High Court takes on question of whether an Item 303 omission is actionable under 10(b)

By Rodney F. Tonkovic, J.D.

A few days before the start of its new term, the Supreme Court granted certiorari for a petition asking if violations of Regulation S-K give rise to a Section 10(b) fraud claim. A Second Circuit panel held that petitioner Macquarie Infrastructure's failure to make a material disclosure required by Item 303 of Regulation S-K can serve as the basis for a fraud claim. The petition argued that the case involves a pure omission, that is, there was no affirmative statement rendered misleading by omission. The Second Circuit's holding places it in opposition to the Third, Ninth, and Eleventh Circuits, the petition says, and its expansion of liability under Section 10(b) conflicts with Court precedent (Macquarie Infrastructure Corp. v. Moab Partners, L.P., cert. granted September 29, 2023).

Macquarie. Petitioner Macquarie Infrastructure owned and operated a portfolio of infrastructure businesses. One of these businesses was International-Matex Tank Terminals (IMTT), a bulk liquid storage service. IMTT has stored a high-sulfur fuel oil known as "No. 6 oil" since the 1970s. Over the years, environmental regulations have caused the demand for No. 6 oil to decline, and in 2016 a regulation (IMO 2020) was issued to cap the sulfur content of fuel oil by 2020. In late 2017 and early 2018, the demand for storage at IMTT's facilities declined as customers failed to renew their contracts for storing No. 6 oil. In early 2018, Macquarie announced that it was reducing its 2018 dividend guidance; the company's stock price dropped after this news.

A lawsuit followed, and the lead plaintiff, respondent Moab Partners, L.P., brought a number of claims. Centrally, the complaint alleged that Macquarie failed to anticipate and disclose that IMO 2020 would have a negative impact on its financial performance. As relevant here, the district court rejected the argument that Macquarie violated a disclosure obligation under Item 303 of Regulation S-K because Moab failed to point to an uncertainty that should have been disclosed and also failed to plead in which SEC filings it should have been disclosed it. The court went on to dismiss the complaint in its entirety after finding no primary violations of the securities laws.

The Second Circuit. The Second Circuit disagreed in a summary order holding that Moab adequately alleged a "known trend or uncertainty" giving rise to a duty to disclose under Item 303. This also sufficed to establish an actionable omission and scienter under Section 10(b). The heightened pleading standard of the PSLRA was satisfied because the defendants were in the position of knowing that it was likely that IMO 2020 would reduce revenue, yet did not make corresponding disclosures, the Second Circuit concluded. The panel vacated the dismissal as to all claims and remanded the case to the district court.

The petition. Filed in May 2023, the petition asks whether the Second Circuit erred in holding that failing to make a disclosure required under Item 303 can support a private claim under Section 10(b), even in the absence of an otherwise-misleading statement. The case presents a square circuit split, Macquarie says, with the Third, Eleventh, and Ninth Circuits all holding that a failure to disclose under Item 303 is not enough on its own to support a private cause of action; the Fifth Circuit has said in dicta that it has never held that Item 303 creates a duty to disclose. In addition, the petition argues that the Supreme Court has repeatedly stated that the private right of action in the Exchange Act should not extend beyond its boundaries. The Second Circuit’s expansion of Section 10(b) liability, then, conflicts with the Court’s precedents.

Furthermore, Item 303 is not a suitable vehicle for an implied private right of action. The Item's disclosure obligations are meant to be flexible and general, and its disclosures comprise the type of "soft information" that is not objectively verifiable. Opening the door to private actions for violations of Item 303 amounts to allowing plaintiffs to plead "fraud by hindsight," which stands in tension with established precedent, the petition says.

Briefs. In its brief in opposition, Moab argued that the petition concerns an issue of "diminishing importance." Macquarie stressed that the Court had granted certiorari in 2017 for a case out of the Second Circuit raising the same issue, Leidos, Inc. v. Indiana Public Retirement System. The petition in Leidos centered around a conflict between the Second and Ninth Circuits, the Ninth being the first circuit to hold that an Item 303 violation cannot support a 10(b) claim. That petition, however, went unheard because the case settled. Moab's brief points out that the Solicitor General, as amicus in Leidos, sided with the Second Circuit. Plus, no other circuit has adopted the Ninth Circuit's reasoning, and there have been no other petitions raising the question since then. The circuit split is "superficial," and could disappear in time. The brief says that the Item 303 issue rarely arises and usually makes no difference to the outcome of the case because the claims are sustained only when investors can meet 10(b)'s other elements (which the Second Circuit held Moab had done).

Macquarie countered in its reply that the "split is anything but 'superficial.'" Three circuits fundamentally disagree with the Second about whether an issuer can be sued for an omission simply by failing to speak under Item 303. Moab is overlooking the distinction between a pure omission—which would not be actionable—and a half-truth, where a duty to disclose would arise because the speaker's affirmative statements would otherwise be misleading.

The brief goes on to note that plaintiffs have unsurprisingly included more Item 303 claims in securities cases in the Second Circuit than in the Ninth. Instead of being "rare," Macquarie suggests that Item 303 "remains fertile ground for litigation, and, successful or not, companies must aggressively, and expensively, defend themselves. Since the three circuits seeing the most securities cases have already weighed in, the court should resolve the split now, the brief contends.

The petition is No. 22-1165.

SEC proposes new requirements for registered index-linked annuities

By Lene Powell, J.D.

The SEC is proposing amendments to rules and Form N-4 to enhance the registration, disclosure, and advertising framework for registered index-linked annuities (RILAs). The proposal is intended to align the RILA offering process with other insurance investment products and implement a recent Congressional mandate to the SEC (Registration for Index-Linked Annuities; Amendments to Form N-4 for Index-Linked and Variable Annuities, Release No. 33-11250, September 29, 2023).

“Given the complexity and growing popularity of RILAs, it is important that investors receive the information they need—in plain English—to make informed investment decisions,” said SEC Chair Gary Gensler. “Implementing Congress’s mandate, today’s proposal would require RILAs to use a registration form tailored to their characteristics. This would improve the disclosure process for these complex products.”

The comment period will be open for 30 days following publication in the Federal Register.

RILAs. As Gensler explained, RILAs are a type of annuity product sold mainly to retail investors.

RILA investors’ returns are linked partly to the performance of a market index like the S&P 500. However, their performance is separate from the performance of the underlying index. Insurance companies often subject investor returns to caps and floors, which can change over time. Investors can experience losses if they withdraw money early.

RILA sales have more than tripled in the last five years, reaching approximately $41 billion in 2022, said Gensler.

Proposed changes. As explained in a fact sheet, the proposal would:

• Require insurance companies to register RILA offerings on Form N-4, the form currently applicable to most variable annuities;
• Amend Form N-4 to specifically address the features and risks of RILAs, including changes to the form’s “Key Information Table” (KIT) to highlight key features of RILAs;
• Permit RILA issuers to use the summary prospectus framework applicable to variable annuities;
• Require RILA issuers to pay fees in arrears on Form 24F-2 to accommodate RILA registrations on Form N-4;
• Apply Rule 156 under the Securities Act of 1933, relating to when sales literature is materially misleading under the Federal securities laws, to RILA issuers;
• Enhance disclosure for variable annuities registering on Form N-4.

The proposed changes would implement provisions in the Consolidated Appropriations Act of 2023, Division AA, Title I.

Investor feedback. As noted by Commissioner Mark Uyeda, the law required the SEC to conduct investor testing relating to RILAs. The Office of the Investor Advocate has issued its Investor Testing Report on RILAs, which describes the Office’s qualitative and quantitative analysis regarding RILA disclosures.

The report found that the number and complexity of RILA investment options could “easily be overwhelming” even for sophisticated retail investors. The OIA recommended further research to continue to promote investor welfare in the RILA market.

The SEC released a flyer asking retail investors for input.

“I encourage the public to comment on the proposal and to offer their views on how key information about RILAs can be conveyed in an understandable way,” said Uyeda.

Gensler faces down often hostile members of House Committee on Financial Services

By Suzanne Cosgrove

In testimony before the House of Representatives’ Committee on Financial Services Wednesday, SEC Chairman Gary Gensler reiterated his stance that the SEC needs to “freshen up” its rules to promote efficiency and competition in the more than $40 trillion equity markets.

“No regulation can be static in a dynamic society,” Gensler told the committee members, noting that quote was taken from a 1963 SEC study of the securities markets. He added that the 1960s study also recommended that “unanticipated changes in the markets and the broader public participation should be accompanied by corresponding investor protection.”

“Two years ago, we laid out a unified regulatory agenda to do just that,” Gensler said. “Included in that agenda were 10 items related to Congressional mandates, most from the Dodd-Frank Wall Street Reform and Consumer Protection Act and one from the Holding Foreign Companies Accountable Act. There were also items exercising new authorities granted under Dodd-Frank.”

