SEC charges investment adviser with violating Compliance Rule

By Anne Sherry, J.D.

The SEC filed a settled order against Sciens Diversified Managers, LLC, for compliance failures in the area of asset valuation. According to the order, Sciens advised private funds that primarily invest in assets that are difficult to value, but Sciens’ policies and procedures gave only minimal guidance. Sciens agreed to be censured and pay a $275,000 civil penalty (In the Matter of Sciens Investment Management, LLC, Release No. IA-6315, May 24, 2023).

Background. Most of Sciens’ U.S.-based advisory business involved providing discretionary investment management services to private partnerships, offshore funds, and other entities that primarily invest in private companies. Its largest private equity fund was Sciens Special Situations Master Fund Ltd. (“SSSMF”), accounting for more than half of Sciens’ total assets under management (either directly or indirectly through other private equity funds managed by Sciens).

Under SSSMF’s offering documents, Sciens was to charge two percent of net asset value as a management fee. The offering documents also described how NAV was to be calculated and that assets were to be valued in a manner that reflected the current fair market value. Virtually all of SSSMF’s portfolio investments were Level 3 assets for which market prices were not readily available and there were no significant observable inputs.

Policies and procedures. Despite GAAP and ASC provisions on fair value and Level 3 inputs, Sciens’ valuation policies did not provide sufficient guidance or parameters on how to value Level 3 investments. The only substantive guidance in its Compliance Manual relevant to Level 3 investments was that fair value is to be “based on available information and several non-exclusive factors which provide the best available estimate of a current market price that [Sciens] will take into consideration” and that Sciens would monitor developments affecting such assets to determine the continuing validity of the fair value using information sources “including news stories, financial wires, broker-dealer and other market contacts and market indices.” The manual did not mention techniques or methodologies applicable to Level 3 investments and lacked procedures designed to promote consistency and conflicts reduction.

While the Compliance Manual referred to the offering documents for the private equity funds and directed that valuation would be done in a manner consistent with the guidelines and requirements in the funds’ offering documents, those offering documents generally didn’t provide any further guidance on Level 3 investments. SSSMF’s offering documents said that the board and Sciens would establish valuation policies and procedures, but none were established beyond those in the Compliance Manual.

Because they were unable to obtain sufficient audit evidence, SSSMF’s auditors provided qualified opinions on SSSMF’s financial statements, putting Sciens on notice that its valuation procedures may have been insufficient. One auditor later withdrew even its qualified opinion, leading Sciens to write down SSSMF’s Level 3 portfolio by about $33 million.

Sanctions. Sciens agreed to retain an independent compliance consultant and report to the Commission. It was censured, ordered to cease and desist from future violations, and ordered to pay a civil penalty of $275,000.

This is Release No. IA-6315.

Market stays quiet as no deals get done for second straight week

By John Filar Atwood

No IPOs were completed last week, the second straight week in which no deals have gotten done. It was the fourth time in 2023 that a week passed without a new issue. With only four offerings so far, May is on pace to be the slowest month for IPOs in several years. So far in 2023, January (nine deals) is the only month with fewer than 10 IPOs.

New registrants. The week’s activity included four new registrations. Advanced Biomed, a Nevada-incorporated holding company that operates through subsidiaries in Taiwan, filed its IPO plans. The company’s platform uses liquid biopsy technology to develop cancer treatments. Taiwan is home to one IPO company already this year after none in 2022. DC-based Mediterranean restaurant chain CAVA Group also registered. The underwriters will reserve some IPO shares for certain CAVA rewards members, suppliers, and others under a directed shares program. The most recent U.S. IPO by an SIC 5812 company (Retail Eating Places) was in September 2022. Signing Day Sports hopes to raise $22.5 million through its IPO. The company’s digital platform is designed to facilitate the recruiting process for athletes, coaches, and recruiters. Signing Day completed a reverse stock split in advance of its preliminary IPO filing. Bowen Acquisition was the latest SIC 6770 (Blank Checks) new registrant. The company plans to target businesses in Asia other than Chinese companies that use a variable interest entity structure. Bowen’s sponsors Createcharm Holdings, Bowen Holding, and EarlyBirdCapital have agreed to purchase $3.9 million of units in a concurrent private placement.

Withdrawals. Three companies withdrew their pending registration statements last week. African Agriculture entered into a merger agreement with blank check 10X Capital Venture Acquisition II and backed out of its IPO plans. 10X Capital Venture II, which went public in August 2021, initially had sought a tech sector target. Squarex Pharmaceutical, a maker of drugs to improve the functioning of a patient’s immune system, decided not to pursue an IPO at this time. The company amended its January 2023 initial registration only once, in April. Makara Strategic Acquisition filed a Form RW after 15 months in public registration. Blank check companies account for 18 of the year’s 30 withdrawals.

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.

State regulators express concern over bundle of capital formation bills

By Mark S. Nelson, J.D.

The North American Securities Administrators Association sent a letter to House Republican and Democratic leaders urging them to put the brakes on a bundle of capital formation bills assembled largely by Republicans on the House Financial Services Committee. Many of the bills were reported out of committee during an April markup in stand-alone form, but the Expanding Access to Capital Act of 2023 (H.R. 2799) would pull many of them together into a legislative package. Many of NASAA’s objections are centered around how the package of bills would preempt state regulations.

Preemption of state laws is not the only objection NASAA raised. The group also flagged many provisions in the legislative package because they could, in its view, lessen investor protections. NASAA raised nearly all of the same objections during the run-up to the hearing and markup of the component bills and in a report detailing its views of what a capital formation agenda should look like.

Division B, Title I would create a safe harbor for private placement brokers and finders. This is an area in which some practitioners have sought Congressional clarity because historically a person who acts as a finder may run afoul of existing broker-dealer rules if they handle securities or receive transaction-based compensation. In NASAA’s view, the legislative bundle creating a new exemption would allow finders to engage in activities that were historically more heavily regulated because of the need to better protect investors.

Division B, Title IV contains the Small Entrepreneurs Empowerment and Development (SEED) Act of 2023, which would legalize micro-offerings of securities amounting to no more than $250,000. NASAA offered five main objections to the SEED Act, the last of which can be combined into one objection with two related parts:

• The SEED Act would undermine well-regulated capital markets;
• There already exist numerous modes of raising small amounts of capital;
• The SEED Act merely complicates an already complex exemption framework; and
• States need registration and notice filings in order to know who is operating within state boundaries because otherwise states may only learn of problems with a particular firm when a concerned citizen files a complaint leading to an investigation.

According to NASAA, Division B, title VIII, which contains the Improving Crowdfunding Opportunities Act, would weaken the requirements for crowdfunding participants, such as funding portals and other intermediaries. The bill would limit the liability of funding portals and increase the amounts issuers could raise via crowdfunding.

Lastly, NASAA voiced concern about Division B, Title IX, the Restoring the Secondary Trading Market Act. According to NASAA, the provision “would erase oversight in the secondary sales of offerings by state governments, including offerings made under Tier 2 of the SEC’s Regulation A.” The provision would amend Securities Act Section 18 to preempt state regulation of off-exchange secondary trading in securities of a company that makes certain information publicly available, including under Securities Act Rule 251(a) (documents and information regarding Tier 2 offerings) and Rule 257(b) (periodic and current reports).

NASAA did say it favors at least one provision in the capital formation package that would broaden the auditor independence standards for newly public companies. That provision, contained in Division A, Title IV, would deem an auditor independent if it met the requirements of the American Institute of Certified Public Accountants applicable to certified public accountants in the U.S.

Third Circuit affirms SEC’s decision to deny award to purported whistleblower

By John Filar Atwood

The Third Circuit Court of Appeals denied a petition to overturn an SEC decision not to issue a whistleblower award, finding that the Commission appropriately reasoned that the petitioner did not follow the requisite whistleblower procedures, particularly the requirement that a whistleblower directly submit information to the SEC. The court also found that the SEC thoroughly explained its refusal to exercise its discretion to grant a procedural waiver, so did not act arbitrarily or capriciously in denying the award application (Doe v. SEC, March 23, 2023, Chagares, M.).

The SEC reached a settlement in 2015 with Focus Media and its CEO after an investigation uncovered improper conduct related to certain company transactions. The company and CEO agreed to pay more than $55 million in penalties, disgorgement, and interest as part of the settlement.

Following the settlement, the petitioner filed an application with the SEC for a whistleblower award based on his alleged contributions to the SEC’s investigation. He claimed to be a principal author of a November 2011 report that examined the company and CEO, stating that information in the report was the cornerstone of the Commission’s case against Focus Media and its CEO.

The report was published by Muddy Waters Research, and in his whistleblower award application, in the section regarding the method of his tip submission, the petitioner checked the “Other” box, writing in “News Media” as the manner via which his tip was submitted to the Commission.

Petitioner was ineligible. The SEC’s claims review staff recommended denying the award claim, noting that the enforcement staff obtained the report through its own initiative from a public website, and not from the petitioner, making him ineligible for the award. The petitioner contested the decision, arguing that the report was provided directly to the SEC via email push notifications, social media postings, and news coverage.

