The final rule satisfies a Dodd-Frank Act Section 939A(b) requirement.

Regulation M credit rating removal and replacement. Federal Regulation M is a set of rules that preserve the pricing integrity of the securities trading markets by prohibiting issuers, selling security holders, distribution participants, and their affiliated purchasers from conducting activities that could artificially influence the market for an offered security. Regulation M’s Rules 101(c)(2) and 102(d)(2) currently except nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities that are rated investment grade by at least one nationally recognized statistical rating organization.

What Dodd-Frank mandated in 2010 and what the SEC has just accomplished with the amendments is:

• Remove from Regulation M Rule 101 and 102 certain exceptions that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-back securities;
• Replace those exceptions with—for nonconvertible debt securities and nonconvertible preferred securities—a probability of default of 0.055 percent or less, estimated as of the sixth business day immediately preceding the determination of the offering price, over the horizon of 12 full calendar months from that day; a distribution participant acting as lead manager would make that determination in writing using a “structural credit risk model” that Regulation M Rule 100 has newly defined. Also, new Rules 101(c)(2)(ii) and 102(d)(2)(ii) except asset-backed securities offered in accordance with an effective shelf registration statement filed on Commission Form SF-3; and
• Require broker-dealers relying on the new exception for certain nonconvertible debt securities and nonconvertible preferred securities to abide by new Rule 17a-4 paragraph (b)(17), which mandates the broker-dealers to preserve the written probability of default determination for not less than three years, the first two years in an easily accessible place.

SEC Chair Gary Gensler declared, “This adoption fulfills Congress’s wishes in the wake of the 2008 financial crisis, ensuring we don’t embed in our ruleset a reliance on credit ratings—and instead have appropriate alternative measures of creditworthiness. This adoption will be the sixth and final of the SEC’s rulemakings to implement this mandate.”

Coinbase operates as unregistered exchange, broker, and clearing agency, SEC says

By Rodney F. Tonkovic, J.D.

The SEC has charged Coinbase, Inc. with violations arising from its trading platform and staking program. According to the complaint, filed in the Southern District of New York, Coinbase has intertwined the services of an exchange, broker, and clearing agency, but is not registered to perform any of these functions. Plus, it has been engaging in unregistered securities offerings through its staking-as-a-service program. The SEC says that Coinbase's refusal to follow the rules has deprived investors of the protections to which they are entitled (SEC v. Coinbase, Inc., June 6, 2023).

The charges. Since at least 2019, the Commission says, Coinbase has made billions by facilitating the buying and selling of crypto asset securities. At the same time, it has, through its Coinbase Platform, operated as an unregistered broker, exchange, and clearing agency, having collapsed these three functions into a single platform. Coinbase has: provided a marketplace to bring together buyers and sellers; engaged in the business of effecting securities transactions; served as an intermediary in settling transactions in crypto asset securities; and acted acts as a securities depository. According to the Commission, Coinbase's failure to register deprived investors of significant protections, including inspection by the SEC, recordkeeping requirements, and safeguards against conflicts of interest.

Also, since 2019, Coinbase has offered a crypto asset staking program. Through this program, Coinbase pools investors' crypto assets and then "stakes" (i.e., commits) them in exchange for rewards, which Coinbase distributes pro rata to investors after paying itself a commission. The complaint says that there are five stakeable crypto assets, and that the staking program as applied to these assets is an investment contract, and therefore a security, but Coinbase has never had a registration statement for offers and sales of the staking program.

The Commission alleges that Coinbase's actions violated Exchange Act Sections 5, 15(a), and 17A(b). In addition, Coinbase’s holding company, Coinbase Global Inc. (CGI), is a control person of Coinbase and is also liable for certain violations. Through the staking program, Coinbase allegedly violated the registration provisions of Sections 5(a) and 5(c) of the Securities Act. The Commission seeks a final judgment permanently enjoining Coinbase from these violations, ordering disgorgement of ill-gotten gains, and imposing a civil money penalty.

