SEC’s Gensler talks about ‘AI washing,’ related financial risks

By Mark S. Nelson, J.D.

Speaking at JAF Communications, Inc.’s nascent news venture The Messenger's livestreamed event “AI: Balancing Innovation & Regulation,” SEC Chair Gary Gensler took questions from moderator Dawn Kopecki, Deputy Business & Finance Editor at The Messenger, and then from the audience during a brief Q&A session. The focus of the discussion was what the SEC may be able to do to reduce the impact of bias and fraud in the marketplace that could arise as artificial intelligence (AI) tools become more available to the general public and ownership of the models driving these tools becomes more concentrated in only a few hands.

Moderator Kopecki opened by recalling a CNN headline that offered a laundry list of things that can go wrong with AI, such as AI outputs being racist, sexist, creepy, and the potential that AI could one day become self-aware, or otherwise lead to a financial crisis. Gensler replied that he sees AI risks along two planes: he said there are micro level risks such as bias and conflicts of interest (which an SEC proposal on predictive analytics seeks to address) as well as macro level risks related to the potential concentration of the ownership of AI models.

Gensler explained that with respect to macro level risks, the problem is that a natural economic progression can lead to the evolution of monocultures in which AI data sets or base models that traders and underwriters rely on are held by only a few companies (Gensler cited the FICO score as an example of a financial monoculture). The result could be that a hard-to-explain AI model could become problematic. Moreover, Gensler suggested that a herding effect potentially could lead markets over an inadvertent economic cliff. Gensler further explained that in the context of networked economies, there is a tendency for concentration to develop and that something akin to the concentration of cloud storage services in a few large companies could happen in the AI setting.

Kopecki then asked who prosecutes wrongdoing if AI goes awry? Gensler said that AI, as we know it, still has humans in the loop who set the hyperparameters (according to a Google Cloud document, “Hyperparameters contain the data that govern the training process itself” and can fine tune a model’s predictive accuracy). The immediately preceding question from Kopecki had asked if regulation can head off the bad effects of AI. Gensler responded that he was unsure if we can head off those effects, but that basic regulations like the SEC’s proposed rules for predictive analytics can help. Gensler emphasized what he has said in other contexts that “fraud is fraud.” Gensler did suggest that the SEC is especially concerned about AI’s potential regarding “faking the markets.”

During the brief Q&A, Gensler was asked a related question about whether small companies that hype their AI products and services could be teetering on the verge of making misrepresentations. Gensler emphatically said, “don’t do it.” He added that companies should not “greenwash,” but they also should not “AI wash.” Gensler then repeated a familiar refrain that if someone offers and sells securities, then they are subject to the federal securities laws.

Kopecki had ended the moderated portion of the discussion by asking Gensler if a working group was in the offing. Gensler said the Financial Services Board (FSB) had AI on its 2024 agenda and that the SEC was looking to collaborate with other U.S. and global regulators on AI, but that he did not want to front run anything that U.S. Treasury Secretary Janet Yellen, as the head of the Financial Stability Oversight Council (FSOC), may be working on in the AI space.

Gensler earlier had indicated that the SEC’s next steps on AI would be to sort through the many public comments on its predictive analytics proposal.

SEC admits it cannot fix Repurchase Rule defects

By Rodney F. Tonkovic, J.D.

The SEC has informed the Fifth Circuit that it was unable to correct defects in the Share Repurchase Disclosure Modernization rule. At the end of October, the court gave the Commission 30 days to fix the identified defects in the rulemaking. The Commission stayed the effectiveness of the rule, but the court rejected a motion to extend the remand period. It is likely that the court will now vacate the rule.

Repurchase rule. The share repurchase disclosure modernization rule (Release No. 34-97424) was adopted on May 3, 2023 and became effective in July 2023. The first filings under the rule, which requires tabular disclosure of an issuer's purchases of equity securities and the reasons for the repurchase, would have been due after the final quarter of 2023.

Chamber challenge. On October 31, 2023, in response to a challenge brought by the U.S. Chamber of Commerce, the Fifth Circuit Court of Appeals found that the final rule was arbitrary and capricious. The panel said that the Commission failed to respond to petitioners' comments and to conduct a proper cost-benefit analysis. The court also said that the rule's primary benefit of decreasing investor uncertainty was inadequately substantiated. The matter was remanded to the SEC to fix the identified deficiencies by November 30, 2023, and the panel retained jurisdiction to consider the Commission's decision made on remand.

On November 22, 2023, the Commission announced that it had postponed the effective date of the rule, which was then stayed "pending further Commission action." On the same day, the Commission filed a motion asking for an extension of the remand period during which the Commission would provide a status update within 60 days. The Chamber of Commerce opposed the motion, and the panel issued an order denying the extension on November 26.

What's next? On December 1, 2023, the SEC's Office of the General Counsel wrote to inform the court that it was not able to correct the defects in the rule within 30 days. The letter notes that this determination was consistent with the statements in the November 22, 2023 filing, in which the Commission said, without elaboration, that its staff was working diligently to "ascertain the steps necessary" to comply with the remand order, but needed additional time.