The Commission’s final order adopted the staff recommendation to deny the award claim, stating that the petitioner not only failed to submit the report in accordance with the relevant whistleblower procedures but in fact failed to provide information directly to the SEC at all. Accordingly, the SEC concluded that he was not a whistleblower under the relevant regulations. Regarding the emails, social media postings, and news coverage, the SEC noted that the petitioner did not assert that he was the author or sender of the emails and postings and therefore failed to show that he provided the information directly to the agency.

Other claimant received $14 million. Complicating the issue was the fact that the SEC did grant whistleblower status to a different claimant who also helped create the report despite the claims review staff’s preliminary recommendation that it be denied. The Commission awarded the other claimant $14 million based on a percentage of the settlement achieved with the company and its CEO. The claimant’s whistleblower application faced many of the same procedural roadblocks as the petitioner’s, with the primary difference being that the claimant emailed the report directly to an SEC enforcement attorney a few days after the report was published online.

The Third Circuit panel noted that to be eligible for an award, a whistleblower must submit information to the SEC in a Form TCR mailed or faxed to the SEC or submitted via its online portal. The court acknowledged that the SEC has interpreted its rules to generally require that information be provided directly to the Commission without any allowance for the online publication of information that happens to indirectly make its way into the hands of Commission staff.

SEC’s decision not arbitrary. The court ruled that the petitioner failed to show that the SEC acted arbitrarily or capriciously in concluding that his award application failed to meet this whistleblower criteria. The court stated that it is undisputed that the petitioner did not submit the report to the SEC via a Form TCR, and that the petitioner indicated only that the SEC learned of the report through news media.

Noting petitioner’s claim that he provided the report to SEC officials through other means such as the email blast and social media posts containing the report that purportedly made their way to SEC investigators, the court held that the SEC appropriately concluded that the petitioner did not claim to have authored those emails and posts. The court stated that while the petitioner’s claims that the necessary implication of his presentation was that he authored the relevant emails and tweets, his conclusory assertions do not undermine the SEC’s inference to the contrary given the lack of evidence of authorship in the record.

The court then stated that the petitioner was left to argue that the SEC should have waived its procedural requirements for him but concluded that he made such argument only obliquely. The SEC concluded that extraordinary circumstances warranting waiver did not exist because the petitioner did not explain why he could not have submitted the report directly to the SEC, and that the public interest would not be served by waiver since the petitioner did not submit information to the agency directly and therefore had not engaged in the sort of activity that whistleblower awards were designed to encourage.

Waiver rationale not addressed. The court considered that the petitioner did not respond to or address the SEC’s rationale regarding the waiver, but instead focused on the alleged incoherence of the SEC’s simultaneous decision to grant a waiver for the other claimant. The court ruled that the other claimant’s award has no substantive bearing on the SEC’s decision as to the petitioner. None of the petitioner’s complaints about the disparate outcome resolve or eliminate the clear procedural deficiencies in his application, the court concluded, nor do they explain why the SEC should have exercised its discretion to waive the procedural requirements in his case.

The court stated that in staking his claim so heavily on the notion that he is entitled to an award because the other claimant received one, the petitioner failed to explain why he is entitled to it on the merits of his own case. The court said that even if it were to credit the petitioner’s assertion that he was similarly situated to the other claimant in all material respects, that would only suggest that the SEC arguably should have denied the other claimant’s award on the same grounds as it denied the petitioner’s award. Accordingly, the court determined that the petitioner’s focus on the other claimant was unavailing because it does not undermine the SEC’s denial of his application on procedural grounds or its attendant decision not to grant a waiver of those procedures.

The case is No. 22-1652.

Investment Company Institute again questions SEC’s assumed timing of climate rules

By Mark S. Nelson, J.D.

According to the Investment Company Institute (ICI), the SEC needs to better prepare the investment community to make carbon footprint disclosures about portfolio investments that would be required if the Commission were to adopt, as proposed in May 2022, the rules set forth in a rulemaking titled Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social, and Governance Investment Practices (Fund ESG Rule). The proposed rule would address concerns that some funds may already be engaged in “greenwashing” in which they promote ESG aspects of their funds but scantily disclose the actual ESG focus (or lack thereof) of their funds. The ICI’s latest comment letter said the Commission should do more to ensure that the sequencing of effective and compliance dates in multiple ESG-themed rulemakings work in tandem so that portfolio disclosures can be made based on data from public companies whose shares are held in those portfolios.

Sequencing. The ICI and/or several of its members have met with SEC officials regarding the proposed Fund ESG Rule (and a related fund names proposal) six times since the Commission issued the proposal almost a year ago, including twice with Chair Gary Gensler and SEC staff, and once each with Commissioners Jaime Lizárraga and Mark T. Uyeda. The ICI has separately submitted two other comment letters in addition to this week’s comment. The ICI’s main public comment was submitted in August 2022.

In its most recent letter, the ICI summed up its view on sequencing of effective and compliance dates thus: “Our position on sequencing is simple: funds should not have to comply with a requirement to report data in a regulatory filing that is dependent on portfolio companies’ data unless the portfolio companies first have to comply with a corollary requirement to report the data in their own regulatory reports” (emphasis in original).

While the ICI’s letter this week is short on details, an Annex submitted by the ICI following a November 28, 2022 meeting with SEC officials, and simultaneously submitted as a comment letter, suggests the scope of the sequencing problem. By the ICI’s calculation, the SEC’s proposed climate risk disclosure rule and the proposed ESG Fund Rule would both have implementation time frames of at least 26 months, with the largest public companies disclosing climate data first, to be followed by smaller companies.

The ICI explained that its estimated implantation time frame was based on several assumptions, some of which come directly from the SEC’s aspirational goals as stated in the agency’s Regulatory Flex Agenda. Thus, the ICI based its estimates on the SEC adopting the climate risk disclosure rule for public companies in early 2023 (the SEC’s April 2023 goal has since passed) and with the SEC adopting the Fund ESG Rule in October 2023.

By way of background, there has been much public speculation about why the SEC missed the aspirational April 2023 date. Reasons for delay could include an attempt to harden the public company disclosures against an expected legal challenge, to attempt some degree of convergence with similar European rules, to reconsider key aspects of the proposal such as whether to mandate Scope 3 greenhouse gas (GHG) disclosures, to align the effectiveness and compliance dates for at least three interrelated ESG proposals, or to finish reviewing the many thousands of public comment letters received (the most recent comment letter was submitted on April 17, 2023 by Ann Wagner (R-Mo), Chair of the House Financial Services Committee's Subcommittee on Capital Markets, and Bill Huizenga (R-Mich), Chair of the House FSC's Subcommittee on Oversight and Investigations (the letter argued that the SEC’s proposal would violate the major questions doctrine as expounded by the Supreme Court in West Virginia v. EPA).

The ICI’s sequencing analysis also assumed that the SEC would mandate that public companies disclose metrics about at the least their Scopes 1 and 2 GHG emissions. Lastly, the ICI assumed that the SEC would provide a phase-in for companies to comply with the climate risk disclosure rule based on the size of the company.

What fund disclosures would be required? In a nutshell, the ESG Fund Rule, if adopted as proposed, would require funds to make disclosures about the characteristics of any funds that incorporate ESG factors into the making of investment decisions. The SEC’s goal would be to reduce the potential for funds to engage in “greenwashing,” the practice of stating lofty ESG investment goals but, in reality, failing to adhere to those goals.

The proposed ESG Fund Rule would divide ESG funds into three categories. “ESG impact funds” would be those funds that seek to achieve specific ESG impacts. An “integration fund” would be a fund that mulls ESG and non-ESG factors but for which ESG factors would have no greater significance than non-ESG factors. Lastly, an “ESG-focused fund” would be a fund that has one or more ESG factors as a significant or main consideration in selecting investments or for engaging with the companies in which it invests.

The latter type of fund, an “ESG-focused fund,” that indicates it considers environmental factors, would also have to disclose aggregated GHG emissions metrics for the portfolio for the relevant reporting period that include: (1) the portfolio’s carbon footprint and (2) the portfolio’s Weighted Average Carbon Intensity or WACI (an ESG-focused fund that affirmatively states in a required tabular disclosure that it does not consider GHG emissions of portfolio companies in which it invests would not have to calculate its portfolio carbon footprint or the WACI).

The SEC’s climate risk disclosure proposal would have companies disclose metrics about their GHG emissions. These emissions come from seven key molecules thought to be drivers of global warming: carbon dioxide, methane, nitrous oxide, nitrogen trifluoride, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. Disclosures would be further grouped into Scope 1 (company-owned or controlled emissions), Scope 2 (purchased emissions), and Scope 3 (all other indirect emissions).

Under the proposed ESG Fund Rule, funds filing Forms N-1A and N-2 would, for each portfolio holding of an ESG-focused fund (other than funds that do not mull GHG emissions), disclose a portfolio carbon footprint that is based on a calculation that takes into account several ratios and multipliers such that: (1) the current value of a portfolio holding would be divided by that portfolio company’s enterprise value; the result would then multiplied by the portfolio company’s Scopes 1 and 2 emissions; (2) the result of the above calculation is then divided by the current portfolio net asset value (NAV).