"We allege that Coinbase, despite being subject to the securities laws, commingled and unlawfully offered exchange, broker-dealer, and clearinghouse functions," said SEC Chair Gary Gensler. "In other parts of our securities markets, these functions are separate, he added.

Gurbir S. Grewal, Director of the SEC's Division of Enforcement, said: "You simply can't ignore the rules because you don't like them or because you'd prefer different ones: the consequences for the investing public are far too great." In addition: "While Coinbase's calculated decisions may have allowed it to earn billions, it's done so at the expense of investors by depriving them of the protections to which they are entitled. Today's action seeks to hold Coinbase accountable for its choices."

Brinksmanship. In March 2023, Coinbase received a Wells notice outlining the SEC's intent to bring charges. At the time, the company said that the notice did not provide much information to respond to, but the company is confident in the way it runs its business: "Tell us the rules and we will follow them," Coinbase said.

In its reply to the notice, Coinbase urged the SEC not to sue. The notice outlined Coinbase's cooperation with the agency through the process of listing its shares followed by an "abrupt move toward litigation" with no new facts about Coinbase's business. Coinbase contends that the litigation is meant to pressure it to accept the Commission's demands that the company agree that the digital assets listed on its platform are securities and to overhaul its entire business model. These objectives are neither supported by law or within the bounds of the Commission's authority, Coinbase says.

The reply asserts that the SEC should be wary of now suing Coinbase not only because of the above, but for other compelling reasons. First, litigation will put the Commission's own practices on trial because the record will show Coinbase's efforts to cooperate with the Commission while the agency never raised any specific concerns. Next, the "laundry list" of proposed charges rest on flawed and untested legal theories. Finally, the departure from the Commission's normal approach will undermine public and judicial confidence in the agency's enforcement practices. The reply asks the Commission to avoid these risks by working with a willing Coinbase.

The case is No. 1:23-cv-04738.

Commission dismisses 42 cases linked to improper breach of agency enforcement and adjudicatory functions

By Suzanne Cosgrove

The SEC said Friday it has completed an extensive review of what the agency described as “a control deficiency” related to the required separation of enforcement and adjudicatory functions within the agency’s system. Discovered in April 2022, SEC Chairman Gary Gensler has directed the implementation of enhanced data access controls to prevent further lapses, the Commission said.

While the data breach was not found to be deliberate, and the investigation failed to uncover evidence that the lapse resulted in harm to any respondent or affected the Commission’s adjudication in any proceeding, “we have nevertheless determined to dismiss, as a matter of discretion, all pending proceedings that the review team found to be connected to the control deficiency … and in which there is no final order against a respondent,” the SEC said.

The Commission’s initial order dated June 2 listed 42 respondents who had their proceedings dismissed. In a second June 2 filing, the SEC also issued an order vacating certain associational bars in additional proceedings.

Data snafu explained. As the SEC reported previously, certain databases in its General Counsel office maintained by the SEC’s Office of the Secretary were not configured to restrict access by staff from Enforcement. “As a result, in a number of adjudicatory matters, administrative support staff from Enforcement responsible for maintaining Enforcement’s case files accessed Adjudication memoranda via OS’s (Office of the Secretary) databases,” the SEC said in a release.

In addition, “in many instances, those administrative staff also emailed Adjudication memoranda to other administrative staff for potential upload to Enforcement databases; once uploaded, the memoranda became accessible more broadly to Enforcement staff,” the Commission said.

As noted last year by Securities Regulation Daily, the Commission has both investigatory and adjudicatory responsibilities. However, the Administrative Procedure Act (APA), which governs how federal administrative agencies make and issue regulations, and how they decide administrative litigation, calls for the separation of those functions among agency staff members.

As a result of the APA, employees who investigate or prosecute an adjudicatory matter before the Commission may not participate in the Commission’s decision-making in the same matter.

