Friday, August 12, 2022

MSRB cautioned against premature regulatory action on ESG

By John Filar Atwood

Municipal securities industry best practices on environmental, social and governance (ESG) issues are still emerging, and the Municipal Securities Rulemaking Board (MSRB) should wait before imposing uniform standards that may limit meaningful ESG risk disclosures. This is among the messages received by the MSRB from commenters on its December 2021 request for information on ESG practices, which the Board summarized in a new report.

The MSRB issued the request for information in order to better understand how ESG practices are being integrated in the municipal securities market. In addition to inviting general feedback on trends in ESG practices, the MSRB specifically asked stakeholders to comment on the disclosure of information regarding ESG-related risk factors and ESG-related practices, and the labeling and marketing of municipal securities with ESG designations.

The MSRB received 52 comments on the request for information. The MSRB said that commenters generally discussed the evolving nature of ESG practices, challenges associated with ESG integration, and opportunities for improving transparency through the MSRB’s electronic municipal market (EMMA) website.

Regulation would be premature. According to the report, the MSRB found wide consensus that ESG practices in the municipal securities market are still evolving, and that premature regulatory action could inhibit further development of best practices. Several commenters pointed out that market-based solutions are being developed, with one association citing its recent release of ESG risk disclosure best practices which it intended as a framework for issuers to how each ESG factor could potentially affect creditworthiness or its ability to repay its debt.

One commenter said that a market-based approach to good municipal disclosure will generate better results than any standardized requirement. Similarly, an industry association representing dealers told the MSRB that its preferred approach would be to let issuers tailor disclosures in a way that discusses risks that are material, including ESG factors.

The MSRB noted that a number of respondents cautioned against premature regulatory action by the MSRB with respect to ESG. The opinions were captured by an industry association representing municipal analysts which stated that at this juncture regulatory actions would not be optimal “as such directives tend to be inflexible, set bare-minimum standards instead of best practices, and introduce unnecessary compliance costs throughout the system.”

ESG integration challenges. The MSRB found that many commenters are concerned about the difficulties surrounding ESG integration including the lack of uniform practices and standards, and possible regulatory compliance challenges for municipal dealers and advisers. One commenter noted that some investors care primarily about what ESG factors say about a company’s risks, but others want to know what impact ESG measures are having. The same set of data and reporting does not necessarily allow for both risk analysis and impact measurement, the group stated.

Labeling is also a concern, according to commenters, since some municipal bonds are labeled as green, sustainable, or ESG based on frameworks that do not include environmental performance standards grounded in climate science or environmental justice performance standards. One association noted the confusion regarding ESG information for labeled bonds and ESG issuer disclosures. Individual investors are likely to assume that “green” or “social” labels are being assigned based on a uniform set of principles since there is not adequate information available to them, said an institutional investor.

The MSRB noted an association’s concern that certification services, standard-setters, and credit rating agencies use different criteria to determine what a municipality’s ESG score may be or how ESG topics factor into a municipality’s credit rating. The proliferation of inconsistent approaches can lead to systemic risks that threaten market structure, potentially creating disruptions that impact bond pricing in the secondary and primary market, one commenter stated.

Disagreement over solutions. While the MSRB found widespread agreement that there is a lack of ESG standards and uniform practices, commenters were divided on what to do about it. Some commenters said that uniform ESG disclosure standards or metrics will not improve investor protections or increase meaningful information for investors. However, one company said that clearer standards as to what constitutes “green” or other ESG-labeled bonds could provide more clarity to issuers, improve investor acceptance, and perhaps lead to a pricing advantage for the bonds.

The report states that commenters also disagreed on the potential benefits to market efficiency. On one hand, a commenter said that standardized ESG disclosures would promote a more efficient municipal market, while on the other a municipal issuer stated that the threat of mandatory ESG disclosure standards could impair the efficient operation of the municipal market. Some commenters worried that requiring additional disclosures would raise the per-dollar cost of funding for small offerings, thereby penalizing small communities.

Enhancements to EMMA. One area where the MSRB found widespread agreement among commenters was on the need for enhancements to the MSRB’s EMMA system. Commenters felt that improvements are needed to make the system easily accessible for the submission and retrieval of disclosure information, including voluntary ESG information. A group representing dealers went a step further by suggesting that improvements to the EMMA website could include clarifying any issuer self-designations, adding in specifics regarding any external review, removing confusing labels, and focusing on objective and standardized ESG labels.

Thursday, August 11, 2022

SEC proposes to amend reporting requirements for all filers and large hedge fund advisers

By Rodney F. Tonkovic, J.D.

The SEC proposed amendments to Form PF to amend reporting requirements for all filers and large hedge fund advisers. The amendments, which passed the Commission by a 3-2 vote, are also being considered by the CFTC. The amendments are intended to enhance the FSOC's monitoring of systemic risk and to collect additional, and more useful, data for use in the Commission's regulatory programs. Comments to the SEC or CFTC are due 30 days after publication in the Federal Register or October 11, 2022, which is 60 days after issuance (Amendments to Form PF to Amend Reporting Requirements for All Filers and Large Hedge Fund Advisers, Release No. IA-6083, August 10, 2022).

According to the SEC, the proposed amendments are designed to provide greater insight into private funds’ operations and strategies, assist in identifying trends, including those that could create systemic risk, improve data quality and comparability, and reduce reporting errors. The SEC and CFTC ("the Commissions") are jointly proposing amendments to Form PF's general instructions, and section 1 of the form, which would apply to all filers. Proposed amendments to section 2 of the form would apply to large hedge fund advisers advising qualifying hedge funds (hedge funds having a net asset value of at least $500 million). The SEC says that the proposed amendments would:
  • Enhance reporting by large hedge fund advisers on qualifying hedge funds. The proposal would enhance how large hedge fund advisers report investment exposures, borrowing and counterparty exposure, market factor effects, currency exposure reporting, turnover, country and industry exposure, central clearing counterparty reporting, risk metrics, investment performance by strategy, portfolio correlation, portfolio liquidity, and financing liquidity to provide better insight into the operations and strategies of these funds and their advisers and improve data quality and comparability.
  • Enhance reporting on basic information about advisers and the private funds they advise. Advisers would be required to report additional basic information about themselves and the private funds they advise including identifying information, assets under management, withdrawal and redemption rights, gross asset value and net asset value, inflows and outflows, base currency, borrowings and types of creditors, fair value hierarchy, beneficial ownership, and fund performance to provide greater insight into private funds’ operations and strategies, assist in identifying trends, including those that could create systemic risk, improve data quality and comparability, and reduce reporting errors.
  • Enhance reporting concerning hedge funds. The proposal would require more detailed information about the investment strategies, counterparty exposures, and trading and clearing mechanisms employed by hedge funds, while also removing duplicative questions, to provide greater insight into hedge funds’ operations and strategies, assist in identifying trends, and improve data quality and comparability.
  • Amend reporting of complex structures. The general instructions would be amended to require advisers to report separately each component fund of master-feeder arrangements and parallel fund structures. Currently, some advisers report in aggregate and some separately, which can make it difficult to compare complex structures and undermines the usefulness of the data collected.
  • Aggregate reporting. The current requirement that large hedge fund advisers report certain aggregated information will be removed. The Commissions have found data to be less meaningful for analysis while more burdensome for advisers to report.
Form PF. Adopted by the CFTC and SEC in 2011, Form PF is used by certain SEC-registered investment advisers, to report confidential information about the funds they advise. The form is also used by advisers registered with the CFTC as a commodity pool operator ("CPO") or commodity trading adviser ("CTA"). These "private funds" are pooled investment vehicles that are excluded from the definition of "investment company" and generally include funds commonly known as hedge funds, private equity funds, and liquidity funds. The data collected is also used by the Financial Stability Oversight Council ("FSOC"), which was consulted for its input on the proposal, as part of its mandate to monitor systemic risk. The SEC proposed amendments to the SEC-only portions of Form PF in January 2022 that would, among other changes, require reporting within one day if an event signals risk to the broader financial system.

The SEC says that since the form's adoption, the private fund industry has grown and evolved into a $20 trillion industry. Experience with reporting on the form has identified ways to improve data quality as well as information gaps and situations in which information could be revised to improve understanding of systemic risk. Improved information would assist the FSOC in its mission and improve the ability of the Commissions to protect investors.

Commissioners' reactions. Chairman Gensler and Commissioners Crenshaw and Lizárraga voted to approve the proposal. In his first open meeting, Commissioner Lizárraga observed that the proposal would be essential to a more comprehensive evaluation of the implications for the integrity of the financial markets, particularly for retail investors. Chair Gensler, who chaired the CFTC when Form PF was jointly adopted said: " I am pleased to support the proposal because, if adopted, it would improve the quality of the information we receive from all Form PF filers, with a particular focus on large hedge fund advisers." He added: "I believe that these proposed amendments would bring greater visibility for regulators into an important part of our capital markets. That will help protect investors and maintain fair, orderly, and efficient markets."

Commissioners Peirce and Uyeda did not support the proposal. Calling the amendments "overreach," Commissioner Peirce said that the proposal "stretches a very limited data collection tool beyond its intended purpose" by "by adding questions of the nice to know, rather than need to know variety." According to Peirce, the main purpose of gathering information on Form PF is to facilitate the FSOC's monitoring of systemic risk. Observing that the release repeatedly uses the word "granular," Peirce said that every missing piece of information is not needed and wondered: "what specifically do we intend to do with the information we are so eager to have?" She also noted that this mass of information could be a target for cybersecurity threats and that stolen data could itself be a systemic threat, a concern shared by Commissioner Uyeda. Peirce nonetheless admitted that some of the proposed amendments "might be worthwhile," such as changes that would streamline the form and eliminate redundancies; to that end, she encouraged commenters " to suggest other ways to right-size Form PF."