The Commission has issued proposals for most of that agenda, he said, and it has finalized 24 rulemakings, “nearly all of which have changed based on public feedback.”

Gensler also pointed out the number of finalized rules under his tenure was less than several of his predecessors in a comparable timeframe – repeating a point he made at a hearing held by the Senate Committee on Banking, Housing and Urban Affairs earlier this month.

House Republicans set the table. Gensler made his remarks in the context of a letter released earlier this week by the House committee’s chairman, Patrick McHenry (R-N.C.), which implied the SEC’s rulemaking was far less deliberate than Gensler indicated.

Signed by McHenry and 28 other House Republicans, the letter stated the group was “troubled by the Commission’s reluctance to consider stakeholder feedback and its failure to conduct thorough economic analysis.”

The congressmen advised the Commission to stop finalizing or implementing rules “until it has comprehensively evaluated the real and cumulative impact of its rulemaking, including the impact on competition.”

But a stoppage by the regulator appears unlikely, barring a federal government shutdown.

Trade group lawsuit. Gensler noted the SEC’s recent slate of rulemaking included rules and rule amendments finalized in August designed to enhance the regulation of private fund advisers and update the existing compliance rule that applies to all investment advisers.

The final rules require private fund advisers registered with the Commission to provide investors with quarterly statements providing information regarding fund fees, expenses, and performance.

While McHenry said the Commission has overlooked the value of public input, Gensler said the final rule was adjusted “in multiple ways based on public feedback on the proposal.” Nonetheless, the final rules incited industry ire.

The Managed Funds Association, the National Association of Private Fund Managers, the National Venture Capital Association, the American Investment Council, the Alternative Investment Management Association, and the Loan Syndications & Trading Association joined in a lawsuit filed in the U.S. Court of Appeals for the Fifth Circuit against the SEC on September 1 that challenged the SEC’s new private fund rule, claiming the Commission had overstepped its statutory authority in its approval.

Crypto tokens tested. In his introductory remarks to Wednesday’s hearing, McHenry LAO charged the SEC chairman’s efforts to “choke off the digital-asset ecosystem has created real harm for consumers.”

The SEC chairman again stood firm. “As I’ve previously said, without prejudging any one token, the vast majority of crypto tokens likely meet the investment contract test,” Gensler told the House members. “Given that most crypto tokens are subject to the securities laws, it follows that most crypto intermediaries have to comply with securities laws as well.”

He said while the SEC has brought enforcement actions—some settled, and some in litigation—it also has addressed the crypto security markets through rulemaking, a comment that clearly addressed his critics who have charged the SEC with regulating crypto by enforcement alone.

“We issued a reopening release that reiterated the applicability of existing rules to platforms that trade crypto asset securities, including so-called ‘DeFi’ systems,” he noted. “While our current investment adviser custody rule already applies to crypto funds and securities, our proposal updating it would cover all crypto assets and enhance the protections that qualified custodians provide.”

Focus on climate risk disclosure. In addition, Gensler said the SEC’s staff is “considering carefully the more than 15,000 comments we’ve received” on its climate risk disclosure proposal.

“The SEC has no role as to climate risk itself,” he stressed. “We, however, do have an important role in helping to ensure that public companies make full, fair, and truthful disclosure about the material risks they face.”

A majority of the top thousand issuers by market cap already make climate risk disclosures, including Scope 1 and Scope 2 greenhouse gas emissions, Gensler said, adding that investors representing tens of trillions of dollars in assets are making decisions relying on those disclosures.

Fast-moving target. “Though we are blessed with the largest, most sophisticated, and most innovative capital markets in the world, even a gold medalist must keep training,” Gensler said. “We now live in the age of electronic trading and generative AI. We’ve had dramatic growth in the scale, size, and interconnectedness of our capital markets, with individual investors participating more than ever before.”

Commission extends no-action relief regarding Ownership and Control Reports

By Suzanne Cosgrove

The CFTC’s Division of Market Oversight has issued an extension of a no-action letter to address what it described as continuing compliance difficulties associated with specific OCR reporting obligations identified by reporting parties and market participants.

The Commission’s latest extension affects the DMO’s position under the CFTC No-Action Letter No. 20-30, issued in September 2020. Without action by the Commission, those terms would have expired on September 29, 2023, the CFTC said.

As a result of the extension, the DMO said in a release that it will not recommend the CFTC enforcement action in nearly a dozen instances, including in the following circumstances:

• Accurately reporting a trading account owner’s (TAC) and volume threshold account (VTA) owner’s name within three business days following the day on which the account became reportable;
• Failure to report certain TAC and VTA controller identifying information;
• Failure to provide the level of confidence a reporting party has in the accuracy of the information provided to it by its customers or counterparties;
• Failure to report a volume threshold account based on a reportable trading volume level of 50 contracts (provided such reporting party reports instead based on a reportable trading volume level of 250 or more contracts per day).

Industry request. In its letter dated September 22, 2023, the CFTC said the latest extension was made in response to a request from the Futures Industry Association, the Commodity Markets Council, and the International Swaps and Derivatives Association to the DMO on behalf of affected reporting entities, carry brokers, and reportable traders.

In the request, the associations requested a postponement of the no-action position regarding certain data reporting requirements of parts 17, 18, and 20 of the Commission’s regulations implemented pursuant to the Ownership and Control Reports final rule.

The CFTC noted in its letter that the DMO has taken a no-action position with respect to certain reporting obligations under the OCR Final Rule since 2014. In September 2017, DMO issued no-action letter 17-45 in response to requests from FIA and CMC on behalf of affected reporting entities, including carry brokers and reportable traders. No-action letter 17-45 extended the time period for the no-action position, which was itself previously granted and extended in several prior no-action letters, from certain reporting obligations under the OCR Final Rule.

Extension called “troubling.” In a statement, CFTC Commissioner Summer Mersinger said she supported the extension of the staff no-action relief but found it troubling that it represented “another instance of successive extensions of staff no-action relief on issues that the Commission has failed to address permanently.”

Mersinger noted that a rulemaking that could address OCR issues on a permanent basis is included in the Commission’s “Agency Rule List” published in the spring of this year, but the target date given for the issuance of a notice of proposed rulemaking regarding the OCR rules was not until March 2024.

“Under the circumstances, I urge staff and the Commission to develop and issue an OCR proposed rulemaking soon – so that staff is not compelled to issue yet another extension when this one expires a year from now,” she said.

In its letter, the CFTC said the current no-action position will remain in effect until the earlier of an applicable effective date or compliance date of a Commission action, such as a rulemaking or order, or September 30, 2024.

11th Circuit adopts 'totality of circumstances' test to find whistleblower's reasonable belief

By Rodney F. Tonkovic, J.D.

In denying a petition for review, an Eleventh Circuit panel took the opportunity to clarify what a "reasonable belief" is in the whistleblower context. In this case, a financial analyst at Office Depot said that he was fired in retaliation for uncovering what he argued was the intentional manipulation of sales data. To determine what evidence is required to establish a reasonable belief that there was a SOX violation, the panel adopted a "totality of the circumstances test" requiring sufficient information for a reasonable person to believe that there was a violation. In this case, the petitioner's claims were mere speculation, which was insufficient (Ronnie v. Office Depot, LLC, September 25, 2023, Wilson, C.).

Sales lift. Petitioner Christian Ronnie was a senior financial analyst at Office Depot. One of his principal duties was calculating a metric called "sales lift," a measure of how sales change at an Office Depot retail store after another nearby Office Depot closes. Ronnie discovered two potential accounting errors that he believed showed securities fraud related to sales lift. He claimed that Office Depot used the wrong data set for projected sales and that Office Depot calculated sales lift incorrectly by using different data sets to calculate pre-closure revenue data when it should have used identical data.

Ronnie reported both issues to his superiors on February 25, 2016. He was able to correct the model for the first issue, but while his superiors seemed to appreciate the seriousness of the second issue, no immediate action was taken. Ronnie was then tasked with investigating and reporting on the root cause—but not to make any changes to the calculation.

After reporting the issue, Ronnie alleged that his relationship with his boss became strained. Ronnie was asked to perform menial clerical work and was frequently reprimanded when his reports were incomplete or late. Suspecting retaliation, Ronnie emailed HR to ask for protection on March 8, 2016.

Terminated. By early April, Ronnie had not been able to figure out the discrepancy and he was given a "final warning" for failing to timely complete the task. On April 19, 2016, Ronnie was terminated for failing to perform his task. He then filed a timely pro se complaint with OSHA, which dismissed his complaint.