Review process and findings. The SEC said the agency initiated a comprehensive review to assess the scope and impact of the control deficiency. The review team interviewed more than 250 current and former staff members, including individuals from Enforcement, the Office of the Secretary, and the Office of the General Counsel (OGC), the Commission said. The team collected and reviewed documents from Enforcement, OS, and the OGC, including more than 500,000 pages of emails and attachments.

The team also reviewed hundreds of case files in Enforcement’s case management, including the electronic files of each of the cases discussed. Working with Berkeley Research Group, LLC, a consulting firm that includes investigators and forensic analysts, the team analyzed over 25 million rows of data from access logs for various systems.

The April 2022 SEC statement disclosed the review team’s findings regarding two matters arising from administrative adjudicatory proceedings that had challenges pending in federal courts: SEC v. Cochran and Jarkesy v. SEC. In both the Cochran and Jarkesy proceedings, Enforcement administrative staff accessed one or more Adjudication memoranda and emailed those documents to other administrative staff who, in some instances, uploaded them to Enforcement’s centralized database. As a result, certain Adjudication memoranda was accessible to all Enforcement staff, including attorneys investigating and prosecuting Cochran and Jarkesy.

In its June release, SEC said the review team found no evidence that Enforcement staff accessed any case-specific Adjudication memoranda relating to the Cochran matter. None of the individuals assigned to investigate and prosecute the Cochran matter accessed or took any action influenced by a November 29, 2017 (or any other) Omnibus Memorandum or communicated with the Adjudication staff advising the Commission in its decision-making.

Similarly, the team found no evidence that any of the individuals assigned to investigate and prosecute the Jarkesy matter accessed related Adjudication memoranda. It also found no evidence that the New York Regional Office enforcement supervisor or any of the individuals assigned to investigate and prosecute the Jarkesy matter were influenced by the memorandums.

SEC reviews of other pending adjudicatory matters included 28 proceedings in which one or more Adjudication memoranda were accessed by Enforcement administrative staff, as well as 61 additional matters in which one or more Adjudication memoranda applicable to pending matters were accessed by Enforcement administrative staff, the SEC said.

Safeguards are ensured. “We deeply regret that the agency’s internal systems lacked sufficient safeguards surrounding access to Adjudication memoranda,” the SEC said in a statement. “We are continuing our work to ensure that, going forward, work product from the Adjudication staff is appropriately safeguarded.”

Does violating Reg S-K give rise to a 10(b) fraud claim?

By Anne Sherry, J.D.

The Supreme Court is being asked to review a Second Circuit holding that a failure to make a disclosure required under Regulation S-K Item 303 can support a private claim under Exchange Act Section 10(b), even in the absence of an otherwise misleading statement. The defendants-appellees maintain that this holding created a split with at least three sister circuits that have rejected 10(b) liability based on a violation of Item 303 (Macquarie Infrastructure Corp. v. Moab Partners, L.P., May 30, 2023).

Challenged decision. Macquarie Infrastructure Corp. was a publicly traded company that owned and operated a portfolio of infrastructure-related businesses, one of which was involved in the storage of a high-sulfur fuel oil, No. 6 oil. The plaintiffs alleged that between February 2016 and February 2018, Macquarie and its management defrauded investors by failing to predict—and disclose—that a proposed cap on sulfur in fuel oil (IMO 2020) would have a material negative impact on Macquarie’s financial performance.

The district court held that the plaintiffs failed to plead a violation of Item 303 and failed to allege scienter. The Second Circuit disagreed, holding that the plaintiffs had adequately alleged a “known trend or uncertainty” that gave rise to a duty to disclose under Item 303 and that this sufficed to establish an actionable omission and the defendants’ scienter under Section 10(b). The heightened pleading standard of the PSLRA was satisfied because the defendants were in the position of knowing that it was likely that IMO 2020 would reduce revenue, yet did not disclose as much, the Second Circuit concluded.