The release is No. IA-6083.

Wednesday, August 10, 2022

SEC, FTC argue in support of exclusive appellate review of final agency orders

By Rodney F. Tonkovic, J.D.

The FTC and SEC have filed a joint brief defending the position that ongoing agency adjudications may not be challenged in district court. The brief addresses petitions brought by the subjects of FTC (Axon Enterprises) and SEC (Michelle Cochran) administrative proceedings who brought constitutional challenges in the district courts. Both cases present the question of whether constitutional challenges to ongoing proceedings may be brought in district courts. The brief for the federal parties argues that the answer is in each Act's statutory scheme: judicial review may be sought only after final orders are issued and only in appellate courts. Oral argument in both cases has been scheduled for Monday, November 7, 2022 (Axon Enterprise, Inc. v. FTC and SEC v. Cochran, August 8, 2022).

Axon v. FTC. The FTC raised antitrust concerns when Axon Enterprises, a maker of policing equipment such as body cameras, acquired a competitor in 2018. Axon sued the FTC in the federal district court in Arizona in 2020, while the administrative process was ongoing. The complaint asked the court to enjoin the FTC from pursuit of its enforcement action (filed on the day Axon sued), arguing that the tenure protections enjoyed by the FTC Commissioners and the ALJ violated Article II and that the enforcement procedures violated the Due Process Clause. The district court dismissed the complaint for lack of subject matter jurisdiction, stating that the FTC Act limits challenges to FTC adjudications to the appellate courts. The Ninth Circuit affirmed, explaining that that Axon could obtain meaningful judicial review at the conclusion of the administrative process.

Axon filed a petition for certiorari in July 2021. The petition raised two questions: whether the FTC Act provision limiting federal court review to the appellate courts stripped the federal courts of jurisdiction over the FTC itself; and whether the FTC ALJs' dual-layer for-cause removal protection is consistent with the Constitution. The petition asked the Court to apply its reasoning in Free Enterprise Fund v. PCAOB and allow federal courts to rule on the constitutionality question without first forcing the accused party to undergo the lengthy and expensive administrative process. Unless specifically excluded by the FTC Act, federal oversight of questions of agency constitutionality should exist before the end of the administrative process, Axon said.

SEC v. Cochran. In 2016, CPA Michelle Cochran was charged by the SEC with failing to comply with PCAOB auditing standards. After Lucia v. SEC was decided in 2018, her case was reassigned to a new, constitutionally-appointed ALJ. Cochran then filed suit to enjoin the proceedings against her, arguing that the ALJ was unconstitutionally insulated from the president’s removal power. A Fifth Circuit panel affirmed the district court's dismissal for lack of subject matter jurisdiction, noting that every appellate court has arrived at the same conclusion: the statutory review scheme is the only path to asserting a constitutional challenge to SEC proceedings. The Fifth Circuit, sitting en banc, then reversed the panel's decision, holding that the Exchange Act says nothing about those who have not yet received a Commission final order or who have claims unrelated to a final order. The court also concluded that Cochran's challenge was collateral to the Exchange Act's review scheme and outside of the SEC's expertise and that Cochran would be deprived of the opportunity for meaningful judicial review.

The SEC then petitioned the Supreme Court to overturn the Fifth Circuit's holding. The crux of the Commission's argument is the fact that every appellate court to consider the issue has held that the statutory review scheme may not be bypassed. Both Cochran and the SEC noted that the Court had granted certiorari to Axon in January 2022 and, respectively, asked the Court to consolidate the cases or hold the Cochran matter until a decision in Axon. Certiorari was granted in May 2022, and the solicitor general proposed coordinating briefing schedules for the two cases and the Court gave its assent, ordering a consolidated response brief on the merits on behalf of the federal parties.

Federal parties' brief. The solicitor general's response maintains that a party may not challenge ongoing FTC and SEC adjudications in district court. First, the FTC Act and Exchange Act (the Acts) set out schemes for judicial review of the agencies' orders, the brief says. Both Acts authorize review only after final orders are issued and only in appellate courts, and this review includes claims of constitutional error. The brief explains that agency proceedings can involve myriad preliminary steps, and allowing judicial intervention at each step would interfere with the efficient conduct of the proceeding and burden reviewing courts, which would be required to engage in "piecemeal review." Deferring review until a final order is entered avoids these costs, the brief says.

Next, non-final agency actions are not reviewable under the APA or any other more specific judicial review provision. Axon and Cochran both point to 28 U.S.C. 1331, granting district courts jurisdiction over civil actions arising under federal law. But, specific provisions control over general ones, and the Acts specifically grant appellate courts jurisdiction to review adjudications after final orders are issued. It is discernible from the structure of the Acts' provisions that no court has jurisdiction to review an administrative proceeding before the filing of the petition for review. In addition, the APA generally authorizes review only after "final agency action," and the challenged actions here are not final. And, the APA sets out that judicial review takes place 'in a court specified by statute," i.e., the appellate courts. There is no exception for constitutional claims, Article II claims, or removal-power claims, all of which are encompassed within the APA, and all of which have repeatedly been raised in petitions for review at the end of agency proceedings.

Finally, where there is an express statutory review scheme, courts cannot create new remedies that Congress has not authorized. The Acts provide what Congress considers to be adequate mechanisms to remedy errors connected to administrative adjudications and courts must refrain from creating their own remedies, the brief says.

Precedent. Continuing, the brief argues that the Supreme Court has also repeatedly held that Congressional authorization of appellate review of agency adjudications precludes district courts from reviewing those adjudications. And, for 100 years in the case of the FTC, until the Fifth Circuit's decision in Cochran, the appellate courts agreed that the Acts preclude district court review of ongoing administrative proceedings. Addressing the Fifth Circuit's holding, the brief rejects the argument that only district court review of final orders is precluded (meaning that the courts can review proceedings preceding the orders); this would lead to "bizarre" results, the brief remarks, and the Acts' structures show that no court—neither district not appellate—may exercise jurisdiction while the proceeding is ongoing.

The brief also says that Free Enterprise Fund is inapplicable here because that case turned on "idiosyncratic" factors that are not present here. That case held that the two layers of "for cause" protection granted to PCAOB members violated separation of powers principles. For one, the firm in Free Enterprise Fund did not challenge a final order, or any SEC action at all, but rather a PCAOB action that was not part of a Commission final order. In addition, to gain review, the firm would have had to commit a violation and trigger an enforcement proceeding, risking significant penalties. These concerns are not implicated in this case, the brief says.

In conclusion, the brief again states that there is no sound reason to exempt Axon's and Cochran's constitutional claims from the general rule that district courts may not review ongoing proceedings. Reviewing courts have repeatedly decided the types of claims made here, the brief observes, and a carveout would lead to duplicative review and parallel litigation. The brief also characterizes Axon's and Cochran's challenges as efforts to secure immediate review by framing their claims as challenges to the proceedings themselves, and the Court has consistently rejected such arguments and has deferred to Congress’s judgment that the costs of interlocutory review usually outweigh the benefits. Axon's and Cochran's other objections to the proceedings lack merit, the brief says, in the face of Congressional policy choices reflected in the FTC Act, Exchange Act, and the APA.

Tuesday, August 09, 2022

CFTC tells PredictIt to wind down non-compliant political betting markets

By Lene Powell, J.D.

The CFTC withdrew no-action relief relating to PredictIt, an online event market focusing on U.S. political betting. According to the CFTC, the market platform is not being operated in compliance with the terms of the no-action relief granted in 2014. As a result, the CFTC says the market should close out contracts and positions by February 15, 2023 (CFTC Letter No. 22-08 [Re: Withdrawal of CFTC Letter No. 14-130], August 4, 2022).

In an announcement, PredictIt maintained that all open markets are within the terms of the no-action relief, but stated it will honor all withdrawal requests. As of the time of writing, the market said it is halting the addition of new markets but will continue to accept deposits and new signups.

Market based on no-action relief. In 2014, the CFTC granted no-action relief allowing Victoria University of Wellington, New Zealand to operate a not-for-profit market for the trading of event contracts, and to offer the contracts to U.S. persons.

The university proposed to create a small-scale, not-for-profit, online market for event contracts in the U.S. for educational purposes using the Iowa Electronic Markets as a model. The proposal described a trading platform that would offer binary options contracts using real money and featured a submarket of contracts on political outcomes, including which presidential nominee would win the party’s primary, the general election popular vote, and the Electoral College.

The CFTC granted the relief in CFTC Letter No. 14-130. The relief was based on the university’s representations regarding the purpose and manner of operation of the market, including that the market would be small-scale and non-profit, that it would be overseen by university faculty without separate compensation, and that only necessary fees would be charged. Other representations included assurances as to contract size, lack of brokerage service and commissions, know-your-customer (KYC) provisions, and limits on advertising.

No-action relief withdrawn. In its letter withdrawing the relief, the Division of Market Oversight said it had determined that Victoria University has not operated its market in compliance with the terms of the letter. The CFTC did not specify which terms were not complied with.