Ronnie appealed, and Office Depot moved for a summary decision, arguing that Ronnie failed to show a protected activity and that he was fired for poor work performance. The ALJ concluded that Ronnie failed to establish an objectively reasonable belief that fraud had occurred. The ARB affirmed.

Reasonable belief. The question before the court on appeal was: what evidence must a whistleblower show to establish a reasonable belief that the reported conduct by the employer violated SOX Section 1514A? As the ARB sees it, reasonable belief is determined by a mixed subjective and objective test, that is, the employee must believe that the alleged conduct violated SOX and a reasonable person would see it the same way. The court's task, then, was to inquire what evidence is required to establish reasonableness.

The panel adopted a "totality of the circumstances test" as used by the Second and Fourth Circuits. Under this test, the petitioner does not have to articulate a specific provision of Section 1514A that is being violated, but must set out sufficient information for a reasonable person (in the same circumstances as the complainant) to believe the wrongdoing amounted to a SOX violation. The totality of the circumstances can include elements of fraud such as scienter, materiality, reliance, and economic loss; while these elements do not need to be proved, there must be more than a conclusory allegation.

Applying this test, the panel concluded that Ronnie failed to show that a reasonable person would find Office Depot's conduct to be violative of SOX. While Ronnie argued that Office Depot intentionally manipulated sales data in order to mislead, he did not support this conclusion. The court pointed out that Ronnie's supervisors' insistence that he find the cause of the discrepancy did not comport with the allegation that they sought to cover it up. Ronnie's assertion that his investigation was a stalling tactic to hide the alleged manipulation of sales data was mere speculation, the panel said, and not enough to create a genuine issue of fact as to the objective reasonableness of his belief.

The panel then concluded that the ARB's decision was not arbitrary or capricious or an abuse of discretion. The petition for review was accordingly denied.

The case is No. 20-14214.

CFTC disapproves KalshiEX Congressional Control Contracts, sees them as ‘gaming’

By Suzanne Cosgrove

The CFTC has disapproved KalshiEX LLC’s Congressional Control Contracts, prohibiting their listing, trading and clearing on its platform. Described as event contracts, they would have been cash-settled, binary (yes or no) contracts offered by the designated contract market based on the question: “Will (chamber of Congress) be controlled by (party) for (term)?”

“The Commodity Exchange Act enumerates certain categories of commodities for which derivatives may be contrary to the public interest if listed on an exchange,” said CFTC Chairman Rostin Behnam in a statement. “These include contracts that involve gaming or activity that violates state or federal law. Kalshi’s Congressional control contracts fall into both of these categories. Betting or wagering on elections, as proposed by Kalshi, meets the definition of gaming,” he said.

The Congressional Control Contracts involve “gaming,” because taking a position in the contracts would be staking something of value upon the outcome of a contest of others, the CFTC said in its order.

Settlement values of the contracts would have been determined by the party affiliation of the leader of the identified chamber of Congress on the contracts’ expiration date. In the case of the House of Representatives, the leader would be the Speaker of the House, and in the case of the Senate, it would be the President Pro Tempore. An absolute amount would have been paid to the holder of one side of the contract at settlement, with no payment made to the counterparty.

Kalshi self-certified the political event contracts on June 12, 2023, and the CFTC initiated a review of the contracts, pursuant to CFTC Regulation 40.11(c), on June 22, 2023, according to a CFTC release. In addition, on June 23, 2023, the Commission opened a public comment period to help evaluate Kalshi’s submission.

Behnam said 1,378 public comments were submitted in response to questions aimed at informing the Commission’s review.

Controversial contracts. Although it self-certified the contracts this summer, Kalshi embarked on their pursuit than a year ago. As reported in Securities Regulation Daily, Kalshi sent a voluntary submission of the product for Commission review and approval in July 2022.

In last year’s submission to the CFTC, Kalshi stated that contracts on political control of Congress have been available to U.S. market participants for nearly a decade. In addition, without naming New Zealand-based PredictIt, it noted a similar contract had been available for trading on an unregistered venue since 2014, operating under a no-action letter issued by the CFTC’s Division of Market Oversight.

The CFTC later withdrew its no-action relief for PredictIt, stating that the trading platform’s operator, Victoria University, had not operated its market in compliance with the terms of the relief.

“The approval of political event contracts of the type presented in the order would require the CFTC to exercise its oversight and enforcement authorities in the manner of an election cop,” Beham said this week. “Our new authorities would per se include monitoring elections, candidates, and countless participants in the political machinations that proliferate in the media and cyberspace in an effort to prevent manipulation and false reporting within the political system -- something that the CFTC currently lacks the mandate to do.”

Mersinger holds fast. As reported in June, Commissioner Summer Mersinger previously argued against the CFTC’s disapproval of the political event contracts. On Friday, she again indicated her dissent.

Mersinger argued that the Commission must permit the listing of event contracts unless they fall into certain categories listed in the Commodity Exchange Act and are contrary to the public interest. Those categories include activity that is unlawful under any federal or state law, terrorism, assassination, war and gaming.

The CFTC order’s focus on individual elections is flawed, Mersinger said. In addition, the order fails to establish that the Congressional Control Contracts involve the enumerated activities of gaming, and activity that is unlawful under state law. “The order eschews a much more natural interpretation of the ordinary meaning of “gaming” in Section 5c(c)(5)(C): Risking money on the result of a game,” she said.

With respect to the category of activity that is unlawful under state law, “I do not question that placing bets or wagers directly on the result of an election of a public official would violate the statutes and common law cited in the order,” Mersinger said. However, the Congressional Control Contracts do not settle directly on the election of any individual representative or senator, she said.

“The order does not cite any authority that any state statute or common law could be used—and no instance in which it has been used—to prosecute a person for staking something of value upon the political party that will control the U.S. House of Representatives or Senate as an indirect result of a multitude of elections,” Mersinger said.

Commissioner Caroline Pham also released a statement regarding the event contracts. Pham said she abstained from voting on the issue because she believed a May 2023 order by the U.S. Court of Appeals for the Fifth Circuit involving PredictIt (Clarke v. CFTC) may eventually prevent the Commission from taking action on KalshiEx, LLC’s Congressional Control Contracts.

SEC asks panelists for Reg D recommendations

By Jay Fishman, J.D.

The SEC Investor Advisory Committee (IAC), in a September 21, 2023 open meeting, welcomed five panelists to discuss Regulation D with emphasis on Rule 506. The SEC commissioners and IAC staff members were particularly interested in panelist recommendations on how to bring the 1982-initiated regulation into the 21st Century to balance capital formation with investor protection, given today’s exploding multi trillion-dollar private offering market.

Christopher Mirabile, the IAC Chief, kicked off the conversation by stating that while it is important to protect investors participating in these low disclosure Rule 506 offerings, this should not be done at the expense of capital formation, especially by small start-up companies, because the private offerings these startups make can, among other things, result in immense job growth for the U.S. population. And because of this potential job growth, the SEC should not immediately shut down a startup simply because it does not have the resources to fully comply with SEC requirements at the pre-offering stage; they will have more information to better comply after they make the offering. Mirabile did, however, advocate for the startups to file Form D. Most interestingly, at the end of the meeting, the IAC asked the panelists to help staff draft the Regulation D Rule 506 recommendations. Leslie Van Buskirk, Wisconsin’s Securities Administrator, moderated the panel.

Opening remarks. SEC Chair Gary Gensler and Commissioner Hester Peirce provided the opening remarks. Gensler relayed the history of the U.S. financial markets dating back to the Great Depression, with the inception of the SEC and the federal Exchange and Securities Acts that later led to the Ronald Reagan era initiation of Regulation D, including Rule 506. He pointed out that Regulation D has served as an important exemption outside of public offering registration by providing full, fair, and truthful disclosure to investors in the private market.

Peirce remarked upon the private market escalating into a primary source for capital, making the Regulation D and accredited investor topics comprising today’s open meeting central to the Commission’s mission to facilitate capital formation while simultaneously protecting investors. Although Peirce emphasized that enhanced access to private capital is a positive development not only for companies but for investors, and that a robust private market contributes to the health of our economy, she said the SEC should not look to impose public-market-style regulations on private markets; instead, she declared the Commission should look for ways to reduce the costs companies face in going and staying public. Peirce further proclaimed that many investors have access only to the public markets, a problem that could be rectified by increasing opportunities for retail funds to access private investments. Lastly, Peirce turned to two draft recommendations the IAC will consider later today, namely (1) a human capital management disclosure recommendation; and (2) an open-end fund liquidity risk management and swing price recommendation. For each recommendation she posed a number of questions for the IAC to consider.