Circuit split. In the cert petition, Macquarie and the other petitioning defendants argue that a Section 10(b) claim cannot rest entirely on a failure to provide a disclosure required under Item 303; there needs to be some affirmative statement rendered misleading by the omission. While the SEC can inquire and bring an enforcement action for a violation of Item 303, the violation should not “open the floodgates to potentially crippling private class action liability.”

The petition argues that the Second Circuit has acknowledged its split from the Ninth Circuit’s 2014 holding in In re NVIDIA Corp. Securities Litigation, which in turn had cited a Third Circuit decision. Subsequently, the Eleventh Circuit wrote that a violation of Item 303 does not ipso facto indicate a violation of Section 10(b), and the Fifth Circuit said in dicta that it has never held that Item 303 creates a duty to disclose under the Exchange Act. Resolving the split is important because it involves the three dominant circuits for securities litigation and because different standards should not apply depending on where a plaintiff files suit, the petition asserts.

Argument. According to the petitioners, the Second Circuit’s expansion of Section 10(b) liability conflicts with the Supreme Court’s precedents. The Court has repeatedly stated that the private right of action in the Exchange Act should not extend beyond its boundaries. On its face, the petition asserts, Section 10(b) is about prohibiting manipulation or deception, not about the completeness of disclosures. This is why Rule 10b-5 makes omissions unlawful only when its disclosure is necessary to make other statements not materially misleading.

Furthermore, Item 303 is not a suitable vehicle for an implied private right of action. The SEC has explained that an issuer’s disclosure obligations under Item 303 are “intentionally flexible and general.” The rule distinguishes between required disclosures of currently known trends and optional disclosures of forward-looking information, and both types of disclosures comprise the type of “soft information” that is not objectively verifiable. Opening the door to private actions for violations of Item 303 amounts to allowing plaintiffs to plead “fraud by hindsight,” which stands in tension with established precedent.

The Second Circuit’s approach conflates the optional and required disclosure scheme of Item 303 and collapses the scienter analysis for Section 10(b) claims, the petitioners continue. When the Second Circuit first recognized a private right of action under Item 303 in Stratte-McClure v. Morgan Stanley (2d Cir. 2015), it attempted to cabin its holding by remaining mindful of the SEC’s distinction between required and optional disclosures and by making clear that scienter remained a separate and independent element of a Section 10(b) claim. The facts of the instant case make it more difficult to distinguish between an actionable expectation and a non-actionable anticipation, and by concluding that the plaintiffs had pleaded scienter based on management’s “position of knowing” the omitted trend or uncertainty, the panel effectively held that an alleged failure to make a required Item 303 disclosure is sufficient in itself to establish scienter.

Finally, the petition argues that the expansion of liability will incentivize over-disclosure, leading to increased burdens on companies and information overload for investors, as well as increase the frequency and cost of securities litigation.

The case is No. 22-1165.

Former Chairman Harvey Pitt Remembered

By Matt Garza, J.D.

The SEC issued a joint statement honoring the career of Harvey Pitt, who passed away on May 30th in Washington, D.C. at the age of 78. Pitt started his career with the SEC’s Office of General Counsel straight out of law school in 1968 and he became the youngest General Counsel in the agency’s history after seven years. It was his dream to lead the agency, according to the statement, and after being appointed by President George W. Bush he led the agency for 15 months from August 2001 to February 2003, when his tenure was cut short after coming under fire for his choice to lead the newly-formed PCAOB. The controversy triggered his resignation letter on November 5, 2002, although he continued in the role during the search for his replacement.

After being succeeded by William Donaldson, Pitt formed Kalorama Partners and remained an active defense attorney and securities regulation thought leader. He maintained a commitment to the education of securities lawyers, serving as a frequent panelist at conferences and as the founding trustee of the SEC Historical Society. He also taught at Georgetown University Law Center, George Washington University Law School, and the University of Pennsylvania School of Law.