A similar calculation is used to determine the WACI, except that here the calculation involves multiplying two ratios such that: (1) the current value of a portfolio holding would be divided by the current portfolio NAV (the proposal uses “current portfolio NAV” regarding Form N-1A but just “current portfolio value” regarding Form N-2); and (2) that result is multiplied by the ratio of the portfolio company’s Scopes 1 and 2 emissions to the portfolio company’s total revenue (in millions).

It is these two calculations that the ICI flagged as problematic if the SEC fails to afford funds enough time to obtain GHG metrics from public company disclosures under a final version of the climate risk disclosure rule. Both calculations depend on having data regarding public companies’ Scopes 1 and 2 GHG emissions.

The ICI explained in its most recent comment on the proposed ESG Fund Rule that the European experience with the similar EU Sustainable Finance Disclosure Regulation (SFDR) demonstrates the issues that can arise regarding sequencing. The ICI said that European asset managers and funds had to rely on third-party data in order to comply with the SFDR. By way of background, the SEC’s proposed climate risk disclosure rule would allow public companies themselves to use third-party data to calculate GHG emissions if certain disclosures are made, including identifying the data source and the process the company used to obtain and assess the data. The ICI noted that the SEC had indicated to it that the agency understood the problems encountered in Europe and that they could likewise occur in the U.S. regarding the SEC’s several ESG proposals.

Court strikes down California board diversity bill as unconstitutional

By Anne Sherry, J.D.

A district court in California overturned a state law that required public companies to achieve board diversity goals for persons from underrepresented communities. The court found that despite the state’s attempt to cast the diversity requirement as flexible, it was a racial quota that was facially invalid under Supreme Court precedent. Furthermore, the court could not sever the racial and ethnic classification provisions from the law without rendering the rest of it incoherent (Alliance for Fair Board Recruitment v. Weber, May 15, 2023, Mendez, J.).

Background. In 2020, California Governor Gavin Newsom signed into law AB 979, which expanded the state’s board diversity requirements, previously focused on women, to a larger group of individuals who self-identify as members of racial and ethnic minorities or as LGBT. By the end of 2022, public companies headquartered in California were to have one to three directors from underrepresented communities (depending on board size). The statute defined "director from an underrepresented community" to include "an individual who self identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self-identifies as gay, lesbian, bisexual, or transgender."

The Alliance for Fair Board Recruitment filed its legal challenge to AB 979 and SB 826 in July 2021. The group, which incorporated in February 2021, lists Edward Blum as its president but keeps its members’ identities confidential. According to the original complaint, Alliance members "include persons who are seeking employment as corporate directors as well as shareholders of publicly traded companies headquartered in California." One of these members was a corporate director before he was "ousted because he is not a woman and does not self-identify as an underrepresented minority," according to the plaintiff.

Facially unconstitutional. In its opposition to the Alliance’s motion for summary judgment, the state argued that AB 979 satisfies strict scrutiny or, in the alternative, should have its unconstitutional provisions severed from the rest of the bill. While the state conceded that the law constitutes a racial classification, it argued that this was permissible because it was aimed at remedying past discrimination. Furthermore, the bill does not create preferred racial and ethnic classes because individuals must still go compete with others and go through an individualized consideration process. Because boards are expressly permitted to expand, no candidate would be forced to lose their board position.

The court did not even reach the strict scrutiny argument, though, because it found that the law is unconstitutional on its face. Under Grutter v. Bollinger (U.S. 2003), a quota is “a program in which a certain fixed number or proportion of opportunities are reserved exclusively for certain minority groups.” The district court found that the California law is a racial quota under this definition because it “requires a certain fixed number of board positions to be reserved exclusively for certain minority groups.”

No severance. The court also agreed with the Alliance that severance of the unconstitutional provisions would be inappropriate. California law allows for severance if it will not affect the wording or coherence of the rest of the statute, which is complete in itself, and the legislature would have adopted the rest of the statute if it had foreseen the partial invalidation. Here, the statute’s language “is almost exclusively cast in racial and ethnic terms and figures,” so that removing the racial and ethnic classifications would affect the coherence of the remaining provision regarding those identifying as gay, lesbian, bisexual, or transgender. Furthermore, the language of the statute, the state’s argument that the main purpose of the statute was to remedy racial and ethnic discrimination, and the lack of a severability clause within the statute indicated that the legislature would not have adopted the remainder of AB 979 alone.

The case is No. 21-cv-01951.

Commission proposes to strengthen risk-management rules for covered clearing agencies

By Suzanne Cosgrove

SEC commissioners on Wednesday unanimously approved proposed changes to certain rules governing covered clearing agencies (CCAs), amending requirements applicable to CCA risk-based margin systems, and adding new requirements to CCA recovery and wind-down plans.

Greater consistency across CCA plans “will enhance the resiliency of this part of our market plumbing, which is fundamental for the capital markets to operate,” said SEC Chair Gary Gensler in a release.

The latest proposal gives specificity to rules adopted by the Commission in 2016 that required CCAs, registered clearing agencies that act as a central counterparty, to have plans for recovery and wind-down.

Recovery is the process by which a CCA maintains its ability to perform critical services if losses render it insolvent, and wind-down is the process by which its services would move to another entity. “We expect that this [new rule] would reduce the risk of an unsuccessful disruption,” said Jessica Wachter, SEC Chief Economist.

Risk-based margining. The proposal also amends existing rules regarding intraday margins and the use of substantive inputs to a CCA’s risk-based margin system. “The Division believes that it is essential that a covered clearing agency monitors its intraday exposure because it faces a risk that its exposure to its participants can change rapidly as a result of intraday changes in prices, positions, or both,” said Haoxiang Zhu, director of the SEC’s Division of Trading and Markets.

“Intraday margin calls played an important role in clearinghouses’ ability to respond to volatility during the January 2021 ‘meme-stock’ events and during recent periods of heightened Treasury volatility,” said Gensler. “I think enhancing these intraday tools would help make our markets more resilient.”

The latest proposal builds on an existing requirement that a covered clearing agency have policies and procedures reasonably designed to cover its credit exposures to its participants by establishing a risk-based margin system that, among other things, includes the authority and operational capacity to make intraday margin calls in defined circumstances.

Specifically, the proposed rule amendments would require that a covered clearing agency’s risk-based margin system monitor intraday exposure on an ongoing basis and make intraday margin calls as frequently as circumstances warrant, including when risk thresholds specified by the covered clearing agency are breached or when the products cleared or markets served experience elevated volatility.

The proposal also requires a CCA to establish a risk-based margin system that addresses the use of substantive inputs to its risk-based margin system, specifically, when such inputs are not readily available or reliable. Substantive inputs could include, for example, portfolio size, volatility, and sensitivity to various risk factors that are likely to influence security prices.

“Margin calls are sometimes pointed to as a source of procyclicality,” that is, as potentially worsening market crises because they are positively correlated with the overall state of the market, commented Commissioner Caroline Crenshaw. “The covered clearing agencies are cognizant of this in setting margin requirements and calibrating their models so that they do not fluctuate too drastically in response to changing market conditions,” she said. “However, this change ensures that covered clearing agencies are aware of intraday exposures that may arise,” enabling them to react without delay, she said.

Wind-down rule. The proposed rule also identifies nine elements that a CCA would need to include in its recovery and wind-down plan (RWP). Specifically, the new rule would require that a covered clearing agency:

• Describe the covered clearing agency’s critical payment, clearing and settlement services and address how the CCA would continue to provide such services in the event of recovery and wind-down;
• Identify any service providers upon which the CCA relies;
• Describe scenarios that may potentially prevent the CCA from being able to provide services;
• Describe criteria that could trigger the RWP’s implementation and the process that the CCA uses to monitor and determine whether the criteria have been met;
• Identify the rules, policies, procedures and other tools the CCA would use in a recovery or orderly wind-down;
• Address how the identified rules, policies, procedures, and any other tools or resources would ensure timely implementation of the RWPs;
• Set procedures for informing the Commission as soon as practicable when the CCA is considering initiating a recovery or orderly wind-down;
• Include procedures for testing the CCA’s ability to implement the RWPs every 12 months;
• Arrange for review of the plans by the board of directors at least every 12 months or following material changes that would significantly affect the RWPs’ viability or execution.

A note of caution. While Commissioner Hester Peirce voted to approve the proposal, she expressed concern that testing the CCAs’ plans every 12 months could impose undue burdens on clearing agencies, participants and other stakeholders. In addition, Peirce said while the proposed amendments are largely principles-based, the release indicates existing recovery and wind-down plans “have, to a great degree, converged in terms of the types of elements that are included in each plan.” Although it may be reasonable to require clearing agencies to ensure that their plans address a common set of issues, “I hope that the amendments do not foreshadow a desire to harmonize recovery and wind-down plans through the Commission’s rule filing process,” Peirce said.

This is Release No. 34-97516.