Commissioners Carolyn Crenshaw and Jaime Lizarraga also weighed in by pointing out that, ironically, the very regulation created to protect retail investors in the private market may now be undermining them by requiring no more than bare bones disclosures, which are not enough to help these investors weigh the benefits against the risks to determine whether to invest or not. Crenshaw also emphasized that a Rule 506 issuer’s Form D information is not certified by the SEC even though the Form contains a Commission logo, possibly leading investors to mistakenly believe the SEC has or will oversee the information. Crenshaw, therefore, calls for gatekeepers, auditors, and other means of SEC oversight to protect Rule 506 investors from fraud.

Panelists. Like Chair Gensler, the panelists delved into various aspects of the history of federal securities regulation, but their most important contribution consisted of recommendations made to the IAC and commissioners.

Kenisha Nicholson, Special Counsel for the Office of Small Business Policy at the Division of Finance within the SEC, pointed out the need for Regulation D changes because of data showing that Rule 506, particularly 506(b), has brought in trillions of dollars more than other exemptions such as Rule 504, Regulation A Tier 2, federal Regulation crowdfunding, state crowdfunding, and even public offerings/IPOs. Moreover, issuers including start-up companies gravitate to Rule 506(b) over the other exemptions because it’s the easiest to put in place: it can be used anytime and without the disclosures the other private offering exemptions or public registrations mandate. Another important point she made is that the Commission states Form D should be filed but is not required to be filed and, further, is only mentioned to be filed at the start of the offering—within 15 days after the first sale—and not at any other point including at the offering’s termination. As a result, federal and state securities regulations do not have data on how the offering progressed or how much money it made by the end of its life cycle…so they may not know the full extent of any fraudulent dealings or significant investor losses until it is too late to get full restitution for the victims. Thus, she advocates for more disclosure requirements, including post-sale and post-offering termination disclosures.

Craig McCann, Principal, SLCG Economic Consulting, was the panelist who presented all of the charts and graphs on what Rule 506(b) data has revealed. The most telling point he made was that data compiled by even the SEC and relied upon by Commission staff and other federal and state regulators may be grossly inaccurate. In one case, he pointed out that one of the ten largest Rule 506 revenue-producing companies overstated to the SEC the capital it raised by billions of dollars—all because that enormous dollar figure on SEC-filed documents was actually the amount in another country’s currency, say Indian rupees; in short, the Indian company either intentionally or unintentionally entered the much lower rupee amount in U.S. dollars on the filing, making the SEC believe the company made much more money on the offering than it actually did. And according to McCann, the Commission never corrected this gross error leading data analysts and regulators looking at the chart to believe that much more money was raised from these large company private offerings than was actually raised.

Yet another chart showed that most of the Reg D Rule 506 offerings are made in pooled investment funds, but there is hardly any data on what industries these funds invest in, whether in construction, technology, or pharmaceuticals for example, that investors might want to know before investing.

Sarah Hanks, CEO of Crowdcheck made a fundamental point: that small start-up companies often fall back on a Rule 506 simply to keep the company doors open and the lights on; that it’s the only offering they can make because the other private exemptions and public registrations are way too expensive and mandate many more disclosures than the start-ups can provide. Hanks said that as result of this intense reliance on 506 coupled with the fact that a Form D filing is not required for them, the amount of even accidental fraud occurring especially to unaccredited retail investors from these many start-up companies can spiral into thousands or millions of dollars in total investor losses. She, therefore, recommends: (1) a link be placed on Regulation D for investors to click on and read the standard risks of this investment; (2) mention on Form D that the issuer-provided information is self-reporting, meaning that the SEC does not oversee it even though the Commission logo is on the form; and (3) provide a legend of risks on all issuer communications to investors—even on Tik Tok communications for the many young investors out there.

Amanda Senn, Director of the Alabama Securities Commission, emphasized how state securities regulators across the country are frustrated by not seeing data on Regulation D Rule 506 offerings by providing more than bare bones disclosures on Form D to glean whether the disclosures are, in fact, effective at preventing fraud. She advocates four proposals: (a) require issuers to file Form D before they solicit investors; (b) require issuers to file an amendment at the close of the offering to see how much money was actually raised and view other factors about the offering, e.g., price, investor demographic, assets, etc. that occurred after the initial filing; (c) amend the “accredited investor” definition to eliminate the value of an investor’s permanent residence and 401(K) retirement account from the calculation for deciding whether the investor qualifies to participate in the Rule 506 offering; and (4) index an investor’s funds for investing by inflation, which may disqualify them from the offering if the funds, indexed for inflation, should have less money than they should have for the offering.

Alexandra Thorton, Senior Director, Financial Regulator, The Center of American Progress, mentioned a severe, unintended consequence of the exploding Regulation D Rule 506(b): that so much of the money raised in this market is not by the small start-up companies Rule 506 was created for (50 percent of whom drop out by failing to raise the needed funds); instead, the bulk of the money raised is by large companies with public company characteristics who avoid making public company disclosures by undertaking private offerings, which do not mandate them. Thornton, therefore, strongly recommended that the IAC staff and SEC commissioners turn these large private companies into publicly reporting companies.

SEC crypto enforcement chief David Hirsch outlines next possible areas of SEC crypto focus

By Lene Powell, J.D.

Crypto assets are causing “a lot of risk and harm to investors” and institutional investors should be careful about acting as statutory underwriters, said David Hirsch, chief of the SEC Crypto Assets and Cyber Unit, Division of Enforcement. Hirsch discussed SEC enforcement actions against crypto exchanges, celebrity touters, and NFT issuers, among other topics, in a Q&A session at the Securities Enforcement Forum Central 2023 conference on September 19.

The Q&A was conducted by A. Kristina Littman, partner at Willkie Farr & Gallagher. The conference was organized by Securities Docket.

Crypto crackdown. The SEC has been “very active” in the crypto space because it is seeing a lot of risk and harm to investors, said Hirsch.

“We are seeing huge amounts of money vaporize overnight, in ways that are surprising to investors and risk market contagion, at least within the crypto markets,” said Hirsch.

As a result, the SEC has continued to emphasize the need for registration, disclosure, and best practices, said Hirsch. The agency has also continued its anti-fraud mission.

On registration, the SEC has continued to look at issuers of tokens, NFTs, and anything else that can be classified as a security, said Hirsch. The SEC has also continued to be active as to intermediaries. This includes brokers, dealers, exchanges, clearing agencies, and any others that are active in the space and not meeting their obligations with respect to registration.

Warning for institutional investors. A lot of clients are asking about the statutory underwriter theory of liability, said Littman.

While the SEC has not gone after institutional investors under this theory so far, the Telegram and Sparkster cases raise concerns that distributing tokens could trigger liability for institutional investors as statutory underwriters.

• In Telegram, the court used “pretty specific statutory language” that the institutional investors could be deemed statutory underwriters, said Littman.
• In Sparkster, the SEC charged a promoter who bought a large number of tokens and created a pool, and sold opportunities to other investors to buy from that pool. The SEC alleged that the promoter bought the tokens with a view toward distribution and charged him with violating Section 5. While the SEC complaint did not explicitly articulate a statutory underwriter theory, it used similar language.

Littman asked if institutional investors who buy large quantities of tokens should be worried.

Yes, said Hirsch.

“To the extent that Section 2a(11) sets out the rules for statutory underwriters, if institutional investors and others are buying tokens with a view to distribute them, then they potentially fall within that definition,” said Hirsch. “They need to either satisfy an exemption or register as such.”

Hirsch pointed to guidance put out by the Division of Examinations in February 2021. The guidance mentioned the potential for statutory underwriter liability and indicated the Division would be looking at this.

Ripple impact. Turning to recent actions, the July decision in SEC v. Ripple caused a lot of excitement, said Littman. The decision ruled that the XRP token was not a security in some contexts. While Hirsch could not discuss the ongoing litigation, Littman gave observations.

“[Ripple] is up is down, black is white. It turns everything I think we all thought about how securities occupy the space on its head,” said Littman.

But while clients celebrated the ruling, Littman is urging caution.

“What I say to clients is, look, take a beat,” she said. “This is probably going to be appealed and there are some areas here that I think are vulnerable to appeal.”

Clients were excited because the “programmatic” purchases that were found not to be securities transactions were situated similarly to secondary market purchases, she said.

“What it said to people was, secondary market transactions are not securities transactions. So, Coinbase wins. Binance wins,” she said.

However, Littman explained, the ruling did not actually extend to secondary market transactions. That issue was not before the court, so that was dicta. Now, the SEC has filed for interlocutory appeal.

Littman further noted that just weeks after the July ruling, Judge Rakoff explicitly said he thought the Ripple judge got it wrong and he would not apply that ruling in SEC v. Terraform Labs . Rakoff’s ruling threw water on the idea that the Ripple ruling might survive appeal, she said.

Coinbase, Binance, and other exchanges. Littman asked why the SEC is going after Coinbase and Binance in particular, when many other exchanges have the exact same business model.