SOX. Chairman Pitt was at the helm of the SEC during the accounting scandals of the late 90s and early 2000s and oversaw the implementation of the congressional response in the form of the Sarbanes-Oxley Act (SOX). The legislation, which came together quickly after major accounting scandals at Enron and WorldCom, was the subject of an SEC Historical Society event in July of last year in which Pitt recalled that WorldCom was a “game changer” that caused Congressional resolve to adopt a statute to become “manifest.” Despite the fact that SOX was initiated by Congress, Pitt said the SEC had input on many issues, although not the “stringent deadlines” Congress would impose for carrying out SEC rulemakings. Pitt also noted that SEC staff were unrestrained in providing technical assistance to Congress and that once SOX became law the SEC was resolved to meet the statutory deadlines. The overwhelming support in Congress for SOX made it easier for the SEC staff and the Commission to carry out the nearly two dozen rulemakings, he said, while also noting that the rule proposals were all adopted unanimously (he later said that this feat might be harder to achieve in today’s environment).

9/11. Pitt was also remembered for being a steadying presence during the chaos of the terrorist attacks on the World Trade Center on September 11, 2001, when southern Manhattan lost power and concerns grew about the operations of the securities markets. Pitt said he worked directly with Richard Grasso, then chairman of the NYSE, to shut down the markets, which remained closed for 4 days, and maintained steady contact with key market players during the week.

The commissioners said Pitt remained available to offer advice on agency rulemaking even in the last year of his life, and he continued to submit comment letters on rulemaking proposals. He is survived by his wife, Saree, and his four children.

European Parliament integrates social and environmental impact into its corporate governance position

By Suzanne Cosgrove

The European Parliament announced Thursday that it has adopted its position for negotiations with member states on rules to integrate human rights and environmental impact into corporate governance. Negotiations with member states on the final text of the legislation are next–the members adopted a draft directive in November 2022, according to the Parliament’s release.

The newly confirmed rules will apply to EU-based companies, regardless of their sector, which have more than 250 employees and company revenues worldwide over 40 million euro, as well as to parent companies with over 500 employees and company revenues worldwide of more than 150 million euro.

Non-EU companies with a turnover higher than 150 million euro also will be included, if at least 40 million euro was generated in the EU.

Companies will be required to identify, and if necessary, prevent, end or mitigate the negative impact of their activities in areas that include child labor, labor exploitation, pollution, environmental degradation and biodiversity loss. The companies also will be required to assess the social and environmental impact of their value-chain partners, not only for suppliers but also for those involved in distribution, transportation, storage, waste management and other areas.

Non-compliant companies will be held liable for damages and can be sanctioned by national authorities. Planned sanctions include measures such as “naming and shaming,” or fines of at least 5 percent of the net worldwide turnover. Non-EU companies that fail to comply with the rules will be banned from public procurement in the EU.

The new obligations will apply after three or four years, depending on the company’s size. Smaller companies will be allowed to delay the application of the rules by one year.

Crypto is the preferred investment of Generation Z, FINRA finds

By Anne Sherry, J.D.

Most Americans between 18 and 25 have some kind of investment, according to a new report from the FINRA Investor Education Foundation and CFA Institute. The report compares these Gen Z investors to their counterparts overseas and to older generations, and it examines the barriers that keep nearly half of Generation Z from investing. According to FINRA Foundation President Gerri Walsh, “It is vital to understand their investing decisions and to provide them with the educational tools to prepare for those decisions.”

Investment trends. The study found that 56 percent of Gen Z own at least some investments. A quarter of them started investing before age 18, which is similar to trends in the U.K. and Canada. However, only 7 percent of Gen Z investors in China started before age 18.