Amid U.S. debt ceiling logjam, Gensler warns of possible Treasury market risk

By Suzanne Cosgrove

Tracing the history of fires – real ones, like the Great Chicago Fire of 1871, and figurative flare-ups, like the global crisis of 2008, SEC Chairman Gary Gensler noted the past “is replete with times when fires in one corner of the financial system or at one financial institution spread to the broader economy.”

Current near-term risks include “a rise in interest rates more significant than in decades … With such a transition of inflation and rates, it’s appropriate to stay alert to financial stability issues,” Gensler said in a speech delivered Monday at the Atlanta Federal Reserve Financial Markets Conference.

The rise in rates fuels “vulnerabilities related to valuation pressures, borrowing by businesses and households, financial-sector leverage, and funding risks,” said Gensler, citing a recent Financial Stability Report by the Federal Reserve.

Repo financing in the non-centrally cleared market also creates risk in times of stress, Gensler said, “particularly when large, interconnected hedge funds achieve high leverage from banks and prime brokers in the Treasury markets.”

Filling in the gaps. Arguing in favor of more dynamic financial reform, Gensler said the SEC has several projects in the works designed to help ensure U.S. capital markets’ resiliency.

Along with the Department of the Treasury and the Federal Reserve System, the SEC is working to broaden central clearing, register dealers, regulate trading platforms, and promote greater transparency, he said.

He cautioned regulators to watch for gaps when technologies provide new ways of intermediating, transforming, or creating risk and money. “In these instances, regulators often fail to keep pace,” Gensler said.

Watching for risks. Looking further out on the horizon, Gensler noted three additional areas to monitor for their economic and financial impact: moral hazard, the digital economy and artificial intelligence.

“There are tradeoffs of governmental interventions in the markets to forestall the spread of a financial fire,” he said. Moral hazard arises in times of stress when sector support incentivizes greater risk-taking by individuals in the private sector.

Further, the costs of an individual market participant’s failure may not fall on that market participant. “Thus, risk appetites and management may change in a way that’s adverse to financial stability,” he said.

Looking at the digital economy, even excluding the “generally noncompliant crypto markets,” Gensler said, we’ve already seen the effects of fintech and social media on significant parts of consumer finance and investing. “It’s possible, particularly in light of the higher rate environment, that we might see consequential changes to the deposit and banking landscape,” he added.

AI looms large. “Looking further out, the use of predictive data analytics and artificial intelligence might be the most transformative technology of our time,” Gensler said. “This transformation is happening throughout our economy, and finance is no exception.”

AI already is being used in call centers, account openings, compliance programs, trading algorithms, sentiment analysis, robo-advisers and brokerage apps, Gensler noted.

“Such applications can bring benefits in market access, efficiency, and returns. It also has the potential to heighten financial fragility as it could increase herding, interconnectedness and expose regulatory gaps,” he said.

Is FERC becoming a new battle ground over ESG investing?

By Mark S. Nelson, J.D.

A group of 17 state attorneys general filed a motion to intervene in a proceeding before the Federal Energy Regulatory Commission (FERC) involving BlackRock, Inc.’s blanket reauthorization from FERC to acquire the voting securities of utility companies, something that is required by law for certain types of acquisitions. The state attorneys general are not challenging FERC’s grant of such authority to BlackRock, but rather they are contesting whether certain “horizontal” environmental groups to which BlackRock is a signatory or a member are previously undisclosed “holding companies” for purposes of FERC’s reauthorization process. The interest group Public Citizen today filed an opposition brief asking FERC to deny the motion of the state attorneys general (BlackRock, Inc., Docket No. EC16-77-002, May 10, 2023).

A little context. Readers of Securities Regulation Daily may recognize FERC as a regulator of interstate transmission of natural gas, oil, and electricity that sometimes appears in the publication because of its overlapping jurisdiction with the CFTC. FERC and CFTC have divvied up their jurisdiction via several memoranda of understanding and the CFTC component of energy market oversight is not directly at issue in the filing by the state attorneys general (See MOUs of January 2, 2014 regarding jurisdiction and information sharing). Likewise, the SEC is not directly implicated by the state attorneys general filing, although the motion to intervene and the relevant FERC process indirectly relates to certain public filings made on the SEC’s EDGAR database and portions of the argument made by the state attorneys general relate to the SEC’s shareholder proposal framework.

By way of additional background, Section 203(a)(2) of the Federal Power Act (FPA) (16 U.S.C. §824b(a)(2)) and Part 33 of FERC's regulations (18 C.F.R. pt. 33) provide for FERC to grant blanket authorizations to entities to acquire the voting securities of utility companies. Blanket authorizations typically must be reauthorized periodically by FERC. As a condition of receiving a blanket authorization, an entity must file with FERC any relevant Schedules 13D-G that are filed with the SEC and at the same time such schedules are filed with the SEC.

In April 2022, FERC granted BlackRock a blanket reauthorization for an additional three-year period allowing BlackRock to acquire the voting securities of utility companies. BlackRock represented to FERC that it is solely an investor and does not directly own physical utility assets in the U.S. FERC first granted BlackRock a blanket authorization in 2010.

Public Citizen, the same group that today filed an opposition to the motion to intervene regarding BlackRock’s Schedule 13D-G filings that was filed by the state attorneys general, filed a protest at the time of BlackRock’s most recent blanket reauthorization. According to Public Citizen, BlackRock is so large that it cannot function as a passive investor if, under the terms and conditions of the reauthorization, it can acquire up to 20 percent a utility’s voting securities.

“BlackRock’s gargantuan role as a manager of voting securities is unparalleled in the history of modern capitalism,” said Public Citizen. “Not only is it impossible for a fund manager of BlackRock’s size and scope to remain a passive investor, scholarly research demonstrates that BlackRock’s accumulation of voting securities constitutes control over utilities, and its horizontal power over competing utilities harms competition.”

BlackRock countered Public Citizen by stating that it had complied with the terms and conditions of numerous prior blanket reauthorizations. FERC, however, denied Public Citizen’s protest because BlackRock had given adequate assurances that it was unable to influence control over U.S.-traded utilities.

FERC went on to conclude that BlackRock’s blanket reauthorization would not deleteriously impact competition, rates, or regulations. As a result, FERC granted BlackRock’s blanket reauthorization application.

FERC Commissioner Allison Clements concurred in FERC’s order, stating that she had “growing concerns” that FERC’s standards for evaluating reauthorization applications may be inadequate to ensure that reauthorization is in the public interest, especially in wholesale rates.

FERC Commissioner Mark C. Christie, noting Public Citizen’s protest about BlackRock’s power, also concurred in the order. Said Christie: “The point is not whether one agrees with BlackRock's public policy positions, or those of Vanguard, State Street or others. You can even agree with their policy positions and still be deeply concerned about the use of their unprecedented financial power in this way. The central issue is whether these asset managers use their huge financial power to promote the interests of their beneficiaries or the political and ideological beliefs of their owners and top managers. You can also be legitimately concerned whether any small group of asset managers should wield this degree of financial power for these ends.”

BlackRock’s latest 13D-G filings. BlackRock most recently filed with FERC two sets of Schedules 13D-G. On April 6, 2023, BlackRock filed schedules for MetLife, Inc., Apollo Global Management, Inc., Packaging Corporation of America, POSCO Holdings Inc., Via Renewables, Inc. and WestRock Company. On May 5, 2023, BlackRock filed schedules for United States Steel Corporation and FuelCell Energy, Inc.

These latest BlackRock filings may not have been the immediate impetus (but the underlying reauthorization was) for the state attorneys general to challenge whether certain environmental groups to which BlackRock belongs should be counted as “holding companies” for purposes of FERC’s blanket reauthorizations, but they do offer examples of the types of companies in which BlackRock may be investing and, thus, the potential for exerting influence on climate change and other ESG matters.

According to the state attorneys general, BlackRock is a signatory to Climate Action 100+ (CA100+) and the Net Zero Asset Managers Initiative (NZAM), both of which the state attorneys general characterize as “horizontal” entities that function like holding companies and which seek to influence corporate behavior, especially regarding the operations of fossil fuel companies. Neither CA100+ nor NZAM, said the state attorneys general, have obtained approvals from FERC.

One group, CA100+ seeks for its members to adhere to its “Three Asks:” (1) strong corporate governance on climate change; (2) adherence to the goals of the Paris Agreement; and (3) adherence to the Task Force on Climate?related Financial Disclosures (TCFD) and sector-specific Global Investor Coalition on Climate Change (GIC) Investor Expectations on Climate Change guidelines.

The other group singled out by the state attorneys general, NZAM, seeks for its members to adhere to the “The Net Zero Asset Managers Commitment,” which borrows, in part, from the Paris Agreement, but adds some additional commitments regarding asset management. Thus, the commitment encompasses striving to reach the goal of net zero greenhouse gas emissions by 2050, if not sooner, plus support for investments that are aligned with the net zero emissions goal.