Generally, the SEC brings cases depending on when the investigation is ready, resources, and priority, said Hirsch.

The SEC’s concerns about crypto intermediaries extend beyond these specific exchanges, said Hirsch. There are over 20,000 tokens, more than the SEC or any agency has the resources to oversee directly. He added that some crypto trading platforms are operating in multiple unregistered capacities, including as brokers, clearing agencies, and dealers.

When those functions are separated out, it creates checks and balances, said Hirsch. A broker is unlikely to route traffic to an untrustworthy exchange, because it would be bad for the broker’s business if clients got bad execution or lost custody of their assets. Similarly, exchanges do not want to clear and settle through an untrustworthy clearing agency.

These levels of oversight are absent when all these functions are collapsed into one, said Hirsch.

“While I don’t think it’s impossible in traditional finance to put all those functions under one roof, it’s inadvisable and potentially illegal,” said Hirsch.

Consolidated functions also create challenges for surveillance. Large centralized crypto exchanges are internalizing trades and processing them in large blocks between exchanges, said Hirsch. This results in the blockchain not showing individual trades in the form of a visible, auditable trail. This reduces transparency.

DeFi. In January the SEC brought a case alleging a crypto Ponzi scheme, SEC v. Eisenberg. Although the SEC did not charge Mango Markets, the trading platform involved, it did discuss governance tokens, which grant rights to vote on things like changes to protocols. Littman asked about a section in the complaint called “The Illusory Rights of Governance Tokens” that implied the SEC did not think the exchange was truly decentralized. She observed that the SEC has not brought an action against a decentralized platform.

“That’s likely a matter of time,” said Hirsch. “With DeFi as with everything, what you call something does control the SEC’s interpretation. We look at function and substance. If the idea is that you’re assuming you’ll avoid liability or accountability by rescuing yourself with new technology, but the substance of what you’re doing is similar to activities that are already under our jurisdiction and securities laws, then we’re going to use those securities laws to bring enforcement actions.”

Littman asked if the recent CFTC settlements against DeFi platforms were an example of dividing labor between the CFTC and SEC.

“My view is that crypto enforcement is a team sport,” said Hirsch.” There is more activity out there than any one agency has the resources for. So by definition we have to work with our law enforcement partners, our civil partners like the CFTC, local law enforcements, as well as state regulators.”

Hirsch continued, “I expect there will continue to be cases where we and the CFTC are both on the scene, where we both have our own independent jurisdictional prerogatives that we have to advance. But there will also be matters where we say that ultimately the result we need—registration, notice to investors that a market’s got problems, enforcement and deterrence—can be accomplished by one agency, we won’t necessarily both be there.”

Celebrity touting. One thing that attracts attention is celebrities like Kim Kardashian, said Littman. But when the Kardashian touting case came out, a lot of people questioned why the SEC went after Kardashian, given all the important stuff happening in crypto. Why are celebrity touting cases important to the SEC’s larger mission?

Hirsch recommended reading Enforcement Director Grewal’s speeches on this topic. A lot of crypto has been marketed to investors who are less financially educated and less able to withstand losses. Touting cases often protect younger and less affluent investors in particular. There is a lot of hype and volatility in these markets, and anything that makes it seem like profits are easy, inevitable, and available is problematic for the SEC. It is extra important for people selling into those markets to be explicit about the compensation they are receiving, said Hirsch.

Littman pointed out that as the Kardashian case made clear, you can’t just slap an #ad hashtag on a post. Disclosure requires more.

NFTs. Littman asked if Hirsch agreed with market sentiment that although the SEC has brought enforcement actions against two non-fungible token (NFT) issuers (Impact Theory and Stoner Cats 2 ), a lot of NFTs are differently situated and many don’t meet the Howey test.

It comes down to expectation of profits, said Hirsch.

Some NFTs suggest they’re as much about personal signifiers as it is about generating profits, Hirsch noted. If the NFT issuers can demonstrate that the mechanism they’re employing is not intended to generate profits for anybody, then that likely would not meet the Howey test.

“So it’s really about whether or not there’s a profitability supporting the distribution. And that extends beyond NFTs to lots of other crypto generally,” said Hirsch. “But a lot of what is driving development in this industry as it exists now is trying to incentivize early adoption by getting in early and drifting off the efforts of others. The promoters make this thing capable of mass adoption and then scarcity will create possibilities for profit, and that would bring in Howey.”

“Nobody wants to miss out on the next Bitcoin,” said Littman.

Crutchfield leads expert panel on ‘The Business Case for AI’

By Katalina M. Bianco, J.D.

On Sept. 14, 2023, Ken Crutchfield, VP & GM, Legal Markets Legal & Regulatory, US, Wolters Kluwer, led a panel of experts in a discussion on building a business case for the use of generative AI (GAI) by law firms. The discussion focused on balancing potential benefits and opportunities against significant costs, risks, and ethical considerations.

To read more about the expert panel and the discussion of GAI in law firms, click here.

Chancery blesses dual-class structure that empowers specific stockholders

By Anne Sherry, J.D.

The Delaware Court of Chancery upheld a governance structure that gave the lion’s share of voting power to two specified stockholders. Because the Delaware corporate statute allows rights to be set by way of a formula, the charter’s means of assigning rights to signatories to a stockholder’s agreement was permissible, and it didn’t matter that the rights were based on the identity of the stockholders instead of the class of stock (Colon v. Bumble, Inc., September 12, 2023, Laster, J.).

Up-C and dual-class explained. The court explained that an Up-C structure allows the public to participate in a company both economically and in governance through Class A shares, while insiders participate economically through their LLC units and in governance through Class B shares. A standard dual-class voting structure also creates two classes of stock, but with different voting rights. In short, “in an Up-C structure, the two classes have the same voting rights but different economic rights … In a dual class voting structure, the two classes have the same economic rights but different voting rights.”

Hybrid approach. In this case, corporate insiders wanted different economic and voting rights. They accomplished this by providing in the corporate charter that each Class A share carries one vote, unless the share is held by a “Principal Stockholder,” in which case it carries ten votes. There are two Principal Stockholders, and they each hold one of the only two Class B shares, which in turn carry the votes the holder would receive if its LLC units were converted into Class B shares. This allows the two Principal Stockholders to exercise over 92 percent of the company’s outstanding voting power.

Stockholder challenge. The plaintiff brought a class-action suit challenging the structure, which the plaintiff said amounts to “identity-based voting” and violates Sections 212(a) and 151(a) of the Delaware General Corporation Law. But the court, after a methodical turn through the workings of the DGCL, held that the structure is valid.

Section 151(a) authorizes a corporation to issue multiple classes of stock and makes clear that these classes may carry the default rights implicitly granted by the DGCL, the default rights specified explicitly in the charter, or whatever special rights the charter sets forth. Section 212(a) provides that if the certificate of incorporation is otherwise silent, then each share of stock carries one vote by default.

In the court’s read of Section 212(a), the provision provides for a default right of one vote per share while acknowledging that the charter can specify a different number. Nothing in the examined DGCL provisions requires the charter to frame the voting power in terms of a specific number of votes per share. The charter can set out a formula or procedure to calculate voting power, and Section 151(a) expressly permits voting rights to depend on facts ascertainable outside of the certificate of incorporation.

In Providence & Worcester Co. v. Baker, 378 A.2d 121 (Del. 1977), the Delaware Supreme Court upheld a scaled voting structure where the voting power of a share depended on the total number of shares that the owner held. (Each stockholder could cast one vote per share for its first 50 shares, then one vote for every 20 shares beyond that, and no stockholder could cast more votes than 25 percent of the total number of issued and outstanding shares.) In other words, the certificate of incorporation departed from the default right of one vote per share to provide for inferior voting rights based on a fact ascertainable outside of the certificate of incorporation: the number of shares that the stockholder held.

The plaintiff actually cited Providence as invalidating the challenged voting structure, arguing that under that case, a corporation cannot create a mechanism that confers different voting power depending on who holds the shares. But at the time Providence was decided, the DGCL did not yet contain the “facts ascertainable” language. Allowing that the Supreme Court’s analysis in Providence was “difficult to parse,” “confusing,” and a “puzzle,” the chancery court said it came to the right result. For purposes of a charter provision that establishes the voting power appurtenant to shares, there is no meaningful distinction between the voting rights of the stockholder and the voting rights of the stock. “We should not dissect [Providence’s] entrails to divine a prediction for future cases that does not make any sense,” the court wrote.

The chancery court also rejected the plaintiff’s argument that if a formula does not create the same outcome for each share in the class, it creates de facto subclasses that violate Section 151(a). The Supreme Court in Providence and the Chancery Court in several other cases have upheld formulas that applied identically across all shares, but created different outcomes for particular shares. The same could be said for other special attributes, like a formula that creates differing conversion rights to effect a poison pill.