Among those who do invest, cryptocurrency is the most common vehicle (55 percent of Gen Z investors), followed by individual stocks (41 percent), mutual funds (35 percent), NFTs (25 percent), and ETFs (23 percent). In contrast, Gen X investors give a slight edge to mutual funds, followed by individual stocks and crypto. Even so, 39 percent of Gen X investors hold some crypto. The report speculates that the widespread availability and popularity of crypto may be what motivated many Gen Zs to start investing, and that the restrictions on cryptocurrency transactions in China may explain some of the differences between Gen Z investors in China compared to in the U.S., U.K., and Canada. (The sample size of non-U.S. participants was also much smaller for the other countries than for the U.S.).

Barriers. The report also looked at some barriers to investment. Gen Z investors and non-investors alike said that their top challenge is inflation and the rising cost of living. However, non-investors were more likely to cite employment and income or lack of financial knowledge as challenges, while investors cited economic and market conditions. The most common reasons for not investing were insufficient savings, insufficient income, insufficient knowledge, and a focus on other expenses.

Sources of information. Gen Z investors and non-investors cite social media, internet searches, family, and friends as their top resources for learning about investing and financial topics. The most-cited source of information is YouTube, relied upon by 60 percent of investors; only about a third of investors look to Reddit. The investor group is more likely than non-investors to use four or more resources to stay informed. Notably, however, the survey also asked participants to select their three most trusted sources. Social media fared poorly here, with family, financial professionals, internet searches, and financial companies ranking highest among investors.

Digital apps have an influence on Gen Z investors, both in terms of managing and making specific investment decisions. Nearly two-thirds of Gen Z investors use investing apps, compared to 55 percent of millennials and 38 percent of Gen X investors. Of the 69 percent of Gen Z investors who have received suggestions from an app, 67 percent said the suggestions influenced them to make a particular investment, trade, or purchase.

“These new entrants to the world of investing are reshaping investment practices, products, and platforms,” observed Paul Andrews, Managing Director for Research, Advocacy and Standards at CFA Institute.

NASAA says added guardrails needed for FINRA’s pilot program on remote inspections

By Suzanne Cosgrove

In a letter commenting on a proposed FINRA pilot program that could make remote supervision of firms a bona fide alternative, the North American Securities Administrators Association (NASAA) has urged FINRA to take a more prescriptive approach toward risk assessments, written supervisory procedures and firms’ supervisory capabilities.

FINRA’s proposed plan amends its Rule 3110 (Supervision) to adopt a voluntary, three-year remote inspections pilot program that would allow member firms to elect to fulfill their by conducting inspections of branch offices and locations remotely without an on-site visit to such office or location, subject to specified terms.

The proposed program would not change current regulatory requirements under Rule 3110, but it would provide firms with greater flexibility on how they could satisfy their inspection obligations.

Is change needed? FINRA’s pilot proposal, dated April 28, 2023, significantly changes how firms carry out fundamental supervisory responsibilities, “but it does not establish a sufficient record to demonstrate the need for or the acceptability of such a change,” the NASAA said in written comments. “In particular, the pilot proposal lacks meaningful data despite most firms operating remotely (including supervision) for more than three years” during COVID.

The data from the program shared so far represents information from only about 18 firms, the NASAA said. Sixteen are large firms with corresponding resources, have conducted a similar number of inspections in the remote environment and reported similar numbers of findings. However, according to the NASAA’s comment letter, these firms’ conclusions do not appear to have considered the relative quality of the inspections or whether the nature of findings changed from prior on-site inspections.

In addition, FINRA’s proposal makes general references to advancements in technology, but it provides little information about how, and to what extent, these technologies are being used by firms, whether firms are using them effectively, or why these technologies can replace the advantages of in-person inspections designed to detect and prevent customer harm, the NASAA said.

Because there is no guarantee that associated persons will use firm systems that purportedly enable remote surveillance, and because many of the same technologies touted as supporting the proposal can also serve as vehicles to operate outside of firm systems, FINRA’s pilot proposal could result in firms failing to detect investor harm, the NASAA said.