The CFTC directed that “to the extent that Victoria University is operating any contract market in a manner consistent with each of the terms and conditions provided in CFTC Letter 14-130, all related and remaining listed contracts and positions comprising all associated open interest in such market should be closed out and/or liquidated no later than 11:59 p.m. (EDT) on February 15, 2023.”

PredictIt statement. In its announcement, PredictIt said the “security of trader funds” is not affected by the action. The platform stated that no determination has been made on how markets with end dates after February 15 will be settled.

PredictIt invited market participants to “respectfully comment” on the action to the CFTC.

Other prediction markets. PredictIt is not the only event contracts market to run afoul of the CFTC.

In 2012, the CFTC issued an order prohibiting the North American Derivatives Exchange (Nadex) from listing or making available for clearing or trading a set of self-certified political event derivatives contracts. The contracts were binary option contracts that were to pay out based upon the results of various U.S federal elections to be held in 2012. The CFTC found that the contracts involved “gaming” contrary to the public interest under the Commodity Exchange Act and CFTC regulations adopted pursuant to the Dodd-Frank Act. The CFTC indicated that political event contracts lack an economic purpose and could potentially be used in ways that would have an adverse effect on the integrity of elections.

In January 2022, the CFTC settled charges against Blockratize, Inc. d/b/a Polymarket, for operating an unregistered facility for event-based binary options online trading contracts. The CFTC found that Polymarket had offered more than 900 separate event markets on a variety of contract types, including cryptocurrency movements (“Will $ETH ((Ethereum)) be above $2,500 on July 22?”) and U.S. politics (“Will Trump win the 2020 presidential election?”). Polymarket deployed smart contracts hosted on a blockchain to operate the markets. Here, the CFTC’s findings focused on Polymarket’s offering of off-exchange binary options and failure to obtain registration or designation of its facility.

Whether under the “gaming” prohibition or registration requirements, the CFTC has regulated prediction markets in the past, and may be keeping an especially close watch in this U.S. election year.

Monday, August 08, 2022

SOX whistleblower must prove retaliatory intent

By Anne Sherry, J.D.

Retaliatory intent is a required element of a whistleblower claim under Sarbanes-Oxley, the Second Circuit held. The plain meaning of the statutory language, particularly its admonition that an employer not “discriminate because of whistleblowing,” required this conclusion, which is consistent with the Second Circuit’s interpretation of nearly identical language in another federal statute. Because the district court declined to instruct the jury as to retaliatory intent, the appeals court vacated the verdict in favor of the whistleblower and remanded for a new trial (Murray v. UBS Securities, LLC, August 5, 2022, Park, M.).

The employee was a commercial mortgage-backed security strategist and executive director at UBS Securities. He claimed that CMBS division personnel pressured him to create reports bolstering the company’s activities, regardless of his independent, research-based opinions to the contrary. Rather than succumb to the pressure, the employee complained to his superiors and continued to turn out honest reports. Nine months later, he was fired. The employee sued for retaliatory termination under both the Dodd-Frank Act and Sarbanes-Oxley Act Section 806(a), with UBS maintaining that it terminated him as part of a reduction in staff during an economic downturn. The Dodd-Frank whistleblower protection claim was dismissed, but the SOX claim survived.

Jury instructions. At trial on the SOX claim, the district court instructed the jury on the elements of the claim: that the plaintiff engaged in protected activity; that UBS knew the plaintiff engaged in the protected activity; that the plaintiff suffered an adverse employment action; and that the protected activity was a contributing factor in the adverse action. Those jury instructions further stated, “For a protected activity to be a contributing factor, it must have either alone or in combination with other factors tended to affect in any way UBS’s decision to terminate plaintiff’s employment. Plaintiff is not required to prove that his protected activity was the primary motivating factor in his termination, or that UBS’s articulated reasons for his termination was a pretext, in order to satisfy this element.”

UBS objected to the jury instructions because they did not include the element of retaliatory intent in taking the adverse action, which UBS argued was a key element of a SOX whistleblower claim. The district court overruled this objection, and the jury found UBS liable. In post-trial briefing, UBS again moved for judgment as a mater of law or for a new trial, but the district court again did not view retaliatory intent as an element of a SOX whistleblower claim, and it denied the motions. The court adopted the jury’s advisory verdict of damages and awarded the plaintiff $650,000 in back pay and $250,000 in non-economic damages, as well as nearly $1.8 million in attorney fees and costs.

De novo review. On the parties’ cross-appeal, the Second Circuit examined de novo whether SOX requires a whistleblower to prove retaliatory intent. First, the court looked to the statutory text in concluding that retaliatory intent is an element of a SOX claim. Under the statute, no covered employer “may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee because of whistleblowing.” The court reasoned that dictionaries define “discriminate” as “to act on the basis of prejudice,” which requires a conscious decision to act based on a protected characteristic or action. Discriminatory action “because of” whistleblowing therefore requires retaliatory intent: that the employer’s adverse action was motivated by the employee’s whistleblowing.

The court had previously interpreted nearly identical language in the Federal Railroad Safety Act as requiring evidence of retaliatory intent, another reason to interpret SOX consistently with that holding. As in that case, a SOX whistleblower does not need to show that retaliatory intent was the sole factor in the disciplinary action or that the employer acted only with retaliatory motive. However, there must be more than a temporal connection between the protected conduct and the adverse action.

Error not harmless. Finally, the court determined that the court’s error was not harmless. An error is harmless only if the appeals court is convinced the error did not influence the jury’s verdict. On the contrary, the district court itself remarked that it was a close case. UBS offered evidence at trial of non-retaliatory reasons for the firing, supporting its position that it acted without retaliatory intent. While there was also circumstantial evidence that UBS did terminate the plaintiff in retaliation for whistleblowing, the court could not know whose explanations the jury credited because the jury instructions did not require a finding of retaliatory intent. Even though the jury found that the plaintiff’s whistleblowing was a contributing factor, this was not enough to know that it would have found that UBS acted with retaliatory intent. Because the error in instructing the jury was not harmless, the court remanded to the district court for a new trial.

The case is No. 20-4202.

Friday, August 05, 2022

Global CFOs, institutional investors express support for proposed IFRS sustainability disclosure standards

By Lene Powell, J.D.

A group of 86 chief financial officers at major companies around the world signed a statement of support for proposed IFRS Sustainability Disclosure Standards, while making recommendations for further development.

Aimed at standardizing disclosures by providing a global baseline, the proposals set forth requirements for the disclosure of material information about a company’s significant sustainability-related risks and opportunities.

Also responding to the IFRS proposals, a group of institutional investors including the HSBC Bank (UK) Pension Scheme supported a global alignment of standards, but urged the IFRS Foundation to broaden investment factors to include “double materiality,” referring to a company’s impact on the environment and society.

The group statements were highlighted by Accounting for Sustainability (A4S), an organization established by HRH The Prince of Wales to inspire action by finance leaders to drive a fundamental shift towards resilient business models and a sustainable economy.

Proposed sustainability disclosure standards. In March, the International Sustainability Standards Board (ISSB) launched a consultation on two proposed IFRS Sustainability Disclosure Standards:
According to ISSB, the proposals were developed in response to requests from G20 leaders, the International Organization of Securities Commissions (IOSCO) and others for enhanced information from companies on sustainability-related risks and opportunities. The proposals build upon the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) and incorporate industry-based disclosure requirements derived from SASB Standards.

The consultation period closed on July 29, 2022.

CFOs statement. In a letter submitted by the A4S CFO Leadership Network, the CFOs said they welcome the ISSB’s consultation on the first two IFRS Sustainability Disclosure Standards. The signatories included officials at major financial institutions such as Bank of America and HSBC as well as officials at global companies including Salesforce and Intel.

The CFOs believe the ISSB is well-suited to establish a comprehensive baseline which will enhance compatibility and interoperability. And in turn, a comprehensive baseline would enable consistent and comparable information to assess an entity’s performance and value.

“The disclosure of robust, comparable and decision-useful information is vital to address climate, and other environmental and social, risks and opportunities,” the officials wrote. “As CFOs from a wide range of sectors, we recognize that sustainability disclosures are most effective when they inform decision making—providing comparable, relevant information to investors and other stakeholders.”

The CFOs shared recommendations for further development of the standards:
  • Align with relevant existing and emerging sustainability reporting standards to promote harmonization and convergence;
  • Consider the dynamic, industry-specific nature of materiality and provide clarity around the assessment of users’ expectations on what constitutes enterprise value;
  • Have clear definitions and guidelines that enable preparers to report in a transparent, consistent and comparable manner;
  • Recognize that reporting is a means to an end, not an end in itself;
  • Connect to financial reporting standards and promote integrated thinking as illustrated through frameworks such as the Integrated Reporting Framework;
  • Address the broad set of environmental, social and economic issues that materially impact decision making.
Institutional investors urge more info on impact. A group of asset owners and investors convened by A4S also released a statement in response to the IFRS proposals. The signatories to the statement included HSBC Bank (UK) Pension Scheme, Tesco PLC Pension Scheme, and Church of England Pension Board, among others.

While the group generally supports global alignment of sustainability disclosure standards, the signatories urged ISSB to adopt a “double-materiality” approach and include more information about companies’ impact.