The plaintiff attempted to distinguish the other cases by observing that any stockholder had an equal opportunity to gain the superior right; the charters did not create a closed set of stockholders that only insiders could modify. In the court’s view, this argument “intentionally appeals to American cultural ideals like equality of opportunity and resistance to entrenched hierarchies. … In many areas of the law, those noble sentiments could carry weight. They cannot overcome the plain language of the DGCL.”

In closing, however, the court left a door ajar by noting that corporate action in Delaware is “twice tested”: once for legal compliance and again in equity. The court’s decision only speaks to the legal validity of the challenged provisions.

The case is No. 2022-0824-JTL.

IAA asks SEC to conduct rulemaking to redefine ‘small entity’ for investment advisers

By John Filar Atwood

The Investment Adviser Association (IAA) has asked the SEC to conduct a rulemaking to change the definition of “small entity” under the Investment Advisers Act to base it on number of employees rather than on assets under management (AUM). In its rulemaking petition, the IAA explained that the current definition—an adviser with less than $25 million in AUM—precludes the Commission from analyzing the impact of its regulations on smaller advisers since only advisers with at least $100 million in AUM can register with the SEC.

The IAA’s specific request is that the SEC amend Investment Company Act Rule 0-7 to state that for purposes of Commission rulemaking the term “small business” or “small organization” under the Investment Advisers Act will mean an investment adviser registered with the Commission that has 100 or fewer employees as of the investment adviser’s most recent fiscal year. The IAA proposed that “employee” be defined as any person that is included in determining the number of employees reported by the adviser under Item 5.A of Form ADV.

The IAA said that it shares the Commission’s goals of protecting investors through effective regulations, but noted that those regulations must be appropriately tailored to balance their burdens and benefits, and take into account size differences and resource constraints of the regulated entities. The IAA believes that a more realistic measure of what constitutes a smaller adviser would help the SEC develop more effective regulations.

Flawed approach. The IAA noted that when the current AUM-based definition was adopted by the SEC in 1982 the Small Business Administration specifically advocated for an employee-based standard. The Commission rejected that approach because “neither the investment company nor the adviser industry is labor intensive, and investment companies are generally externally managed and operated by their investment advisers so that most investment companies have few employees.”

The IAA believes this reasoning is flawed because it does not follow that because an investment company may have few employees, an investment adviser will also have few employees. Moreover, the IAA pointed out that there is no doubt that regulatory compliance depends heavily on human resources, and is in fact increasingly labor intensive.

The IAA is of the view that using an assets-based size standard that is tied to the SEC registration threshold as the measure for being considered “small” does not accurately reflect the burdens of regulations being imposed on smaller advisers. While advisers with lower AUM are likely to be small businesses, those advisers comprise only a subset of the larger group of advisers that are small businesses facing small-business challenges, the IAA stated.

Significant burdens. According to the IAA, regulations imposed by the Commission often require substantial fixed investments by advisers in infrastructure, personnel, and technology. In addition, the SEC increasingly expects that advisers will incur the bulk of the costs associated with compliance of new regulations initially, rather than on an ongoing basis.

The IAA said that while initial undertakings are likely to pose a greater burden on smaller advisers that may not have as much capacity to take on the immediate costs, it disagrees with the Commission’s assessment that the costs will be transitory. On the contrary, the IAA argued, the costs relating to ongoing compliance will continue to impose substantial burdens on smaller advisers.

Smaller advisers typically have fewer resources to spend than larger firms, have limited access to the services of third parties and service providers, and have little ability to recognize savings through in-house leveraging of resources or scaling, the IAA noted. They have a limited number of personnel, many of whom perform multiple functions within the adviser, and face increasing challenges attracting and retaining qualified personnel, including for compliance roles. Consequently, the IAA said, smaller advisers face significant challenges to address their increasing regulatory burdens.

Speed and scale of rulemaking. The IAA stated that its concerns about the current definition of small advisers have been exacerbated by the scale and speed of the Commission’s rulemaking activities over the past two years. The SEC has proposed or adopted more than a dozen consequential regulations during the past two years that will significantly alter the regulatory regime for advisers on an unprecedented scale, according to the IAA.

The IAA claimed that this has created implementation problems for advisers who will be forced to re-allocate the time and resources that are already budgeted to their compliance programs to implement the new regulations concurrently and in a compressed time frame. Making matters worse, the IAA said, is the Commission’s departure from a principles-based approach to more prescriptive regulation for advisers which makes it more challenging for smaller advisers to scale regulatory requirements to their specific circumstances.

Accordingly, the IAA asked that the Commission amend Rule 0-7 to adopt an employee-based standard for defining small advisers. In addition to the reasons already outlined, the IAA believes that basing the size standard on number of employees will be more “evergreen” in comparison to asset-based standards that are more susceptible to fluctuation and will likely be distorted over time.

SEC proposes EDGAR enhancements, announces public beta

By Anne Sherry, J.D.

The SEC proposed new rules meant to enhance the security of its EDGAR filing system and improve how users access the system. Whereas currently each filer has a single login that gets passed around the firm, the amendments would require each individual using EDGAR to have their own credentials and to use multi-factor authentication. The SEC will soon roll out a public beta version of a new EDGAR user interface that will include a set of APIs for further flexibility in how users access the system (EDGAR Filer Access and Account Management, Release No. 33-11232, September 13, 2023).

EDGAR enhancements. The proposed changes to EDGAR would overhaul how individual users access the system. Currently, filers share credentials to log in to EDGAR, which include an EDGAR password, password modification authorization code (PMAC), and passphrase. The new system would require each individual user to obtain individual account credentials, which will be simplified relative to the current system, and to log on using multi-factor authentication. The current system “of several codes with differing functions is not in accord with standard access processes,” the release states.

The SEC believes that individual credentials would make EDGAR more secure and easier to use. It would also allow SEC staff and filers to easily determine the individual making specific filings on EDGAR, which the release says would be “particularly useful … when problematic filings are made.” In a statement, SEC Chair Gary Gensler likened the current system of one-login-per-firm to a family sharing a password to a streaming service. “You know where that can lead,” he said ominously.

The proposal also contemplates requiring firms to designate individuals with specific roles in the EDGAR filing process. These roles are account administrator, user, and technical administrator. Each filer must authorize and maintain at least two individuals to act as account administrators (or just one, for individual filers and single-person companies). The account admins, in turn, authorize users, additional account admins, or technical admins (for filers using APIs). Filers would also be able to delegate filing authority to other EDGAR filers, like a filing agent.

Beta release. On September 18, the SEC will open a public beta environment for testing and feedback. A webinar to demonstrate the beta environment will be held at noon on September 19 and a recording posted to the SEC’s YouTube channel afterwards.

This new user interface will include a set of optional application program interfaces (APIs) to allow machine-to-machine communication with EDGAR. Initially, the release will include three APIs:

• Submission APIs that allow filers to make live and test submissions on EDGAR;
• Submission status APIs for checking the status of an EDGAR submission; and
• EDGAR operational status API for checking the operational status of the EDGAR system itself.

The latter two APIs could cut down on network traffic and reduce user tedium by allowing filers to check the status of multiple EDGAR submissions, or the system as a whole, in a batch process.

To use the APIs, filers must authorize at least two technical administrators. The technical admin as well as the individual who submits the filing would each need to generate an API token, which would be valid for one year. This would address a significant concern uncovered in a 2021 Request for Comment by eliminating the need for manual individual account credential multi-factor authentication, the release states.

An API Developer Toolkit will be forthcoming, and the SEC will hold four Q&A sessions for developers beginning September 26 to facilitate discussion and guidance around the toolkit.

Testers are instructed to use their real name and email to obtain access to the testing site, because the account credentials are likely to carry over to the real filing environment after the beta concludes. However, filers should only supply fictitious data for testing. The SEC is also providing test cases.

Comments. The proposing release contains specific requests for comment on the mechanics and impacts of the proposal, as well as requests for feedback on the costs and benefits of the proposal and any reasonable alternatives. The comment period is 60 days from publication in the Federal Register.

This is Release No. 33-11232.

Senate subcommittee takes yet another look at AI regulation

By Mark S. Nelson, J.D.

The Senate Judiciary Committee’s Subcommittee on Privacy, Technology, and the Law held its third public hearing on the potentially far-reaching implications of artificial intelligence (AI) on American society and the world, especially from large language models (LLMs) such as OpenAI’s Chat-GPT, a form of generative AI. European regulators have sprinted ahead of the U.S. in proposing rules for AI, but U.S. lawmakers may be seeking a somewhat different path to AI regulation than their global counterparts.