The state attorneys general argued that BlackRock’s support for environmental and social shareholder proposals has significantly increased in the time since BlackRock joined CA100+ and NZAM. “Maybe BlackRock was a passive investor ten years ago, but today it’s an environmental activist,” said the state attorneys general. The implication of what the state attorneys general allege is that BlackRock may be acting in a manner beyond passive investing and, instead, allegedly influencing the day-to-day operations of utilities, including what power output is brought to market.

The state attorneys general also noted that BlackRock’s power may affect shareholder proposals. Even if shareholder proposals are ultimately withdrawn, the state attorneys general said, BlackRock’s alignment with other groups can result in BlackRock obtaining concessions from companies. This possibility, said the state attorneys general, means that companies have to mull the “downside” risks of shareholder proposals that fail to get majority support because company executives may be pressured by proxy advisory firms if those executives do not respond sufficiently even in the case of a failed proposal.

Moreover, the state attorneys general argued that even if BlackRock alone does not exceed the ownership percentage threshold set by FERC, the firm’s ownership of utility companies nevertheless should be considered in the context of the overall influence of BlackRock and various aligned environmental groups. As a result, the state attorneys general posited that BlackRock, CA100+, and NZAM collectively may hold voting securities at utility companies that would exceed FERC’s threshold for blanket reauthorizations.

The state attorney generals assert “standing” to intervene in BlackRock’s FERC blanket reauthorization based on their interests in consumer protection, competition, and utility rates affecting state citizens and residents. In the Article III context, where a federal regulation is challenged in federal court via petition for review, standing for states can be fraught. For example, in the securities law context, a Second Circuit panel upheld the SEC’s Regulation Best Interest, but only after finding that a private plaintiff—not the state plaintiffs—had Article III standing (See, XY Planning Network, LLC v. SEC (state petitioners had argued that standing existed because of the potential for reduced tax revenues from investment income)).

The state attorneys general want FERC to audit whether BlackRock has complied with the representations it made regarding its blanket reauthorization and/or order BlackRock to stop coordinating with other asset managers and instead function solely as a passive investor. The state attorneys general also seek an evidentiary hearing but, if FERC denies any of their requests for relief, the state attorneys general want their motion to intervene treated as a complaint under FERC’s rules.

Public Citizen opposition. Public Citizen filed an opposition to the motion to intervene filed by the state attorneys general asserting that the intervention was unjustifiably late. “The States and Attorneys General claim that their 14-month late intervention is justified because BlackRock has not ‘withdrawn’ from its association with ‘CA100+ and NZAM’, among other claims,” said Public Citizen. “But their tardy motion comes after the Commission issued an order more than a year ago approving BlackRock’s Section 203 application” (emphasis in original; footnote omitted).

The state attorneys general, by contrast, argued that good cause existed for their late intervention. They recalled that a similar coalition of state attorneys general had sought to intervene in a reauthorization proceeding for Vanguard in late 2022, which they said prompted Vanguard to withdraw from NZAM (they also noted that Vanguard never joined CA100+). “At bottom, the States have brought this motion now because it is clear (as of March 15, 2023) that BlackRock will not voluntarily withdraw from CA100+ and NZAM, but instead will stay the course of horizontal agreements to influence utility companies,” said the state attorneys general.

Public Citizen, in its opposition, also argued that FERC should deny the motion to intervene because it would be disruptive and would burden Public Citizen.

The matter is No. EC16-77-002.

K&L Gates’ Sean Jones and Julie Rizzo help diverse clientele navigate the ESG chaos

By Brad Rosen, J.D.

In this fourth installment of The ESG Ready Lawyer, K&L Gates’ partners Sean Jones and Julie Rizzo describe the firm’s ESG practice and capabilities, as well and their own client-centric philosophy and approach to providing advice and grappling with today’s complex ESG-related challenges.

Both Jones and Rizzo bring a wealth of experience and passion to their ESG practices. Jones, who has been practicing law for 30 years, describes ESG as the most interesting, challenging, and dynamic topic he has seen. Meanwhile, Rizzo leans heavily on her diverse background which includes a stint as an attorney-advisor with the SEC’s Division of Corporation Finance, working as an in-house counsel, and now, as an outside lawyer, advising companies on their own ESG journeys.

During the interview, Jones and Rizzo generously share their insights and observations in connection with:

• How the K&L Gates enables its clients to see broader trends and dynamics in an ever-changing ESG ecosystem;
• Advising clients in light of the uncertainties around the SEC’s pending and long-awaited final climate disclosure rules;
• Consideration of a number of other ESG-related actions the SEC has taken that companies should be aware of;
• Helping clients navigate the ESG-related legislation of all 50 states, federal legislation, and legislation in the EU and other jurisdictions; and,
• Providing counsel and guiding clients in an increasingly politically charged and chaotic environment around all matters ESG.

You can read this installment of The ESG Ready Lawyer here.

ESG culture war battles rage on in House Oversight Committee hearing

By Brad Rosen, J.D.

In setting the tone and tenor for a highly contentious House Oversight and Accountability Committee hearing on ESG practices, Chairman James Comer (R-KY) proclaimed in opening remarks “ESG is just window dressing for liberal activism and radical far-left ideology”.

In response, Ranking Member Jamie Raskin (D-MD) asserted, “Responsible Investing principles – including ESGs – have been freely chosen by America’s companies and employed by asset managers and pension fund managers for decades.” Raskin added, “Right-wing attacks on these principles—fueled by dark money, corporate special interests, and flawed legal arguments—threaten the savings and retirements of Americans by forcing asset managers to ignore material risks and considerations and violate their fiduciary duties.”

The three and a half hour hearing, titled ESG Part I: An Examination of Environmental, Social, and Governance Practices with Attorneys General, featured the testimony of two Republican state attorneys general, Sean Reyes from Utah and Steven Marshall from Alabama, both strident ESG opponents. Michael Frerichs, the Democratic state treasurer from Illinois, testified in favor of utilizing ESG principles in managing funds entrusted to his office.

ESG is part of a radical political agenda. In his opening statement, Chairman Comer claimed that asset managers and activist shareholders are partnering with liberal advocacy groups to push ESG priorities and a radical political agenda with Americans’ money. Moreover, Comer asserted that ESG commitments are often at odds with their clients’ best interests, occur without their clients’ knowledge, and are used to force businesses to comply with a far-left ideology.

The chairman further stated that asset managers control an estimated $126 trillion dollars, which constitutes almost 30 percent of all global financial assets, noting, “That’s a lot of money being manipulated to push a leftist ideology.” Comer also expressed his concerns about two proxy advisory firms he claims have been unduly influenced by ESG activists, and their broader control over 90 percent of the market. He characterized these arrangements as “a coordinated effort by unelected shadow organizations to force their policies on U.S. taxpayers, investors, and retirees.”

American businesses don’t buy climate denialism propaganda. In his remarks, Ranking Member Raskin spoke about responsible investment principles, of which ESG is one, and underscored the need to take into account all material considerations and risks. This means companies and investment professionals consider “the calamitous consequences of climate change—the devastating hurricanes, the dangerous droughts, the sea level rise and coastal erosion, the incessant stormwater flooding, the spread of disease, and other costly natural disasters produced by radical destabilization of the earth’s climate.”

According to Raskin, “honest American businesses don’t buy the propaganda of climate denialism. They have a duty of loyalty and care to their shareholders and they’re focused on the actual bottom line, and that always means facing reality, not swallowing myths.” He further stated, “America’s most successful investors and asset managers have systematically embraced responsible investment principles as a fulfillment of their fiduciary duty to minimize risk, maximize returns, and prudently plan for long-term challenges, like the ones associated with the destabilizing factor of climate change.”

An open conspiracy to bypass Congress. Utah Attorney General Sean Reyes, in his prepared remarks, asserted that ESG involves some of the biggest and most powerful players in the global economy attempting to force costly operational changes on American companies in pursuit of the 2015 Paris Agreement, the goal of which is to limit global warming to 1.5? C above pre-industrial temperatures.

Reyes underscored that the Paris accord had never been enacted into law and that “there has been an open conspiracy to bypass Congress and instead impose costly changes on American consumers.” He further claimed these changes drive up the cost of goods and harm shareholders by reducing returns. In sum, Reyes asserts that ESG is an undemocratic tax on our economy and productivity.

Alabama Attorney General Steven Marshall’s remarks echoed many of the sentiments of his Utah colleague. Similarly, he stated that “ESG is a clear and present danger to consumers and to our democracy. He also argued that an unelected cabal of global elites are using ESG, a woke economic strategy, to hijack our capitalist system, coerce corporations, and threaten the hard-earned dollars of working Americans.

ESG is about maximizing value. Illinois state treasurer Michael Frerichs called the attack on ESG investing principles “a widespread, highly coordinated, politically motivated attack on investors and the hard-working people they serve” in his prepared statement. He characterized that pushback as anti-free market and anti-investor, harmful to pensioners, working people, businesses, and America.

Frerichs further explained that ESG is data and simply additional information investment professionals use to assess risk and return prospects. He observed, “It is about value, not values. In order to maximize returns, an investor must be able to manage and mitigate risk.” The treasurer concluded, “The more data we as investors have, the better informed our decision is when selecting investments over the long-term.”