“As asset owners and investors, convened by A4S, we support the call for global alignment as the ISSB develops its standards. As investors in the real economy, we need decision-useful data that considers both environmental and social impacts on a company as well as the company’s impact on the environment and society,” the group stated. “This double-materiality approach will give investors earlier insights into likely financial and business impacts, and provide the information we need to deliver on our own net zero and broader sustainability commitments. We call on the IFRS Foundation to strengthen their inclusion of factors beyond those narrowly impacting enterprise value.”

Thursday, August 04, 2022

July is slowest month for IPOs since January 2019

By John Filar Atwood

Six companies made their public market debuts in July in the slowest month for new issues in more than three years. To find a month with fewer completed offerings, you have to look back to January 2019, when five IPOs were completed. The aggregate proceeds raised by July’s six deals was $188 million, the lowest monthly total since January 2016 when no companies went public. In seven months, 2022 has seen 125 IPOs. During the same period last year 665 companies made their public market debuts. The final two deals of July were completed by Mobile Global Esports and MAIA Biotechnology. Mobile Global Esports was the first SIC 7900 (Amusement & Recreation Services) company to go public in the U.S. since June 2021. The offering was the seventh of 2022 to generate $10 million or less in proceeds. Cancer treatment developer MAIA Biotechnology is headquartered in Illinois, which is now home to four IPO companies this year after producing 23 in 2021.

New registrants. The week’s activity included five new registrations. New registrant Sedibelo Resources is headquartered in Guernsey but conducts its operations in South Africa. The company produces platinum group metals under an exclusive processing license within a majority of the Southern African development region. Sedibelo has applied to list its shares on the New York and Johannesburg Stock Exchanges. Lipella Pharmaceuticals also registered, becoming the twelfth SIC 2834 (Pharmaceutical Preparations) preliminary filer of 2022. The Pennsylvania company develops new drugs by reformulating active agents in existing generic medicines. Lipella’s initial drug candidate addresses urinary blood loss resulting from certain chemotherapies. EF Hutton was enlisted as lead underwriter by blank check filers Cetus Capital Acquisition and Global Star Acquisition. Taiwan-based Cetus Capital will target industrial, information technology, and internet-of-things businesses with a focus on Taiwanese companies. Global Star will search for a partner in the financial technology and property technology industries. SIC 6770 (Blank Checks) also added Australia-based PROTONIQ Acquisition to its list of 2022 new registrants. PROTONIQ will focus on fintech companies delivering wealth management, financial advisory, and investment management services. Australia has seen five companies go public in the U.S. in the past five years, but none of them were blank checks. The pace of preliminary registrations slowed slightly to 17 in July compared to 19 in June. As of the end of July, 170 companies had filed new registrations this year compared to 941 in the first seven months of 2021.

Withdrawals. The number of withdrawals in July rose to nine with one Form RW in the final week of the month. June 2021 public registrant Foresight Acquisition II decided to abandon its IPO plans. The company had not amended its filing since last October. From January through July 113 Forms RW were filed. Only 18 companies withdrew in the first seven months of 2021.

The information reported here is gathered using IPO Vital Signs, a Wolters Kluwer Regulatory U.S. database that includes all SEC registered IPOs, including REITs and those non-U.S. IPO filers seeking to list in the U.S. markets. IPO Vital Signs does not track closed-end funds, best efforts or non-underwritten deals, or IPO offerings for amounts less than $5 million.

Wednesday, August 03, 2022

PSLRA safe harbor protects some yearly estimates as forward-looking statements, court rules

By Lene Powell, J.D.

Estimates by a medical company about the number of nerve injuries and surgeries occurring “each year” were forward-looking statements protected by the PSLRA safe harbor, a three-judge panel of the Eleventh Circuit ruled. In context, the estimated annual number of procedures was at least in part a prediction about the number of injuries requiring nerve repair procedures likely to occur “each year” in the future. Accordingly, the panel affirmed the dismissal by the district court (Einhorn v. Axogen, Inc., August 1, 2022, Brasher, A.).

Yearly estimates. Axogen is a medical technology company specializing in “nerve repair” products. Axogen’s leading product is Avance Nerve Graft, a product used to support nerve regeneration. In connection with two stock offerings, Axogen stated that it:
  • Believes that more than 1.4 million people suffer traumatic injuries to peripheral nerves each year; and
  • Estimates that over 700,000 extremity nerve repair procedures result.
A short seller investigating Axogen published a research report in December 2018 challenging Axogen’s claims about the frequency of peripheral nerve injury repair procedures and the size of Axogen’s market. The report concluded that there were only 28,000 peripheral nerve injury repair procedures each year in the U.S. and that Axogen’s total market for Avance in trauma cases was only 52 million dollars—almost 20 times less than the market Axogen represented to investors during the class period. The release of the short seller’s report caused a market shock, causing a stock drop from $27.53 to $17.09 per share within a few days.

Investors filed a class action suit alleging that Axogen had misled investors about the estimated number of procedures and market size. The district court dismissed the complaint with prejudice, holding that the challenged statements were: (1) forward looking and protected by the safe-harbor provision, 15 U.S.C. § 78z-2, and in the alternative; (2) non-actionable statements of opinion under Omnicare. The district court further found the plaintiffs had failed to show scienter. The issue on appeal was limited to whether Axogen’s statements concerning the frequency of nerve injuries and peripheral nerve injury repair procedures are shielded from liability.

Forward-looking statements protected by safe harbor. The panel first found that in context, the statements were forward-looking. Although the phrase “each year” could be used in a historical context, these statements here were made in a predictive context. The “each year” statement was, at least in part, a prediction about the number of injuries requiring nerve repair procedures that are likely to occur “each year,” including the current year, the year after that, and the year after that, said the panel.

Buttressing this conclusion, as the plaintiffs conceded, the statements were used to support Axogen’s predictions about the size of the market that “could be serviced” by its products. The only reason Axogen made the statements—and the only reason the plaintiffs found them material—was to predict the size of the going-forward or anticipated market for Axogen’s products. Those market-size predictions were about “future economic performance” and are defined as forward-looking statements under the statute, said the panel.

Next, the panel found that the statements’ forward-looking aspect was not severable from their present-tense or historical implications. To the extent the phrase “each year” may have both forward and backward-looking components, the phrase was not readily severable into “distinct present-tense and forward-looking components.”

In the next step of its analysis, the panel found that the forward-looking statements were protected by the PSLRA safe harbor. The panel agreed with the district court that the plaintiffs failed to show “actual knowledge that the statements were false or misleading.” The plaintiffs had made only cursory allegations to this effect, and in fact had disclaimed any allegation that Axogen intentionally misrepresented anything.

The plaintiffs’ argument that the statements were not accompanied by “meaningful cautionary statements” could not rescue the claim. Under Harris, “even if a forward-looking statement has no accompanying cautionary language, the plaintiff must prove that the defendant made the statement with ‘actual knowledge’ that it was false or misleading.”

Concurrence on alternate grounds. Circuit Judge Lagoa wrote separately to concur on the alternative basis that the statements at issue were clear examples of nonactionable statements of opinion under Omnicare. The use of the phrase “We believe” coupled with the use of inherently imprecise phrasing should have triggered the purchaser to realize that Axogen was reciting an opinion in the form of an estimate.

Lagoa concluded that the plaintiffs could not show that Axogen believed the statement to be false because they had expressly disclaimed any allegations that Axogen’s opinion was not honestly held. Further, the plaintiffs did not challenge whether referenced studies exist (they do) or whether Axogen reviewed those studies (it did). Finally, Lagoa concluded that the plaintiffs had failed to state a claim under the omissions provisions.

Dismissal affirmed. Accordingly, because the panel agreed with the district court’s ruling, the dismissal of the claim was affirmed.

This is case No. 21-11246.

Tuesday, August 02, 2022

Company founder holds on to control under dual-class share structure

By Anne Sherry, J.D.

An amendment to a company’s articles designed to prolong the CEO’s control under a dual-class share structure passed muster with the Delaware Court of Chancery. With no dispute that the amendment was an interested transaction involving a controlling stockholder, the parties argued whether the defendants satisfied the MFW framework. The court concluded that they had, earning the transaction deferential review under the business judgment standard (City Pension Fund for Firefighters and Police Officers in the City of Miami v. The Trade Desk, Inc., July 29, 2022, Fioravanti, P.).

Jeff Green co-founded The Trade Desk, Inc. (TTD), an advertising software company, and serves as its president, CEO, and board chairman. Green controls the company through his combined ownership of class A (one vote per share) and class B (10 votes per share) stock. Class B shares are converted into class A once transferred. Due to Green’s continuing sale of shares under a 10b-5 trading plan, the number of outstanding class B shares diminished, threatening to trip a dilution trigger in TTD’s certificate of incorporation. If tripped, each share of class B would automatically convert to class A, and Green would lose voting control.

To avoid this happening, the board formed a special committee of three members and empowered it to evaluate amending the certificate of incorporation to extend the company’s dual-class structure. The committee retained Morris Nichols as its counsel and Centerview Partners as its financial advisor. Following negotiations, Green and the committee came to an agreement-in-principle that dropped the idea of a new dilution trigger based on share percentage, instead sunsetting class B stock after five years or when Green is removed as CEO or president. The board voted to approve the amendment (which also included several governance concessions on Green’s part), and the company noticed a special meeting to solicit stockholder votes. Given insufficient stockholder support, the company adjourned the special meeting, but 52 percent of unaffiliated shares approved the amendment two weeks later.