At present, Congress has proposed two frameworks, one comprehensive regulatory bill, and a smattering of more focused bills addressing a range of topics from elections to water marks to national security. In addition to the NIST AI Risk Management Framework, the White House has published a Blueprint for an AI Bill of Rights, and has issued voluntary AI guidelines, to which an additional eight AI firms expressed their commitment shortly before the latest Senate subcommittee hearing on AI. The Senate subcommittee also is expected to hold private sessions with AI firms this week.

Legislative options to date. To put the Senate Judiciary Committee’s subcommittee’s work in context, it is helpful to review what U.S. lawmakers have proposed thus far regarding regulation of AI. According to the Subcommittee on Privacy, Technology, and the Law’s Chair, Sen. Richard Blumenthal (D-Conn), the subcommittee’s work is “complementary” to other work streams currently in progress, including that of a bipartisan working group led by Senate Majority Leader Chuck Schumer (D-NY).

Given that the Schumer group and the Subcommittee on Privacy, Technology, and the Law have both offered bipartisan AI regulatory frameworks, it makes sense to begin with a comparison of those frameworks. The SAFE Innovation Framework, published by the Schumer group, seeks to ensure America’s national security, promote responsible development of AI systems, and preserve democracy in the face of the potential use of AI to manipulate democratic processes. The Schumer framework is short on details and does not appear on its surface to contemplate a singular AI regulatory agency.

By contrast, the Bipartisan Framework for U.S. AI Act, published by Sen. Blumenthal and the Subcommittee on Privacy, Technology, and the Law’s Ranking Member Josh Hawley (R-Mo), does contemplate an independent oversight body that would administer a registration and licensing regime for the most powerful AI products. The Blumenthal-Hawley framework would provide for the oversight body to bring enforcement actions for violations of the law and would allow for private lawsuits. The Blumenthal-Hawley framework also would address national security, international competition, transparency, and the protection of children and consumers.

Moreover, the Blumenthal-Hawley framework would clarify that Section 230 of the Communications Decency Act, the statue that immunizes Internet and social media platforms from most lawsuits over third-party posts, would not apply in the context of AI. That has been a growing question of concern now that the Supreme Court essentially dodged the question by remanding a recent case to lower courts while expressing doubts about whether the plaintiff could leverage Section 230 regarding video posts they said promoted terrorism, resulting in an attack that killed their loved ones (See also the companion case). During oral argument in that case, Justice Gorsuch questioned whether Section 230 would apply to AI: “I mean, artificial intelligence generates poetry, it generates polemics today. That -- that would be content that goes beyond picking, choosing, analyzing, or digesting content. And that is not protected,” said Justice Gorsuch (See oral argument transcript at p. 49). Another recent development in which the Fifth Circuit held that individuals and two states had standing to sue the federal government over the government’s attempts to police social media could cast a pall over some aspects of AI regulation if that decision were to be upheld by the Supreme Court, assuming that the government decides to appeal. Senator Hawley's separate bill, the No Section 230 Immunity for AI Act (S. 1993), would deny Section 230 immunity for interactive computer services’ use of generative AI.

Other legislative options exist, including the reintroduced Digital Platform Commission Act of 2023 (S. 1671), sponsored by Sens. Michael Bennet (D-Colo) and Peter Welch (D-Vt), which would establish a commission to broadly regulate digital platforms and AI. Short of creating a new federal agency, several bills would target specific AI problems. The Protect Elections from Deceptive AI Act (S. 2770), sponsored by Sen. Amy Klobuchar (D-Minn) and co-sponsored by Sens. Hawley, Chris Coons (D-Del), and Susan Collins (R-Maine), would bar the use of materially deceptive AI in federal elections and would provide a mode for such content to be taken down and for affected candidates to seek damages in federal courts.

During the Q&A with the subcommittee’s witnesses, Sen. John Kennedy (R-La) suggested yet another plausible response by lawmakers. According to Senator Kennedy, most senators think AI can make lives better if it does not make them worse first. He predicted that Congress was more likely to take baby steps toward regulation of AI rather than make a grand legislative bargain.

Act with “dispatch”—setting the stage for debate. The opening statements from lawmakers and the three witnesses, William Dally (Chief Scientist and Senior Vice President of Research, NVIDIA Corporation), Brad Smith (Vice Chair and President, Microsoft Corporation), and Woodrow Hartzog (Professor of Law at Boston University School of Law and a Fellow at the Cordell Institute for Policy in Medicine & Law at Washington University) suggest where each is coming from in their views of AI.

Senator Blumenthal noted the need to balance encouragement of new technologies with safeguards around trust and confidence in order to address the technology industry’s “deep appetite” for guardrails and its desire to use AI. Senator Blumenthal also suggested the pace at which he believes Congress must act to address the risks of AI by stating lawmakers must act with “dispatch” that is “more than just deliberate speed.” Senator Blumenthal also struck a theme common among lawmakers from both major parties: “…If we let this horse get out of the barn, it will be even more difficult to contain than social media.”

Ranking member Hawley said AI is both “exhilarating” and horrifying” and suggested that lawmakers not make the same regulatory mistakes that were made during the early years of the Internet and social media.

Dally’s company makes a widely used, massively parallel graphics processing unit or GPU (as compared to the serial central processing unit or CPU) that was initially used in video gaming but has come to have other uses, such as for building virtual currency mining rigs just a few years ago (miners raided game consoles for GPUs), to AI applications requiring ever-increasing amounts of processing power. Dally testified that while AI has escaped its figurative bottle, he is confident that humans will always determine how much discretion to grant to AI applications. Dally also said that “frontier models,” those next-generation models that are much bigger than anything available today and which may enable artificial general intelligence that rivals or exceeds human capabilities, remain “science fiction.” Dally also said that no company or nation state currently has the ability to impose a “chokepoint” on AI development. According to Dally, AI regulation must be the product of a multilateral and multi-stakeholder approach.

Smith, whose company is a major investor in OpenAI, the creator of Chat-GPT, characterized the Blumenthal-Hawley framework in both his prepared remarks and in his oral testimony as “a strong and positive step towards effectively regulating AI.” For Smith, effective AI regulation would have multiple components: (1) making safety and security a priority; (2) creating an agency with oversight responsibilities to administer a licensing regime for high-risk use cases; (3) implementing a set of controls to ensure safety such as those announced by the White House and which a number of AI firms have voluntarily committed to follow; (4) prioritizing national security; and (5) taking steps to address how AI affects children and other legal rights. Smith also suggested that the federal government follow the lead of California and several other states that seek to study how AI can make government more efficient and more responsive to citizens (e.g., this month California Governor Gavin Newsom signed an AI executive order calling on state agencies to assess the state’s use of AI in government).

By way of further background, federal lawmakers have mulled legislation similar to the California executive order. For example, the AI Leadership To Enable Accountable Deployment (AI LEAD) Act (S. 2293), sponsored by Sen. Gary Peters (D-Mich), would require the Director of the Office of Management and Budget to establish the Chief Artificial Intelligence Officers Council for purposes of coordinating federal agencies’ best practices for the use of AI.

As the one academic on the panel, Hartzog sought to debunk what he viewed as myths about AI regulation. Central to his thesis is the notion that regulatory half measures may be necessary but are not sufficient to adequately control the deployment of AI. Hartzog was especially critical of regulators’ reliance on transparency (insufficient accountability), bias mitigation (“doomed to failure” because fair is not the same as safe and the powerful will still be able to dominate and discriminate), and the adoption of ethical principles (ultimately, there is no incentive for industry to leave money on the table for the good of society). For Hartzog, it will be critical for lawmakers to incorporate the design aspects of AI into any laws and regulations and for them to not be beguiled by the concept that the rise of AI is inevitable when tools can be adopted to ensure human control of AI.

Deep fakes. The bulk of the questioning from senators emphasized how AI might be used in election ads and disinformation campaigns. Questions from Sen. Klobuchar emphasized the need for watermarks or other indicia that something was generated by AI, especially in the context of elections. Smith replied to this line of questioning by stating that indicators of provenance and watermarks could label legitimate content as a means of addressing the problem of deep fakes. According to panelist Hartzog, bright line rules are needed because procedural rules only give the veneer of protection; Hartzog would add abusive practices to the list of unfair or deceptive practices that should be the subject of AI regulation. Dally clarified that regulators would need indicators of both provenance and watermarks to prevent deep fakes because provenance is the flipside of watermarks (i.e., one identifies source, the other identifies something as having been created by AI).

Senator Klobuchar has introduced the Require the Exposure of AI–Led Political Advertisements (REAL Political Advertisements) Act (S. 1516), which would require that political ads state in a clear and conspicuous manner whether the ads include any images or video footage generated by AI. The House version of the bill (H.R. 3044) is sponsored by Rep. Yvette Clarke (D-NY).