More to come. Chairman Comer further indicated this hearing will not be the end of the committee’s work on this topic. In his view, there is clearly a need to continue oversight of the Biden Administration’s government-wide efforts regarding ESG, and what he sees as unelected bureaucrats dictating to the American people what they are allowed to say, spend their money on, or do with their hard-earned savings.

Forcing crypto assets into qualified custodians would ‘destroy’ crypto, industry association says

By Lene Powell, J.D.

The SEC is seeking to destroy the crypto industry, an industry association said in a strongly worded comment letter on the SEC’s recent proposal on safeguarding advisory client assets. The Global Digital Asset & Cryptocurrency Association (GDCA) found fault with specific aspects of the proposal, but also more generally with the overall requirement for investment advisers to hold crypto assets with a qualified custodian.

“For the SEC to try to force crypto assets into qualified custodians when it knows that the banking agencies are refusing to let banks custody those assets, is for the SEC—without Congressional imprimatur—to seek to destroy the trillion-dollar asset class that is crypto,” the association wrote.

In contrast, the watchdog group Better Markets praised the proposal, saying the reforms would help promote investor confidence in advisory services and benefit capital markets.

SEC proposal. The SEC issued a proposal in February to enhance protections of customer assets managed by registered investment advisers. According to a fact sheet, the proposed rule changes would expand the current custody rule to protect a broader array of client assets and advisory activities to the rule’s protections; enhance the custodial protections that client assets receive under the rule; and update related recordkeeping and reporting requirements for advisers. The comment period closed May 8.

Global Digital Asset & Cryptocurrency Association (GDCA). According to the comment letter, GDCA is a “global, voluntary Self-Regulatory Association for the digital asset and cryptocurrency industry.”

GDCA takes issue with the SEC’s position that the current custody rule and proposed safeguarding rule apply to crypto assets. The proposal raises hurdles to compliance with both the current and proposed rule and is “short on solutions” on how investment advisers and qualified custodians can demonstrate compliance with the current and proposed rules, the association said.

“A ‘rule’ that cannot be complied with is hardly a ‘rule’ at all. It’s a ban,” the association wrote.

This is particularly so in the current moment, in which the GDCA says federal banking regulators are “actively discouraging banks from engaging in custody and other crypto asset activities” and only one bank with a federal charter is empowered at present to custody crypto assets.

In this context, requiring crypto assets to be held by qualified custodians would “raise serious issues of statutory authority, administrative due process and deprivation of constitutional rights,” said GDCA.

GDCA also objected that the proposing release inappropriately assumes application of and non-compliance with the current custody rule, and that minimum custodial standards provisions ignore the important role of state regulation. In GDCA’s view, the Commission should adopt flexible standards for demonstrating “possession or control” and should not discourage use of crypto trading platforms.

Objections from finance industry. Some of GDCA’s objections echo criticisms by major finance industry groups like SIFMA and the Investment Company Institute, including opposition to expanding the definition of assets beyond just funds and securities. The alignment reflects that although crypto assets were originally envisioned as an alternative to traditional finance, they have become increasingly ensconced in mainstream financial systems.

Better Markets. Expressing support for the SEC proposal, Better Markets said expanding the scope of assets subject to the safeguarding rule is consistent with the need to modernize custodial practices, and aligns with congressional intent.

The watchdog zeroed in on crypto assets, pointing to the “recent cryptocurrency carnage” including the failure of FTX and other major crypto entities.

“The short history of cryptocurrencies is marked by extremely volatile markets; brazenly fraudulent schemes, hacks, and scams; and innumerable failures and bankruptcies leading to billions of dollars of investor losses,” the group wrote.

Better Markets agreed with SEC Chair Gary Gensler’s view that most crypto assets are securities, but argued that is not a requirement for bringing crypto assets within the custody rule.

“[F]or purposes of the Proposal’s new safeguarding rule, the question of whether or not a given cryptocurrency token is a security is not at issue,” the group wrote. “By expanding the scope of assets subject to the safeguarding rule, as this Proposal does, a determination of whether or not an asset is a security is irrelevant. All assets, including all cryptocurrency assets, would fall under the safeguarding rule as they should.”

The group noted that the custody rule was updated in 2003 and 2009 to reflect technology advances and close loopholes that allowed the massive Bernie Madoff Ponzi scheme to succeed. The group added that the SEC’s economic analysis “amply” satisfies the Commission’s legal obligation to assess the impact of the proposal.

Team Resources again asks High Court to settle disgorgement question

By Rodney F. Tonkovic, J.D.

Team Resources is back before the Supreme Court with a petition asking about the propriety of granting disgorgement without an evidentiary hearing. The case has been tossed in the wake of two other Court decisions affecting disgorgement, including an earlier petition that was remanded in light of Liu. But now, the petitioners are back with a new wrinkle: Can a federal court grant disgorgement without granting the defendant's request for a live evidentiary hearing? (Team Resources Incorporated v. SEC, May 1, 2023).

Back and forth. In 2015, the SEC brought an enforcement action against Team Resources, Inc. The defendants settled immediately, and the Commission moved for final judgment, asking for disgorgement reflecting the alleged gross pecuniary gain. While the SEC's motion was pending, the Supreme Court handed down its decision in Kokesh v. SEC .

Team Resources then argued that post-Kokesh, district courts no longer have authority to order disgorgement in SEC proceedings, but the court granted the requested disgorgement. The Fifth Circuit affirmed, stating that since Kokesh expressly declined to address the issue of whether disgorgement is an equitable remedy, Fifth Circuit precedent upholding the authority of the district courts to order disgorgement controlled.

After Kokesh was decided, Team Resources petitioned the Supreme Court asking if the SEC could still obtain disgorgement as an equitable remedy. Liu then upheld the SEC's ability to seek disgorgement in civil proceedings as a form of equitable relief, so long as the award is limited to the net profits of the wrongdoer and funds go to victims. Soon afterwards, Team Resource's petition was granted, vacated and remanded for further lower court proceedings consistent with Liu.

And back again. On remand, the Commission filed a renewed motion for remedies that reduced its calculation of disgorgement after deducting legitimate business expenses. Team Resources said that the SEC's calculations were flawed and argued that, under Liu, a live evidentiary hearing was necessary to properly calculate disgorgement. The district court denied this request, reasoning that Team Resources waived any right to a hearing in the settlement agreements and noting that Team Resources did not provide any documentary evidence in opposition. Team Resources also objected to the civil penalty, but the court said that this was outside of the scope of its mandate on remand.

On appeal, Team Resources argued that the district court erred in denying a live evidentiary hearing. The panel disagreed, because Team Resources agreed in the settlement that the district court could calculate disgorgement and penalties on the basis of the papers alone. The panel noted as well that the FRCP allows district courts to decide motions on briefs and without oral hearings. The panel did not address Team Resource's objections to the civil penalty because the arguments on that issue were not raised before the district court.

The petition. Team Resources asserts that Liu left open the question of whether the SEC may obtain disgorgement without an evidentiary hearing. The decision not to grant a hearing, the petition says, runs afoul of Liu's mandate that testing the legitimacy of claimed business expenses requires ascertaining whether they are legitimate or are wrongful gains, meaning that an evidentiary hearing must be held to resolve conflicting arguments. The petition posits that the Rules of Civil Procedure and minimum due process guarantees also require an evidentiary hearing.

Team Resources also maintains that they did not waive their right to an evidentiary hearing. The petition bases its argument on the Fourth Circuit's decision in U.S. v. Bank, which held that disgorgement order is not a criminal penalty for the purposes of double jeopardy. When Team Resources entered into the consent judgments, neither Kokesh nor Liu had been decided, and what the waiver represented at the time has changed after the issue of those two opinions. Plus, no court has examined the voluminous records in this case to determine the precise amount of disgorgement in light of the Court's holdings: the SEC only offered an "approximation," the petition says.

Finally, the petition argues that the civil penalty imposed violates the Eight Amendment. The court imposed a penalty of almost $15.3 million against Kevin Boyles, Team Resource's owner—an amount roughly 6.5 times that of the $2.4 million disgorgement imposed. The petition argues that the Eighth Amendment argument did not ripen until the penalty was actually imposed. And, the penalty itself is grossly disproportional to the offense, particularly where, as here, the disgorgement amount is disputed. The district court and the Fifth Circuit did not even consider whether the penalty is excessive, the petition says.

Read the Docket. This case, and others before the Court may be referenced in the latest version of the Supreme Court Docket, a regular feature of Securities Regulation Daily. Issued opinions, granted petitions, pending petitions, and denied petitions are listed separately, along with a summary of the questions presented and the current status of each appeal.

The petition is No. 22-1073.

SEC brings first-ever case enforcing Liquidity Rule

By Elena Eyber, J.D.