The plaintiff pension fund filed suit asserting breach of fiduciary duty against Green and other officers and directors. On the defendants’ motion to dismiss, the parties agreed that the amendment was an interested transaction involving a controlling stockholder, which would usually invoke entire fairness review. However, the defendants had attempted to follow the Delaware Supreme Court’s framework from Kahn v. M & F Worldwide Corp. (2014), which, if successful, would subject the transaction to business judgment review. The plaintiff alleged that the defendants failed to satisfy two of the six MFW elements because the special committee was not independent and the stockholder vote was uninformed.

Special committee independence. First, the court examined the plaintiff’s claims that the special committee was not independent because the chair’s lack of independence undermined the committee as a whole and the committee labored under a “controlled mindset” that made it defer to Green’s wishes. The plaintiff’s challenge to the chair’s independence was limited to the compensation she derived as a consultant to TTD in 2016 and as a director in 2019 and 2020, but the complaint lacked well-pleaded facts as to the materiality of that compensation. Furthermore, even if her compensation was material and she was not independent, the complaint did not allege facts creating a reasonable inference that a majority of the committee lacked independence or that the chair so dominated the committee as to undermine its integrity as a whole.

The court likewise rejected the plaintiff’s argument that the special committee labored under a “controlled mindset” and acceded to Green’s wishes to ingratiate themselves to him and ensure their continued positions on the TTD board. The complaint lacked any well-pleaded allegations that the committee members were beholden to Green or had a disabling personal interest in the amendment. The plaintiff merely argued that no independent fiduciaries would in good faith perpetuate a dual-class structure, an ipse dixit that did not persuade the court. Unlike the cases the plaintiff cited, its complaint lacked allegations that Green sought to interfere or pressure the committee. “At bottom, Plaintiff’s challenge to the Special Committee is grounded in Plaintiff’s belief that maintaining the dual-class structure through the Dilution Trigger Amendment was a bad deal for TTD stockholders. Maybe it was. But the Delaware Supreme Court has clarified that this court’s role in applying the MFW framework is limited to a process analysis, not second guessing the ultimate ‘give’ and ‘get,’” the court concluded.

Stockholder vote. Finally, the court examined alleged disclosure deficiencies in the special proxy that rendered the stockholder vote uninformed. But as long as the proxy statement viewed in its entirety sufficiently discloses and explains the matter to be voted on, it is generally within management’s business judgment to leave out or include a particular fact. Whether individually or collectively, the six alleged omissions, concerning such matters as Green’s wish to sell class B stock and the expectations and efforts of the company and its professionals, did not result in an uninformed vote. Accordingly, MFW was satisfied, the business judgment rule applied, and only a well-pleaded claim for waste could overcome the rule.

The case is No. 2021-0560.

Monday, August 01, 2022

Manufacturers, Chamber sue SEC over rescission of proxy rules

By Rodney F. Tonkovic, J.D.

NAM and the Chamber of Commerce have filed separate suits challenging the SEC's rescission of part of its rules governing proxy voting advice. The final rules scrapped conditions to exemptions from the proxy rules' information and filing requirements that were adopted in July 2020. The complaints argue that the Commission provided no justification for this about-face and failed to provide the APA's procedures. The promulgation of the amended rule was arbitrary and capricious, the complaints argue, and it should be vacated and set aside.

Proxy rule rescission. On July 13, 2022, the SEC, by a 3-2 vote, rescinded certain aspects of proxy voting advice rules adopted just two years earlier. The July 2020 rules codified the Commission's view that proxy voting advice is generally a solicitation under the securities regulations. At issue here, the release added conditions in Exchange Act Rule 14a-2(b)(9)(ii)(A) and (B) requiring a proxy voting advice business to adopt and publicly disclose written policies and procedures reasonably designed to ensure:
  • Registrants that are the subject of the proxy voting advice have such advice made available to them when the advice is disseminated to the proxy voting advice business's clients; and
  • The proxy voting advice business provides a mechanism by which its clients can become aware of any written statements regarding its proxy voting advice by registrants who are the subject of such advice, in a timely manner before the security holder meeting.
The 2022 release rescinded these conditions, as well as related safe harbors and exclusions from those conditions, plus a note to Rule 14a-9 and supplemental proxy guidance issued in connection with the 2020 rules. Commissioners Peirce and Uyeda dissented, objecting to what Peirce called dramatic change of course with little justification; both commissioners also pointed to the 30-day comment period, which overlapped the major December holidays.

NAM sues. On July 21, 2022, the National Association of Manufacturers sued the SEC in the Western District of Texas seeking declaratory and injunctive relief. NAM has long supported increased oversight of proxy advisory firms and called the 2020 rules a "major win for the industry." But, when the SEC suspended enforcement of the rules in June 2021, NAM voiced concern and later filed suit challenging the suspension.

The complaint argues that the rescission is procedurally defective and unlawfully arbitrary and capricious and should be set aside in its entirety. Using the same factual record behind the adoption of the 2020 rules the SEC came to a completely different outcome in 2022. Not only did the SEC lack any compelling justification, NAM says, to the extent the agency explains its action, "its contentions are mere platitudes." The Administrative Procedure Act requires much more, and this and other failures of reasoning require the 2022 rule's vacatur "many times over." Regarding this suit, NAM's Chief Legal Officer Linda Kelly said: "The SEC has failed to provide any substantive justification for its dramatic about-face. Manufacturers depend on federal agencies to provide reliable rules of the road, and the SEC's arbitrary actions to rescind this commonsense regulation clearly violate its obligations under the Administrative Procedure Act."

The complaint offers several reasons why NAM believes that the rescission is fatally flawed both procedurally and substantively. First, the Commission rescinded the regulation based on the same factual record behind promulgating the regulation in the first place; plus, the 2020 rule never went into effect so it could be evaluated in practice. NAM argues further that the SEC failed to articulate any explanation for its action, especially in its conclusion that voluntary measures by proxy firms would render some of the mechanisms of the rule unnecessary. In addition, the SEC failed to respond to comments received and only repeated the premises the comments had rebutted, NAM says.

Moreover, the rescission was done without observing the APA's notice and comment procedures, which provides another basis to set aside the entire rulemaking. According to NAM, "all signs indicate that Chair Gensler's SEC had made up its mind to rescind the 2020 Rule before even initiating the notice and comment process." NAM notes that the reconsideration process began with a June 2021 "secret, behind-closed-doors" meeting with only opponents of the 2020 rule, biasing the agency against good-faith consideration of comments from both sides.

Finally, the complaint takes issue with the "unduly short" comment period of 30 days. The comment period ended on December 27, 2021, in the middle of the holiday season, and it was predictable, NAM remarks, that concerned parties were unable to submit comment letters during this period. The abbreviated comment period indicates a lack of good-faith consideration by the SEC, and this provides another reason for the court to set aside the rulemaking, NAM maintains.

Chamber of Commerce. The Chamber of Commerce filed its suit in the Middle District of Tennessee on July 28, 2022. The Chamber also seeks a declaratory judgment that the rescission is arbitrary and capricious and should be vacated in its entirety. It is worth noting that the Chamber has issued a summons to Chairman Gensler, who is being sued in his official capacity.

The Chamber's complaint argues that the rescission violated the Commission's obligations under the APA in numerous ways. Like NAM, the Chamber argues that the Commission's justifications for the rescission are "riddled with flaws and logical inconsistencies" and provide no evidence of new or changed circumstances that would support reversing its position.

In addition, the complaint posits that the rescission's cost-benefit analysis is opportunistically framed. According to the Chamber, the analysis focuses on the benefits to proxy advisors' profitability while ignoring the substantial costs to companies and investors. The SEC also failed to consider alternatives and downplayed or ignored the problems leading to the adoption of the 2020 rule. Plus, by deferring to the advisors' voluntary self-regulation, the Commission had given them special treatment in contrast to other regulated entities for which it has concluded self-regulation is insufficient.

The Chamber asserts that the rescission was "plainly the by-product of political objectives" and contrasts this move away from transparency to efforts in other areas, such as ESG. As the complaint notes, Chairman Gensler was sworn in April 2021, and the Commission "abruptly flip-flopped" on the 2020 rule in June 2021. The complaint also points out the "rushed comment period" that generated about one-tenth of the amount received for the 2020 rule, most of which expressed opposition to the sudden rule change. The Chamber also accuses the Commission of "stonewalling" in its refusal to respond to requests to extend the comment period and in its delay in responding to the Chamber's FOIA requests concerning the June 2021 meeting.

"The SEC's harmful decision to roll back these reforms will allow proxy advisors to operate as a black box, as they have for decades, and create disincentives for companies to go, and stay, public," said U.S. Chamber President and CEO Suzanne P. Clark. She added that the SEC "failed to engage in reasoned decision-making and provided no serious evidence of new or changed circumstances to justify its actions. The Chamber will continue to fight on behalf of businesses to ensure the SEC holds proxy advisors accountable and does not move forward with regulation that harms companies, investors, and the capital markets."

The cases are Nos. 3:22-cv-00561(Chamber) and 7:22-cv-00163 (NAM).

Friday, July 29, 2022

Sen. Toomey says SEC murkiness on cryptoassets is hurting consumers

By Lene Powell, J.D.

In a letter to SEC Chair Gary Gensler, Senate Banking Committee Ranking Member Pat Toomey (R-Pa) slammed a “continued unwillingness by the SEC to give regulatory clarity to the cryptocurrency community and consumers.” According to Toomey, a “regulation-by-enforcement” approach by the SEC has contributed to financial losses for American consumers.