In related questioning, Sen. Mazie Hirono (D-Hawaii) asked what could be done about political influence campaigns and other efforts to spread misinformation and disinformation via AI. She gave the example of alleged foreign influence campaigns in the aftermath of the Lahaina wildfire disaster on the Hawaiian island of Maui. According to the senator, online information falsely told residents not to sign up for FEMA assistance.

Smith agreed with the senator that half measures in this sphere are not enough. According to Smith, AI should be used to detect such disinformation campaigns and Americans must stand up as a country to set red lines regardless of how much else we disagree about.

In still more questions about the right to know if something was created by AI, Sen. Kennedy tried to break this question into two: one about the AI origins of something, and another question about the source. With respect to knowing something was produced by AI, Dally agreed that information should be disclosed. Smith answered in a somewhat more nuanced manner by distinguishing between a first draft of a document (no disclosure) and the final output with the human author’s own finishing touches (disclosure). Hartzog’s answer was even more qualified; he suggested that if there is a vulnerability to AI, then disclosure should be required.

On the question of whether the source of an AI generated text should be disclosed, there was a seeming consensus among the three panelists that there may be good reasons to protect some anonymous speech. Dally said this was a harder question. Smith said he believed that generally one should say if AI created something and who owns it, but he also asked rhetorically whether disclosure would be appropriate in this context for something like the Federalist Papers, the combined unofficial explanation and marketing pamphlet known to have been authored by James Madison, John Jay, and Alexander Hamilton under the pen name Publius that sought to convince skeptics to support the 1887 constitution under which Americans still live. Hartzog suggested that there may be times to protect anonymous speech and other times when such speech might not be protected.

Questions from Sen. Marsha Blackburn (R-Tenn) asked about Chinese influence and the potential for adapting the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network, which provides secure financial messaging for banks and other financial institutions, in the AI context. Smith replied that the U.S. can use export controls to ensure that products and services are not used by foreign governments. Smith also suggested in both his oral testimony and in his prepared remarks, where he offers greater detail, that AI regulations could include the AI equivalent of “know-your-customer” regulations familiar to banks along with some AI-specific rules akin to a “know-your-cloud” requirement. That would require the developers of the most powerful AI systems to know who operates the cloud computing platform on which they deploy their AI systems and to only use licensed cloud infrastructure.

Both before and after Smith’s exchange with Sen. Blackburn, Senator Hawley pressed Smith and Microsoft on issues related to children and China. First, Sen. Hawley observed that the age to use Microsoft’s Bing Chat was only 13 years old. The senator asked Smith to commit to raising the age and adopting stronger verification procedures. Smith answered that the first rule was not to make any news without first talking to stakeholders at Microsoft. Smith agreed that children should use AI in a safe way and that other countries, such as South Korea, sought to create AI apps to teach math, coding, and English. Although he never gave any specific commitments to Sen. Hawley, Smith agreed to raise the issue of minimum age requirements at Microsoft.

Senator Hawley also raised questions about Microsoft’s business ties to China, including Microsoft serving as an “alma mater” for Chinese AI scientists. The senator suggested that Microsoft could decouple from China in the interests of American national security. Smith noted that Microsoft is a large company with many years in business and that it had trained persons who now work around the world. Smith also said he would prefer that an American company doing business in China would be able to use Microsoft tools rather than tools developed in a foreign country.

What to regulate? A common question at the first AI hearing held by Senate Judiciary Committee’s Subcommittee on Privacy, Technology, and the Law was what regulatory threshold to employ to determine whether an AI firm, product, or service should be regulated. OpenAI’s Sam Altman suggested the possibility of using the computer as a threshold. At the third, and most recent, Senate AI hearing, a similar theory emerged that is based on whether the AI system is highly capable or less capable.

Senator Jon Ossoff (D-Ga) said the lawmakers must define in a legislative text what would trigger regulation. In the AI context, the senator said that could be the scope of the technology, a product, or a service.

For Smith, regulations would need to address three layers; (1) the model layer (e.g., frontier or foundational models); (2) the application layer where people directly interact with AI (enforce existing laws equally against those who deploy AI); and (3) the cloud layer, which is more powerful than the ubiquitous data center (licensing would be key).

Senator Ossoff also asked if there is a power at which one should draw the line for deployment. Dally suggested balancing risks against innovation and then regulating things with high risk if the AI system were to go awry.

All three panelists answered Sen. Ossoff’s question about how important international law will be to regulating AI. According to Hartzog, the U.S. could create an AI regulation that is compatible with similar E.U. regulations. Smith said the U.S. will need international law but cautioned that such solutions were likely to come from like-minded governments rather than global regulations. Dally observed that AI models are portable on large USB devices, thus suggesting that AI models cannot be contained within any one country.

That last observation about the portability of AI models was immediately preceded by a colloquy between Sen. Ossoff and Smith about the global proliferation of AI. The senator had asked what should be done about a less powerful AI model that nevertheless is capable of having a big impact. Smith acknowledged that this is a critical question and likened the problem to an AI system that can only do a few things well versus Chat-GPT, which can do many things well. Smith said licensing of deployment would be needed, something he analogized to the building of an aircraft—the building phase is not as regulated as the phase at which the aircraft is going to be flown. Smith said licensing depends on a combination of industry standards, national regulations, and international coordination.

Senator Blumenthal picked up on the proliferation issue in the closing moments of the hearing. The senator suggested the atomic energy and civil aviation models as worthy of consideration in the AI context. Both models depend on governments to cooperate, in the one case, by limiting access to nuclear materials and in the other to have common protocols for routing aircraft across national borders.

Smith noted in this context that the U.S. leads in GPUs, the cloud, and foundation models and that export controls may be needed. Senator Blumenthal noted that the nuclear proliferation model uses a combination of export controls, sanctions, and safeguards to achieve safety and that the Biden Administration has used existing laws to ban the sale of some high-performance chips to China. Dally then suggested that because there is not a real chokepoint for AI, companies around the world can get AI chips (i.e., if they cannot get chips in the U.S., they will get them elsewhere). Dally also observed that software may be more important than chips.

Council for Institutional Investors urges ISSB to make human capital disclosures ‘highest priority’

By Lene Powell, J.D.

The Council for Institutional Investors identified human capital as a “highest priority” project area for the International Sustainability Standards Board (ISSB) in the next two years. In a response to an ISSB call for feedback, CII said that clear definitions of reporting items and a well-developed framework could substantially improve consistency and comparability of human capital disclosures for the benefit of investors and the capital markets.

“Human capital is an important intangible asset and CII believes there is a pervasive need for more information about human capital management in financial reports,” the group said in a letter.

Human capital as priority area for ISSB. The ISSB published a Request for Information Consultation on Agenda Priorities on May 4, 2023 to seek feedback on its priorities for its next two-year work plan. The comment period closed on September 1.

The ISSB identified human capital as one of four priority topics for proposed research and standard-setting projects. In this topic, ISSB included workforce composition; workforce stability; diversity, equity and inclusion (DEI); training and development; health, safety and wellbeing; and compensation, with regard to an entity’s employees and contractors.

According to ISSB, human capital is a priority topic because human capital management drives value, but investors have said they do not have sufficiently decision-useful and comparable information in this area.

Institutional investor groups seeking more disclosures on human capital include the Human Capital Management Coalition, a group of 37 institutional investors representing more than US$8 trillion in assets under management, and the Workforce Disclosure Initiative (WDI), an investor coalition of 68 institutions with US$10 trillion AUM.

CII: human capital is “highest priority.” Research and standard setting on human capital warrants the highest priority, said CII.

CII supports enhancements to human capital disclosure in at least four key areas:

1. Total number of employees;
2. Breakdown of the numbers of full-time, parttime, and contingent workers;
3. Employee turnover rates; and
4. Total cost of a company’s workforce.

“A project delivering comparability on these four areas for companies of similar size and industry, paired with qualitative disclosures giving companies the opportunity to provide context, could substantially strengthen investors’ ability to evaluate this pillar of company value,” CII wrote.

Relevant to investors. CII stressed that the ISSB should only pursue projects with significant relevance to investors. CII generally supports the ISSB’s stated criteria for assessing workplan priorities, which lists importance to investors as the top criterion.

Other calls for human capital disclosure. SEC Chair Gary Gensler has signaled that the SEC is looking at proposing new rules for human capital disclosure.

In August 2021, Gensler stated on the X social media site (formerly known as Twitter):

“Investors want to better understand one of the most critical assets of a company: its people. I’ve asked staff to propose recommendations for the Commission’s consideration on human capital disclosure.”

The SEC’s rule agenda for Spring 2023 states, “The Division is considering recommending that the Commission propose rule amendments to enhance registrant disclosures regarding human capital management.”

The AFL-CIO recently submitted a letter in support of two rulemaking petitions for additional human capital disclosures.