The SEC charged investment adviser Pinnacle Advisors LLC with aiding and abetting Liquidity Rule violations by a mutual fund it advised and whose Liquidity Risk Management Program it administered. The SEC also charged the fund’s two independent trustees, Mark Wadach and Lawton Williamson, and two officers of both Pinnacle Advisors and of the fund it advised, Robert Cuculich and Benjamin Quilty, with aiding and abetting Liquidity Rule violations by the fund. A third trustee, Joseph Masella, agreed to settle charges that he caused and willfully counseled the fund’s violations (SEC v. Pinnacle Advisors, LLC, May 5. 2023; In the Matter of Pinnacle Investments, LLC, Release No. 34-97448, May 5, 2023; In the Matter of Joseph Masella, Release No. 40-6303, May 5, 2023).

Complaint. The SEC’s complaint alleges that, from June 2019 to June 2020, the fund held 21 to 26 percent of its net assets in illiquid investments. According to the complaint, Pinnacle Advisors and its officers, Cuculich and Quilty, classified the fund’s largest illiquid investment as a “less liquid” investment, ignoring restrictions, transfer limitations, and the absence of any market for the shares, and disregarding the advice of fund counsel and auditors. The complaint further alleges that Pinnacle Advisors and its officers did not present the fund’s board with a plan to reduce the fund’s illiquid investments to 15 percent or lower or make required filings with the SEC, as required by the Liquidity Rule. The complaint also states that Cuculich, Quilty, and Masella misled the SEC’s Division of Investment Management about the basis for the fund’s liquidity classifications. According to the complaint, the fund’s board had oversight responsibilities regarding the fund’s Liquidity Risk Management Program, and Wadach and Williamson, who knew that the shares were restricted and illiquid, aided and abetted the fund’s violation by recklessly failing to exercise reasonable oversight of the fund’s program. The SEC’s complaint seeks permanent injunctions and civil money penalties.

Settlements. Masella settled the SEC’s charges by consenting to an order requiring him to cease and desist from violations of the Liquidity Rule and pay a civil penalty of $20,000, and suspending him from association with any investment adviser, registered investment company, and others for six months.

The SEC also announced charges against Pinnacle Investments LLC, an affiliate of Pinnacle Advisors, for making false and misleading statements in its Form ADV brochure regarding reviews of advisory client accounts and failing to disclose certain conflicts of interests, adopt and implement related policies and procedures, and deliver to clients required information about advisory personnel. Pinnacle Investments settled the SEC’s charges by consenting to an order requiring it to cease and desist from violations of the antifraud and other provisions of the Investment Advisers Act of 1940, a censure, and disgorgement and a civil penalty totaling approximately $476,000.

"The Liquidity Rule provides substantive protections to shareholders of open-end funds," said Sheldon L. Pollock, Associate Regional Director in the SEC’s New York Regional Office. "Trustees must exercise oversight on behalf of shareholder interests, and the Commission will hold trustees accountable when they fail to fulfill the most basic requirements under the applicable rules."

The case is No. 5:23-cv-00547-FJS-ATB; the releases are No. 34-97448 and No. 40-6303.

Adviser misunderstood unique characteristics of LETFs

By Rodney F. Tonkovic, J.D.

An investment adviser has settled SEC charges for breach of fiduciary duty in connection with its use of leveraged ETFs. The firm and one of its owners invested clients in leveraged exchange-traded funds in a manner contraindicated in the funds' prospectuses. The Commission found that the respondents misunderstood the characteristics of the leveraged ETFs and so lacked a reasonable belief that they were in their clients' best interests. They also failed to appropriately monitor the performance of the ETFs throughout the holding period. In addition to a cease-and-desist order and censure, the respondents were ordered to pay disgorgement and civil penalties (In the Matter of Classic Asset Management, LLC and Douglas G. Schmitz, Release No. 34-97427, May 4, 2023).

Classic Asset Management, LLC is a North Dakota-based registered investment adviser. Douglas Schmitz is a one-third owner and investment adviser representative of the firm.

LETFs. Between January 2017 and December 2020, CAM held leveraged exchange-traded funds in advisory client accounts. These complex securities included at least 15 different funds seeking to deliver multiples of the performance of the index or benchmark they tracked. Schmitz reviewed the prospectuses for the LETFs, which warned—on the first page, in bold type— of the risks inherent in the products. Among other warnings, the prospectuses cautioned that the products were not meant to be held longer than one trading day and required frequent monitoring.

CAM and Schmitz made investments for their clients in LETFs to the point that the clients' portfolios were highly concentrated in them. Plus, CAM caused the portfolios to hold these positions for much longer than one day—some were held for months and even years. As a result, certain clients suffered substantial losses.

No reasonable basis. According to the Commission, CAM and Schmitz had no reasonable basis to concluded that LETFs were suitable for their clients, even if used as intended. The respondents failed to fully consider fundamental characteristics of the LETFs, especially the material risks associated with holding them for too long, which could, for example, magnify the compounding risk, which can result in substantial index tracking error as volatility increases.

In addition, despite warnings in the prospectuses highlighting the need for frequent monitoring, the respondents failed to assess whether they were in their clients' best interest throughout the holding period. Schmitz, the Commission says, was generally aware of the performance of the reference index and market conditions, but did not monitor the actual LETFs' performance or consider the unique risks associated with the structure and daily rebalancing of the LETFs. Finally, CAM lacked written policies and procedures to ensure that its representatives’ policies and procedures that were reasonably designed to ensure CAM’s representatives understood the material features and risks of products like LETFs before purchasing them for advisory clients.

"Investment advisers have fiduciary duties to act in their clients’ best interest, and this is particularly important when investing clients in complex products such as leveraged ETFs," said Jason J. Burt, Director of the SEC’s Denver Regional Office. "Complex products present unique risks, and investment advisers must ensure that there is a reasonable basis to recommend these products before purchasing them for clients."

Violations. The Commission found that CAM and Schmitz violated Section 206(2) of the Investment Advisers Act and that CAM also violated the Act's compliance provision in Rule 206(4)-7. In addition to a cease-and-desist order and censure, CAM was ordered to pay disgorgement of $81,824 plus prejudgment interest of $13,404, and a civil monetary penalty of $100,000. Schmitz will disgorge $523,086 plus $13,404 in prejudgment interest, and to pay a $100,000 civil penalty.

The release is No. 34-97427.

Does a bankruptcy foreclose whistleblower recovery? Two claimants say no

By Anne Sherry, J.D.

Two claimants that blew the whistle on a massive fraud at Life Partners Holdings are challenging an SEC order calculating the maximum whistleblower award at $32,000. Life Partners filed for bankruptcy after a federal court ordered the company and two individuals to pay $46 million in penalties and disgorgement to the SEC. According to the SEC in the challenged order, the claimants are entitled to an award based only on what the SEC actually collected prior to the bankruptcy (Barr v. SEC, April 25, 2023).

Fraud and bankruptcy. In December 2014, a jury found that Life Partners Holdings, Inc., its CEO Brian Pardo, and General Counsel Scott Peden defrauded investors in life settlements, or fractional interests of life insurance policies traded on the secondary market. By materially understating the life expectancy estimates the company used to price transactions, the defendants misled shareholders into thinking the company’s revenues and profit margins were sustainable. The district court ordered the company to pay a civil penalty of $23.7 million and disgorgement of $15 million. Pardo and Peden were ordered to pay penalties of $6.2 million and $2 million, respectively.

The next month, in January 2015, Life Partners filed for bankruptcy. The SEC voluntarily subordinated its claim in the bankruptcy proceeding.

SEC whistleblower order. In March 2023, the SEC awarded three claimants some percentage of the approximately $100,000 it had recovered from Life Partners prior to the bankruptcy petition. One of the claimants, who is still anonymous and has petitioned the D.C. Circuit Court of Appeals to review the SEC’s whistleblower order, argued that the SEC’s rule implementing the Dodd-Frank provision bases whistleblower recovery on the amount “the Commission and the other authorities are able to collect,” and the SEC did not in fact collect all that it was “able” because it voluntarily subordinated its bankruptcy claim.

The SEC rejected this argument on three bases. First, the SEC said, the argument assumes the Commission could have collected the full penalty had it not subordinated its interest. But the civil penalties would have been disallowed or subordinated as a matter of law, and as to the disgorgement, the SEC would have been a general unsecured creditor entitled to a de minimis payout.

Furthermore, despite the rule’s reference to what the SEC is “able to collect,” the statutory maximum whistleblower award is based on the amount actually collected. And calculating awards based on a hypothetical amount “able to” be collected “would introduce uncertainty, inconsistency, and could delay the processing of award claims.”

The SEC also disagreed with the claimant’s argument that the award should be based on recoveries from the bankruptcy estate. Bankruptcy proceedings are not brought by the Commission or one of the authorities designated in Dodd-Frank, and payments resulting from bankruptcy proceedings are not imposed in SEC covered actions or in related actions. The SEC also declined to exercise its discretion to set a higher award, as it’s never used this authority to approve an award amount above the statutory limit.

District court challenges. Two of the claimants are challenging the SEC’s whistleblower award. Via a petition for review filed in the Fifth Circuit, John Barr asserts that the SEC’s order “misreads the operative statute and contains multiple prejudicial errors that violate [his] legal rights.”