Pointing to the recent failure of several companies providing cryptocurrency lending services, including the collapse of Celsius LLC, Toomey said “things could have been different” if the SEC had provided regulatory clarity.

“Had the SEC responded to calls for clarity on how it would apply existing securities laws to novel digital assets and services, things could have been different,” said Toomey. “Companies could have adjusted product offerings accordingly, preventing investor losses today, and the SEC would have been free to focus enforcement efforts on the worst actors.”

Recent crypto collapses. Several cryptocurrency lending and trading platforms have filed for bankruptcy in the past month. Celsius LLC, a crypto lending platform that according to its CFO had over $10 billion in assets as of June 8, halted withdrawals, swaps, and transfers on June 12. The company then announced on July 13 it had filed for bankruptcy. The collapse follows similar failures by the Vauld and Voyager platforms.

Lack of regulatory clarity? Toomey said the failed crypto lending companies were “arguably within the SEC’s purview” and suggested that consumer losses could have been prevented if the SEC had been clearer about how the federal securities laws applied.

For example, the SEC could have clarified how the Howey and Reves tests applied to crypto lending platform products that paid interest to customers making crypto deposits, said Toomey. He added that the SEC concluded several months ago that BlockFi, another crypto lending company, offered a similar product that fell under the Howey test. In February the SEC announced that BlockFi had agreed to pay $100 million in penalties for failing to register offers and sales of its retail crypto lending product.

Toomey also noted the SEC recently brought insider trading charges against a former employee of the Coinbase cryptocurrency exchange and two other persons, alleging they illegally traded nine digital asset securities.

“In this circumstance and elsewhere, the SEC ostensibly had a clear opinion on why it thinks these digital assets are securities, yet it did not disclose that view publicly before launching an enforcement action,” said Toomey.

Harm to consumers? According to Toomey, regulatory uncertainty and a “haphazard and an apparently sluggish enforcement pace” makes it hard for companies to comply with SEC regulations and harms investors. Toomey stated that press reports in January indicated the SEC was investigating whether Celsius and Voyager were complying with securities laws, yet the SEC failed to act before the companies went bankrupt. Celsius customer funds have been frozen since mid-June, leaving in question the status of billions of dollars’ worth of deposits, said Toomey.

Toomey raised his consumer protection concerns one day after introducing a bill to carve out a tax exemption for personal crypto transactions under $50. The bill would ease adoption of digital currencies, which Toomey said “have the potential to become an ordinary part of Americans’ everyday lives.”

Questions for the SEC. Toomey ended with eight questions for the SEC:
  1. Are there other major crypto lending companies besides BlockFi that have not registered their services with the SEC? If so, please identify them.
  2. After the SEC determined that BlockFi’s lending product was a security, did the SEC determine whether any other companies, including Celsius and Voyager, were offering similar services that the SEC believed were securities? a. If so, for what companies did the SEC make those determinations and on what date were those determinations made?
  3. What material differences has the SEC identified between BlockFi and other crypto lending companies?
  4. Did Celsius, Voyager, BlockFi, or any similar crypto lending company ever ask the SEC for guidance as to whether their crypto lending services were securities? If so, when were those inquiries first made and what did the SEC say in response?
  5. Did the SEC determine whether to pursue an enforcement action against Celsius or Voyager? If so, when did the SEC make those determinations?
  6. The SEC’s insider trading charges against a former Coinbase employee and two other persons allege that they illegally traded nine digital asset securities, yet the U.S. Department of Justice’s criminal charges against those defendants claim they made illegal trades in at least 25 digital assets. What distinguishable features do these nine digital assets have that the SEC determined were securities, compared to the other 16 digital assets the SEC did not include in its charges? a. What guidance does the SEC plan to provide for these 16 digital assets?
  7. In the absence of a commitment by the issuer of a digital asset to provide an investor a specific return or a claim against the issuer, how would an investor have a sufficiently well-founded expectation of profits to pass Howey’s “expectation of profits” and “investment in a common enterprise” prongs?
  8. How does a decentralized open-source network compromised [sic] solely of software code meet the “common enterprise” and “efforts of others” prongs of the Howey test?
Toomey requested written answers by August 9, 2022.

Thursday, July 28, 2022

Willkie partners caution companies about updating whistleblower policies

By Martin J. Weinstein, Robert J. Meyer, Jeffrey D. Clark, and Andrew English of Willkie Farr & Gallagher

Recent actions by the SEC have highlighted the importance of monitoring SEC enforcement and adjusting company policies accordingly. In this Strategic Perspective, members of Willkie Farr & Gallagher’s Compliance, Investigations & Enforcement Practice Group in Washington, D.C. discuss the cost of not keeping company confidentiality policies up to date, using the example of The Brink’s Company, the cash transit operator. Failure to update their whistleblower policy in light of the SEC’s widely-reported 2015 action against KBR, Inc. cost the company a $400,000 fine. The Brinks enforcement action makes clear, according to the authors, that the SEC continues to actively monitor companies’ compliance with required protections for whistleblowers and considers public companies to be on notice of the requirements. Read the entire Strategic Perspective here.

Wednesday, July 27, 2022

SEC’s data analysis team cracks three alleged insider trading schemes

By Lene Powell, J.D.

The SEC announced insider charges against nine individuals in connection with three separate alleged schemes, including a former chief information security officer (CISO), an investment banker, and a former FBI trainee. The actions originated from the SEC Enforcement Division’s Market Abuse Unit’s (MAU) Analysis and Detection Center, which uses data analysis tools to detect suspicious trading patterns. The U.S. Attorney's Office for the Southern District of New York charged parallel criminal violations.

The alleged schemes yielded more than $6.8 million in ill-gotten gains.

“If everyday investors think that the market is rigged at their expense in favor of insiders who abuse their positions, they are not going to invest their hard earned money in the markets,” said SEC Enforcement Director Gurbir S. Grewal. “But as today's actions show, we stand ready to leverage all of our expertise and tools to root out misconduct and to hold bad actors accountable no matter the industry or profession. That's what’s required to restore investor trust and confidence.”

Former FBI trainee linked to law firm associate. As alleged, former FBI trainee Seth Markin’s then-girlfriend worked as an associate for a law firm representing Merck & Co., Inc. in a planned tender offer to acquire Pandion Therapeutics, Inc. Markin allegedly learned material nonpublic information by secretly reviewing the binder of deal documents, which he then traded on and tipped to several friends and family members, indirectly causing more than twenty people to trade on the basis of the inside information. According to the SEC, Markin made approximately $82,000 and another charged defendant made $1.3 million. Markin allegedly lied to FBI agents, as well as to his girlfriend when she questioned why her name came up in a FINRA inquiry.

The SEC seeks permanent injunctive relief, civil penalties, and disgorgement with prejudgment interest against Markin and his friend. Markin is charged with nine counts of securities fraud, eight counts of tender offer fraud, one count of conspiracy, and one count of making false statements. Another defendant was charged with 11 counts of securities fraud, 10 counts of tender offer fraud, and one count of conspiracy (SEC v. Markin and U.S. v. Markin).

Investment banker. According to the filings, Brijesh Goel was an investment banker in the financing group at a major international investment bank in New York City (widely reported to be Goldman Sachs). Goel allegedly learned confidential internal information about potential mergers and acquisitions transactions the investment bank was considering financing and tipped the information to a friend, who worked at another investment bank. The friend allegedly then used the information to trade call options, including short-dated, out-of-the-money call options, in brokerage accounts in the name of his brother. According to the filings, between approximately 2017 and 2018, Goel tipped the friend about at least seven deals, yielding total illegal profits of approximately $280,000. Goel allegedly directed his friend to delete electronic communications about the scheme.

The SEC seeks permanent injunctive relief, civil penalties, and disgorgement with prejudgment interest against Goel and his friend. Goel is charged with four counts of securities fraud, one count of obstruction of justice, and one count of conspiracy to commit securities fraud and tender offer fraud (SEC v. Goel and U.S. v. Goel).

Chief information security officer. According to the SEC and DOJ, Amit Bhardwaj, former CISO of Lumentum Holdings Inc., learned material nonpublic information about the company’s plans to first acquire Coherent, Inc. and later acquire NeoPhotonics Corporation. Bhardwaj allegedly bought Coherent securities ahead of the merger and tipped a friend with the understanding that the friend would share some of his ill-gotten gains. Bhardwaj then tipped several friends about the planned NeoPhotonics acquisition, who then amassed large positions of NeoPhotonics, and one friend indirectly transferred funds to Bhardwaj’s relative in India, as instructed by Bhardwaj. The defendants allegedly acted to obstruct the federal investigation, including by concocting false stories and creating false documents.

The SEC seeks permanent injunctive relief, civil penalties, and disgorgement with prejudgment interest, including from relief defendants. The DOJ charged Bhardwaj with seven counts of securities fraud, two counts of wire fraud, one count of conspiracy to commit securities fraud and wire fraud, and one count of conspiracy to obstruct justice. Two of Bhardwaj’s friends were also charged, and an additional two defendants have separately pleaded guilty and are cooperating with the government (SEC v. Bhardwaj and U.S. v. Bhardwaj).

“The crimes we allege threaten both the integrity of our financial markets and investors’ faith in them,” said FBI Assistant Director-in-Charge Michael J. Driscoll. “Our actions demonstrate we remain committed to ensuring a level playing field for all.”