The path forward. In the NASAA’s view, FINRA can avoid detection failures by withholding approval until firms have demonstrated that conducting remote inspections will not materially impair investor protection and compliance with the securities laws. “The safest way to do so is to require FINRA to conduct a fulsome examination sweep, produce a public report of its findings, and offer a proposal consistent with the evidence gathered,” the NASAA said.

If an examination sweep is not an option, additional safeguards should be implemented before the pilot program is approved, the group added. Those protections include requiring a firm to conduct and document a risk assessment after identifying any “red flags,” and reporting it to FINRA, even if it has already completed a previous risk assessment for that office or location.

“Requiring firms to document these decisions and provide the information to FINRA would help to maintain accountability by requiring firms to articulate a sound basis for these decisions based on analyses of the risks,” the NASAA said.

Further, firms should be required to report, “with specificity,” the technologies used by the firm and provide evidence that the firm and its supervisory personnel have sufficient access to and proficiency with those technologies.

The fundamental purpose of any pilot program is to gather information to determine an appropriate course of action, the NASAA said. If the pilot program is approved, it should maximize the opportunity to collect data that will inform policy discussions regarding investor protection.

“As such, we maintain that Proposed Rule 3110.18 should be clearer and more specific about what information firms need to collect and provide,” the group added. “Such specificity is necessary to ensure that FINRA can supervise the pilot program appropriately, as well as to enable the SEC to conduct its own examinations of firms and oversee FINRA itself,” the NASAA said.

SEC Chair Gensler addresses the Investment Company Institute on fund proposals

By Jay Fishman, J.D.

SEC Chair Gary Gensler spoke to the Investment Company Institute (ICI) about Commission fund proposals at the ICI’s Leadership Summit held in Washington D.C. from May 23rd to May 25th. Gensler specifically remarked upon new SEC proposed rule amendments for money market and open-end funds and also addressed short-term and collective investment funds that banks solely manage because the SEC has no authority over them.

Gensler weaved into his discussion the history of the 1940-promulgated Investment Company and Investment Adviser Acts, along with the ICI’s 1940 formation, to acknowledge the terrific strides these Acts and the ICI have made in reversing the negative consequences of the 1929 Great Depression, together with SEC 2014 and 2016 rules to prevent the 2008 financial crisis’s harsh effects from occurring again. But he emphasized the need for updated regulatory initiatives because the potential for investor losses, i.e., dilution of funds, is higher—even on comparatively safe money market funds—because of trillions of dollars now at stake in assets (including risky digital assets).

SEC proposals. Money market funds. The Commission’s proposed amendments to its 2014 money market fund reforms, Gensler said, are needed more than ever since these funds now stand at $5.8 trillion and have increased by $717 billion last year when interest rates were rising. The following proposals would help protect investor funds particularly during cycles of market stress by:

• Preventing money market funds from imposing redemption limits, thus sustaining fund liquidity for investors;
• Enhancing liquidity requirements; and
• Adding swing pricing and alternatives regarding liquidity fees but solely for institutional prime and tax-exempt money market funds.

Open-end funds. The open-end fund proposals would:

1. Update the SEC’s 2016 liquidity rule by creating minimum standards for liquidity classifications in order to prevent open-end funds from overestimating their investment liquidity;
2. Set forth pricing alternatives, i.e., swing pricing or liquidity fees, so that particularly during times of market stress, redeeming shareholders bear the appropriate costs associated with their redemptions; and
3. Shorten the lag between when investors’ orders are placed and when the fund receives those orders; doing so can lessen risk.

Bank regulatory products. Gensler proclaimed that the SEC is currently discussing with the banking industry two products exclusively regulated by banks, namely short-term investment funds and collective investment funds. He emphasized a regulatory gap needs to be closed involving the liquidity of these investments. Specifically, banking rules for these investments lack limits on illiquidity because there is: (a) no limit on leverage; (b) no requirement for regular reporting on investor holdings; and (c) no requirement to have an independent board.