Claimant #1, filing as John Doe, petitioned the D.C. Circuit for review.

The case is No. 23-60216 (Barr) and No. 23-1121 (Doe).

SEC approves amendments to Form PF; expands reporting requirements for fund advisers

By Suzanne Cosgrove

The SEC adopted amendments to Form PF, the confidential reporting form for certain SEC-registered advisers to private funds. The reporting changes are designed to provide the Financial Stability Oversight Council (FSOC) with more timely information to assess systemic risk, and to boost the Commission’s oversight of private fund advisers and its investor protection efforts, the SEC said.

The amendments passed by a 3-2 vote, with Commissioners Hester Peirce and Mark Uyeda voting against their approval. Commissioner Peirce commented that the expansion of Form PF data collection “is the latest reflection of the Commission’s unquestioning faith in the Benevolent Power of More, a faith that I do not share.”

Arguments for and against. Defending the changes, SEC Chair Gary Gensler noted that in the 12 years since the Commission first adopted Form PF in 2011, “private funds have evolved significantly in their business practices, complexity, and investment strategies.” In addition, private funds “are ever more interconnected with our broader capital markets,” he said. “They also nearly have tripled in size in the last decade.”

Gensler said private funds managed by registered investment advisers currently hold approximately $21 trillion of gross assets, including $20 trillion reported on Form PF – close to the size of the $23 trillion U.S. commercial banking sector. Including exempt reporting advisers, the private fund space is as large as $25 trillion.

Arguing that the form’s amendments were unnecessary, Commissioner Mark Uyeda said that the adoption of the original Form PF fulfilled Dodd-Frank’s statutory directive to the Commission to collect information on behalf of FSOC “in a way that reduces the compliance burden on advisers. Today’s amendments are the first step to reversing those initial, fruitful efforts at effective regulation.”

Peirce also suggested that the expansion of Form PF requirements could backfire. “By demanding almost real-time data about some relatively commonplace events, we send a message to the markets that the government is a back-up risk manager for funds,” she said.

“Far from improving our ability to understand what is going on with private funds in times of stress, requiring funds to provide granular information on a compressed timeline on a government form could impede free-flowing, productive communication between fund advisers and the SEC,” Peirce added.

Investors in private funds are not only well-resourced sophisticated investors, but also pension funds and non-profits, “who deserve the protections of an updated and improved rule that is more effective for assessing potential risks to financial stability,” said Commissioner Jaime Lizárraga, who supported the amendments. “This is precisely the type of update that best serves the public interest.”

“History is replete with times when tremors in one corner of the financial system or at one financial institution spill out into the broader economy,” Gensler said. “When this happens, the American public –bystanders to the highway of finance -- inevitably gets hurt.”

Fund advisers’ requirements. The final form amendments apply to large hedge fund advisers with at least $1.5 billion in hedge fund assets under management; private equity fund advisers with at least $150 million in private equity fund assets under management; and large private equity fund advisers with at least $2 billion in private equity assets under management.

The amendments will require large hedge fund advisers and all private equity fund advisers to file current reports upon the occurrence of certain events that could indicate significant stress at a fund or investor harm. Large hedge fund advisers must file these reports not later than 72 hours from the occurrence of the relevant event.

The SEC said “trigger” events for large hedge funds include certain extraordinary investment losses, significant margin and default events, terminations or material restrictions of prime broker relationships, operations events, and events associated with withdrawals and redemptions.

Reporting events for private equity fund advisers include the removal of a general partner, certain fund termination events, and the occurrence of an adviser-led secondary transaction. Private equity fund advisers must file these reports on a quarterly basis within 60 days of the fiscal quarter-end.

The amendments also require large private equity fund advisers to report information on general partner and limited partner clawbacks on an annual basis as well as additional information on their strategies and borrowings as a part of their annual filing.

Commissioner Peirce says ESG standards serve government goals, not investors

By Lene Powell, J.D.

In pointed remarks, SEC Commissioner Hester Peirce found fault with mandatory standards for environmental, social, and governance (ESG) disclosures, saying regulators’ true aim is not to bring about comparability or consistency, but rather to direct private capital flows toward government objectives. Peirce warned that “fallible regulators and herd-prone investors” could cause a “green bubble” and fail to solve problems ESG investing is meant to address.

“[ESG standards] are meant not primarily to serve investors’ needs but rather to direct the allocation of private capital to further government ends,” said Peirce.

Peirce gave the remarks at a Eurofi event on April 28 in Stockholm.

No need for new standards. Peirce began with a critique she has made before, that ESG-specific standards are not needed. Companies, asset managers, and investors always have considered a wide range of factors in investment decisions, and materiality-based disclosure standards already provide necessary information, she said.

Peirce noted that “ESG is an ambiguous term” and did not provide a definition. Generally, ESG investing is seen as a framework for evaluating environmental, social, and governance factors that can cause financial risk. It can form the basis of investment strategies with the aim of optimizing financial returns or promoting sustainability goals.

Serving government, not investors. Peirce stated that too often, ESG disclosure standards do not serve investors’ needs, but instead government ends. In the commissioner’s view, mandatory ESG standards appear intended to direct capital flows to further government ends. This is especially true when combined with sustainable finance initiatives designed to encourage financing of favored activities and the defunding of disfavored activities, she said.

“This commandeering of private capital in the name of ESG causes me grave concerns,” said Peirce.

Peirce did not detail how mandatory disclosure standards force capital to flow to government-desired ends.

Leave technocrats out of investing. According to Peirce, ESG is an “impossible” effort by “brilliant people in tidy conference rooms far removed from the nitty-gritty complexity of the world” to classify all of economic activity in terms of its effect on an increasing number of complex, sometimes mutually contradictory, metrics.

Not even the most capable regulators advised by the most qualified experts can advise about the viability of climate solutions, she said.

“Collecting bushels of data to measure the unmeasurable and quantify the unquantifiable is an unreliable basis for deciding where to send capital, even if all these data create the illusion that we understand the world and how humans live and work in it,” said Peirce.

“Green bubble.” Peirce warned that moving capital to government-designated sustainable activities could create a “green bubble” within the financial system as investors pour money uncritically into green asset. She said investors are complaining about the lack of investable assets, and the search for investable assets may cause them to forgo standard risk management precautions.

Asset bubbles always pop, said Peirce. Compounding the fallout, standards likely will lead to underfunding of activities that could produce real change but that do not fit within ESG taxonomies, she said.

“The messy economic aftermath may not even be softened by the consolation that these standards brought us closer to solutions to any of the problems these taxonomies were designed to address,” said Peirce.

Global ESG standards would cause systemic instability. Global convergence in ESG standards could create a global asset bubble, said Peirce.

“Any problems in the taxonomy—favoring harmful activities or disfavoring socially useful activities—will reverberate through the whole world, rather than being confined to a particular jurisdiction,” said Peirce.

Also, regulators will have a difficult time writing standards that apply equally well everywhere, stated Peirce. Global standards could miss important nuances about the physical, legal, social, and cultural environment where an activity occurs.

On a final note, Peirce expressed concern that applying standards extraterritorially, would undermine national sovereignty and the rule of law.

NASAA requests public comments on securities manual exemption

By Jay Fishman, J.D.

The North American Securities Administrators Association, Inc. (NASAA) has requested public comments on whether the Uniform Securities Act’s manual exemption should be amended by Model Act or Model Rule. NASAA’s Corporation Finance Section Small Business/Limited Offering Project Group asks interested persons to submit their comments electronically by email to NASAAComments@nasaa.org, with a cc: to the Project Group Chair, Faith Anderson (faith.anderson@dfi.wa.gov). The comment deadline is May 26, 2023.

Does the manual exemption continue to protect investors? NASAA’s overall quest is to determine whether the securities manual exemption under the Uniform Securities Act (USA) of 1956, 1985 and/or 2002 continue to protect investors from fraud and, if not, what changes are recommended to ensure complete protection for investors in today’s complex financial market world. Most states have adopted the manual exemption from one of the three NASAA model acts.

The USA of 2002. The USA of 2002 remains the most restrictive of the three Model Acts by mandating the exemption for only a nonissuer transaction by or through a registered or exempt broker-dealer, or a resale transaction by a 1940 Act unit investment trust sponsor, in a security of a class that has been outstanding in the public’s hands for at least 90 days, so long as a laundry list of conditions are met. But, NASAA says, even with these conditions a lot has changed in global financial markets since 2002, particularly with the advent of electronic trading platforms to greatly expand an investor’s ability to engage in secondary trading of securities that are not otherwise listed on an exchange in reliance on the manual exemption. Moreover, NASAA noted a 2016 SEC staff report proclaiming the securities of issuers that trade on these platforms present significant risks.

NASAA’s request. First, the project group asks interested persons for information on the use of the manual exemption to effect securities transactions, particularly data about how frequently the manual exemption is used. Subsequently, the project group seeks comments about:

• Whether the manual exemption’s existing requirements provide an appropriate level of protection for investors who buy securities from sellers relying on the exemption; and
• How the manual exemption could be amended if commenters believe the 2002 version provides inadequate investor protection.