This is case Nos. 1:22-cv-06276 (SEC v. Markin) and 22 CRIM 395 (U.S. v. Markin); 1:22-cv-06277 (SEC v. Bhardwaj) and 22 CRIM 398 (U.S. v. Bhardwaj); 1:22-cv-06282 (SEC v. Goel) and 22 CRIM 396 (U.S. v. Goel).

Tuesday, July 26, 2022

Blue-sky law challenge explores parameters of securities versus joint ventures

By Suzanne Cosgrove

A state appeals court has affirmed a decision by the Iowa Insurance Division that two salesmen from Texas company Carson Energy, Inc., violated the state’s blue-sky laws. The Division had previously charged the company, its president, Earl Carter Bills II, now deceased, and two of Carson’s salesmen, Anthony Weber and Jerrold Rothouse, with the soliciting of investment in Carson’s oil and gas wells in Texas and elsewhere as joint venture shares. The Division alleged what Weber and Rothouse sold to Iowans in “cold call” sales pitches were unregistered securities and constituted securities fraud (Weber v. Iowa Insurance Division, July 20, 2022, Ahlers, J.).

“Blue-sky laws” protect investors from fraudulent investment schemes by requiring the licensing of brokers, registration of securities and approval of investment offerings by appropriate governmental agencies. In Iowa, those statutes are enforced by the Iowa Insurance Division.

The Division initially filed a motion for partial summary judgment on the unregistered-securities count, seeking a declaration that the investments Weber and Rothouse sold qualified as securities under Iowa law. Weber and Rothouse filed a competing motion for summary judgment, contending the investments they sold were not securities.

An administrative law judge agreed Weber and Rothouse engaged in the sale of unregistered securities but determined that the Division failed to prove that Weber and Rothouse engaged in fraud. The judge imposed penalties against Weber and Rothouse, including fines of $6,000 against Weber and $9,000 against Rothouse, for the sale of unregistered securities. A district court affirmed that finding in a later judicial review, but Weber and Rothouse appealed.

Were the investments securities? According to court documents, the appeal’s “fighting issue” continued to be whether the agency properly determined as a matter of law that the joint venture shares that Weber and Rothouse sold to Iowans were securities that were required to be registered.

The court noted with certain exceptions, Iowa Code section 502.301(3) (2015) prohibits a person from selling a security in Iowa unless the security is registered in Iowa. There was no dispute that the agreements were not registered—the issue was whether the agreements qualified as “securities” under Iowa law. The Iowa Insurance Division argued the investments in this case were securities. Weber and Rothouse argued they were not.

Noting the term “security” can be broadly defined to include investment contracts, and leaning on federal law and guidance provided previously by the state supreme court, the court defined securities as contracts that require an investment of money in a common enterprise, on an expectation of profits to be derived “solely from the efforts of individuals other than the investor.”

Joint ventures come with responsibility. In contrast, joint venture participants are provided significant management powers which they are expected to exercise. They also are prohibited from relying on the “managing venturer” for its success or profitability.

More to the point of the Carson case, the court submitted affidavits obtained by the Division from 14 Iowans who signed the investment agreements. All 14 stated their sole involvement with Carson’s well projects was to send money to Carson. There was no evidence that the investors exercised their formal partnership powers, nor did they appear to have any experience with oil and gas wells.

In their appeal, Weber and Rothouse disputed the credibility of the affidavits but did not provide any evidence that contradicted the investors’ affidavits of statements.

“We find no genuine issue of material fact that the agreements Weber and Rothouse offered to Iowan investors were securities and they were not registered as required by Iowa law,” the court concluded.

The case is No. 21-1022.

Monday, July 25, 2022

SEC enforcement director’s House testimony sheds light on agency’s priorities

By Suzanne Cosgrove

Appearing before the House Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, SEC enforcement director Gurbir Grewal told legislators he aimed to restore the public’s trust in financial markets and “make clear that there is only one set of rules” while maintaining the SEC’s mission -- ensuring fair, orderly and efficient markets, and facilitating capital formation. The SEC has seen an increase in the number of cases that are litigating and going to trial. During fiscal year 2021, the Division had approximately 2,000 pending civil litigations and 1,200 pending administrative proceedings, Grewal said.

In addition, the SEC division is taking proactive steps to police new areas of importance for investors, as well as the “continually evolving risks” they face, he said, including in crypto assets and cybersecurity.

Speaking the day before a House vote on FY23 appropriations, Grewal stressed the need for the allocation of more than 100 new SEC positions, with 20 slated for the agency’s Crypto Assets and Cyber Unit, a request contained in the SEC’s fiscal year funding proposal. The added positions would still result in a total number of positions that would be smaller than the agency had in 2016, Grewal said.

As reported previously in Securities Regulation Daily, the House subsequently passed a bill that would provide FY23 funding for the SEC and the CFTC. The SEC would be funded at more than $2 billion if the House bill is enacted, but it still must go before the Senate.

Trust restoration. Circling back to the issues of trust, Grewal noted rapid increases in technology have created new avenues for misconduct. Public companies and other market participants need to think carefully about how their business models and products interact with both emerging risks and their obligations under the federal securities laws, he said.

“Robust compliance is a responsibility shared by all market participants,” he said. Companies “cannot rely on check-the-box compliance policies, but should consider, where appropriate, developing bespoke policies tailored to their businesses and the associated risks,” Grewal said. “Where they fall short, we have not hesitated in holding them accountable.”

Citing recent charges against Ernst & Young LLP in connection with cheating by audit professionals on exams required for Certified Public Accountant licenses, Grewal said when gatekeepers, such as accountants and attorneys, fail to live up to their obligations, investors and the integrity of markets suffer. Ernst & Young admitted the facts underlying the SEC’s charges and agreed to pay a $100 million penalty and undertake remedial action.

Contentious questioning. Following his prepared remarks, Grewal faced often sharp questions from House committee members, who focused mainly on the SEC’s involvement related to digital assets–and their recent meltdown--and ESG issues. Addressing the SEC’s complaints regarding ESG disclosure rules, for example, Rep. Ann Wagner (R.-Mo.) asked the director, “What statute allows the SEC to regulate climate change?”

“We can enforce when there are lies,” Grewal said. As an example, he noted the SEC’s charges against BNY Mellon Investment Adviser, Inc. for misstatements and omissions about ESG considerations in certain mutual funds it managed. To settle the charges, BNY Mellon later agreed to pay a $1.5 million penalty.

Friday, July 22, 2022

SEC Historical Society panel discusses the making of a corporate governance law

By Mark S. Nelson, J.D.

Former President George W. Bush on July 30, 2002 signed the Sarbanes-Oxley Act into law after the accounting scandals at Enron and WorldCom Inc. shook markets and U.S. financial regulators. The president’s signature came five days after first the House and then the Senate passed the Act by votes of 423-3 and 99-0, respectively, within four-and-a-half hours of each other. Few pieces of wide-ranging legislation come together so quickly as did the Sarbanes-Oxley Act, but when Congress senses a felt need, it can move with surprising speed.

The SEC Historical Society today presented a panel titled The Sarbanes-Oxley Act at 20: A Corporate Governance Legacy featuring many of the key players at the SEC who implemented the Congressional mandate on corporate governance meant to reassure investors that public company financial statements could again be trusted. The persons telling that story were: Harvey L. Pitt, former SEC Chair (2001–2003); Alan L. Beller, former Director of the SEC's Division of Corporation Finance (CorpFin) (2002–2006); Shelley E. Parratt, former Deputy Director in CorpFin (2003–2021); and Annemarie Tierney, former Assistant General Counsel, NYSE Euronext (2002–2008). David M. Lynn, former Chief Counsel in CorpFin (2003–2007), and currently a Partner at Morrison & Foerster LLP, moderated.

In a way, the history of the Sarbanes-Oxley Act, sometimes called SOX, suggests a dual history—there is the story of how the SEC initially sought to address the emerging accounting scandals of the late 1990s and early 2000s followed by its implementation of the Act, but there also is a separate and equally dramatic history of how the Act’s centerpiece—the Public Company Accounting Oversight Board—has withstood a serious legal challenge and internal turmoil to remain largely intact if perhaps with some lingering imperfections and a constitutional legacy that may have long coattails for federal agencies.

Getting SOX implemented. Moderator Lynn began the session with a general question about what the facts on the ground were as the push for the Sarbanes-Oxley Act began, something that the panelists said occurred outside the SEC, which did not originate the call for legislation. According to former Chair Pitt, the events surrounding Enron were “shocking” but that it was unclear there would be a legislative solution until after the WorldCom scandal broke. Pitt later recalled that WorldCom was a “game changer” and that Congressional resolve to adopt a statute was “manifest.” Then-CorpFin Director Beller agreed that within 24 hours of WorldCom notifying the SEC of its disclosure failures, it was 100 percent clear that it was not a question of whether legislation would happen but what it would say and how fast it would happen.

Beller had previously explained that SEC staff had begun to revamp the agency’s disclosure review program before SOX became inevitable and that the SEC was understaffed for what was to come. The person who led disclosure review, former Deputy Director Parratt, noted that SEC staff were concerned at the time that they would be criticized for not being a better cop on the beat. She added that disclosure review then was focused on transactions instead of current and periodic reports (a focus that would soon change) and that disclosure review is a poor vehicle for uncovering fraud or other intentional conduct. Tierney, the former Assistant General Counsel at NYSE Euronext, said NYSE was already pursuing its own governance reforms before the Enron scandal and had issued a set of best practices, including best practices for audit committee independence.

Pitt commented that the SEC maintained good relationships with people on The Hill and that the agency had contacts on the relevant Congressional committees. Despite the fact that SOX was initiated by Congress, Pitt said the SEC had input on many issues but not the “stringent deadlines” Congress would impose for carrying out multiple 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.

According to Beller, the overwhelming support in Congress for the Sarbanes-Oxley Act made it easier for the SEC staff and the Commission to carry out the nearly two dozen rulemakings. Both Beller and Pitt noted that all of the required rulemakings were adopted unanimously by the Commission (Pitt would later note that this feat might be harder to achieve in today’s environment). With respect to those rulemakings, Beller recalled that there was lots of communication between SEC staff and the Commission and that there was remarkably little ego involved in the whole process with no push back from Congress on what the Commission ultimately implemented. Beller observed that SEC staff spent a lot of time on audit committee independence issues and that, in the case of the loan provisions in SOX, the SEC opted not to take exemptive action because that provision was self-executing and the SEC was not in the business of providing exemptions to a statute with overwhelming Congressional support. Pitt noted the need to work around SOX provisions that had both civil and criminal enforcement components; Pitt also lamented the existence of the Sunshine Act, which he said hinders communications on multimember regulatory bodies.

When asked what was surprising about the Sarbanes-Oxley Act, Pitt immediately said it was the deadlines, although he also said the review requirement was a surprise because Congress was telling the SEC how to conduct disclosure reviews. By way of background, Section 408 of the Sarbanes-Oxley Act requires the SEC to review the filings of reporting companies at least once every three years. Beller would separately comment that much of CorpFin’s work centers on conducting disclosure reviews and, as a sidelight, that after CorpFin had received dozens of Freedom of Information Act requests during his tenure for specific companies’ staff comment letter dialogs, CorpFin decided to put those dialogs on EDGAR, which it did beginning in May 2005. Perhaps Parratt’s discussion of the practical realities of disclosure review under SOX was the most revealing insight into how a key part of the SEC’s work gets done.

According to Parratt, reviews were a big challenge because of the number of reporting companies (then about 15,000) had to be reviewed at a rate of roughly 5,000 companies per year. Before SOX, Parratt said the SEC would review Forms 10-K whenever it could, but that SOX changed that approach. As a result, the SEC had to figure out how to count different types of reviews in order to comply with the SOX review mandate. Parratt said the SEC divided companies in to three groups; (1) the top 1,000 companies by market capitalization; (2) the next 6,000 companies; and (3) all of the rest. The SEC also adopted a tripartite review structure in which companies could be subjected to a preliminary review, a full review, or a financial statement review (all three types of reviews would be counted for SOX purposes).

Parratt then explained that preliminary reviews had been added to the mix in order to give the SEC a chance to look at the adequacy of a company’s disclosures and then recommend further review if needed (the SEC, however, does not assess the accuracy of companies’ disclosures). The SEC, Parratt continued, also planned to review the top 1,000 companies annually, while spending somewhat less time reviewing the next 6,000 companies (mostly preliminary reviews with about one-third of such companies getting further reviewed). The smallest companies would only get high level reviews for key issues.

Both Beller and Parratt noted how the SEC had to staff up to meet the disclosure review demand imposed by SOX. A serious problem for the SEC, said Parratt, was that SOX demanded the agency hire about 100-150 more accountants with specialized audit skills but federal hiring rules made it difficult to hire people with the right credentials. Parratt explained that the SEC was able to solve this problem by obtaining a workaround to the federal hiring rules.

Also with respect to implementation by the SEC, Tierney would also note that CorpFin would have to grapple with how to treat foreign issuers under SOX. Many of these companies were subject to home country rules that would not allow them to meet certain SOX requirements.

Sarbanes-Oxley Act legacy. The SEC Historical Society panelists noted some of the lasting results of the Sarbanes-Oxley Act. Beller had already mentioned CorpFin’s decision to publish SEC staff correspondence with companies on EDGAR and later observed that, without SOX as a precursor, the SEC’s 2005 offering reforms would not have been possible. Pitt noted that while SOX applies only to public companies, the Act nevertheless had a significant impact on not-for-profit companies, which now follow many of the governance provisions contained in the Act. Pitt also mentioned that current reports are now an important means to get information out faster. Beller had noted earlier in the discussion that he came to the SEC from private practice without any specific plans about governance rulemakings but that having had the experience of working in boardrooms both before and after SOX, he had seen how dramatically SOX changed the work of board members, which he jokingly recalled was once said to be to show up on time, don’t fall asleep, and eat the sandwiches.

As for the Sarbanes-Oxley Act’s legacy at age 20, all of the panelists had ideas which, in some instances, overlapped. Tierney cited the increased review of companies’ SEC reports. For Parratt, it is that companies now will reach out to SEC staff about reviews in contrast to the unhappy state of many companies facing increased regulatory scrutiny when the Act became law. Beller said SOX forced companies to think about disclosure more seriously, especially regarding timing and process. Although Beller did not reprise an earlier statement about investor protection, he might have added that another legacy of SOX is, as he previously mentioned, numbers matter; Beller observed that investors have no chance if the numbers are not right. Pitt suggested the Act’s legacy is how the SEC staff handled the implementation of the Act and how that process increased the agency’s credibility.

A brief history of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act is twenty years old this year, its namesakes and authors, Senator Paul Sarbanes (D-Md) and Rep. Michael Oxley (R-Ohio), are both deceased, it has withstood a serious court challenge and, at least conceptually, remains intact. While there may be open questions about its ultimate implementation and execution in practice, the bill that began as a response to the Enron and WorldCom accounting scandals of the late 1990s and early 2000s remains a significant force in corporate governance.

A part of the Sarbanes-Oxley Act’s structure was challenged in 2010 as a unconstitutional structural overreach that put the members of the Public Company Accounting Oversight Board (PCAOB), the Act’s audit regulator, out of reach of presidential control. A majority of the Supreme Court upheld the PCAOB but struck provisions in the Act that gave Board members dual tenure protection. Then-Justice Breyer wrote a detailed dissent noting the many ways in which the majority’s opinion might undermine administrative law judges (ALJs) at many federal agencies, especially the Social Security Administration, but also the SEC. The Supreme Court’s opinion has been cited for the now constitutional rule that ALJs are officers of the U.S. who may not enjoy more than one layer of tenure protection (i.e., Board members are at will employees subject to being fired by the Commission, whose members in turn can be removed for cause by the president). The opinion still reverberates in federal courts regarding the removal of ALJs, one of several lines of attack on ALJs that may end up at the Supreme Court in the upcoming OT22 term (See, e.g., Jarkesy v. SEC (5th Cir. 2022) and the SEC’s en banc petition and the respondent’s opposition).

Other, non-audit-related provisions of the Sarbanes-Oxley Act have been interpreted by courts to simultaneously constrict and expand federal government authorities. The Supreme Court decided a case that was affectionately dubbed the “fish case” in which John Yates, a commercial fisherman in the Gulf of Mexico, was prosecuted for tossing allegedly undersized red grouper overboard after an encounter with wildlife conservation officials. Yates was convicted of violating 18 U.S.C. §1519, an evidence spoliation provision added to the federal criminal laws by the Sarbanes-Oxley Act. Under 18 U.S.C. §1519, a person can be penalized if they knowingly destroy a "tangible object" with the intent of obstructing a federal agency investigation. The question was whether a fish is a "tangible object." Justice Ginsburg, writing for the majority, answered that a fish, although it can be destroyed, is not the type of "tangible object" contemplated by the statute. Rather, she explained that a "tangible object" is an object that has ties to the purpose of the SOX provision, meaning that it is "used to record or preserve information." Justice Kagan’s dissent took the view that the words surrounding "tangible object" in the statute indicated Congressional intent for the statute to apply widely to all kinds of objects. To further make her point, Justice Kagan cited the Dr. Seuss book "One Fish Two Fish Red Fish Blue Fish." As a result of the opinion, a SOX provision was narrowed.

In U.S. v. Blaszczak, the Second Circuit held that the Dirks personal-benefit test does not apply in criminal prosecutions under the wire fraud and securities fraud provisions of Title 18 of the U.S. Code. The Sarbanes-Oxley Act added 18 U.S. §1348 to the criminal code, in part, to overcome the technical legal requirements of the Title 15 fraud provisions. The court reasoned that Titles 15 and 18 were intended to give prosecutors different avenues to prosecute securities fraud so it made little sense to extend Title 15 requirements to Title 18. The case, thus, confirmed that a SOX provision had potentially broad application.

More recently, the PCAOB has withstood criticism for its lack of oversight regarding a cheating scandal involving one of the Big Four accounting firms. The PCAOB Board also remains the subject of criticism for its high salaries as compared to other quasi-federal entities—the theory upon enactment of SOX was that high salaries would attract the best minds to the Board, but critics contend that Board members have some of the cushiest jobs among financial regulators. Today, the PCAOB Board has been almost reconstituted in whole for second time in about five years. The PCAOB recently implemented one of the more significant changes to the auditor’s report by mandating discussion of critical audit matters (CAMs). The PCAOB also finds itself working on a new project with the SEC to implement the Holding Foreign Companies Accountable Act, a markets-based approach to curbing the influence of the Chinese government on companies listed on U.S. stock exchanges (See also, PCOAB determinations on Mainland China and Hong Kong).