In its opinion, the panel said that it was not vacating the rule at that time in order to give the SEC a chance to remedy the deficiencies. Because the Commission has not done so, the court presumably will soon issue an order vacating the rule (the opinion does not explicitly state the consequences). The Commission then has the choice to appeal the decision or issue a new rule, following the required notice and comment procedures. Should the rule be vacated, the existing disclosure requirements for buybacks will remain in place.

The case is No. 23-60255.

Stockholders violated voting agreement by departing from board recommendation

By Anne Sherry, J.D.

Stockholders who voted against a charter amendment breached a stockholders agreement that bound them to follow the board’s recommendation. Each side had a reasonable interpretation of the contractual provision, so the court looked at extrinsic evidence showing that the defendants knew they were bound to vote with the board. The court deemed the shares voted in favor of the amendment and declared the amendment to have been approved, subject to the plaintiff completing a stock split (Texas Pacific Land Corporation v. Horizon Kinetics LLC, December 1, 2023, Laster, J.).

Conversion and stock issuance issues. The plaintiff corporation used to be a land trust. In 2019, as one result of a proxy contest involving some of the defendants, the trust agreed to form a committee to explore converting into a corporation. The trust also negotiated a stockholders agreement with the investors who wanted representation on the board.

The stockholders agreement required the stockholder signatories to vote all shares in accordance with the board’s recommendations. Two exceptions applied: if the proposal up for a vote related to an “Extraordinary Transaction” or related to governance, environmental or social matters. An exception to the latter exception said that stockholders must follow the board recommendation if the proposal relates “to any corporate governance terms that would have the effect of changing any of the corporate governance terms set forth in the plan of conversion recommended by the Conversion Exploration Committee of the Trust on January 21, 2020.”

In 2021 the trust converted into the corporation, but the corporate charter fixed the total number of authorized shares at the number that had already been issued. Accordingly, the company had no authorized but unissued shares available, which limited its executive compensation options and its M&A opportunities. In the fall of 2022, the board approved a proposed charter amendment to increase the authorized number of shares and recommended a vote in favor, without disclosing that two directors—each affiliated with one of the defendant investors—opposed the proposal.

The defendants voted against the amendment, and it failed. The company sued them for breach of the stockholders agreement.

Agreement is ambiguous. The stockholders agreement disclaimed contra proferentem, a fairly standard and enforceable agreement that ambiguities not be construed against the drafter. However, it went even further by stating, “any controversy over interpretations of this Agreement will be decided without regard to events of drafting or preparation.” The company argued that this provision is unenforceable, but the chancery court disagreed. Parties regularly agree to limit what a court will consider, and Delaware in particular respects contracts. The parties could have a variety of rational reasons for agreeing to the no-drafting-history clause. Furthermore, the clause does not bar the court from considering all extrinsic evidence, just drafting history.

By itself, the voting commitment contained in the stockholders agreement obligated the investor defendants to vote in favor of the proposal. The court’s decision therefore turned on the exceptions to the voting commitment. On whether the proposal, motivated in large part to facilitate M&A transactions, “related to” one of the enumerated types of transactions, both sides advanced reasonable readings of the contract. The court could not determine as a matter of clear meaning whether the transaction exception applied, so the provision was ambiguous.

Similarly, the exception for “governance, environmental or social matters” was ambiguous. ESG has no settled meaning, making it difficult to use in contract interpretation. Beyond “core” issues like reclassifying the board or drilling on company land, the concept of ESG becomes ambiguous: some governance professionals might agree that increasing a corporation’s authorized shares is a governance issue, but others might not. And as for the exception to this ESG exception, which restores the voting commitment for certain enumerated governance terms, some of those terms are core ESG issues while others are not. “The fact that the parties included the Conversion Plan Exclusion suggests that otherwise, the reference to ‘governance’ could sweep broadly.”

Finding the contract ambiguous, the court looked to extrinsic evidence. Neither side’s expert gave sufficiently persuasive testimony, so the court looked at the parties’ acts and conduct prior to the onset of the controversy. Prior to the litigation, both dissenting directors acknowledged that they were bound to vote in favor of the proposal. This evidence was persuasive, and the defendants did not offer any evidence that was more persuasive. Accordingly, the court held that the investor group breached the voting commitment.

As a remedy, the court exercised its equitable authority to “treat as done that which in good conscience ought to be done.” The investor group should have voted in favor of the proposal, and if it had done so, the proposal would have passed. Accordingly, the court declared the proposal to have passed. This relief is conditioned on the company’s completing a stock split that it repeatedly relied on throughout the litigation.

The case is No. 2022-1066-JTL.

Justices mourn passing of Sandra Day O’Connor

By Mark S. Nelson, J.D.

The Supreme Court last week announced the passing of retired Justice Sandra Day O’Connor, who died in Phoenix, Arizona at the age of 93 due to complications related to advanced dementia and a respiratory illness, said a Court press release. In 1981, then-President Ronald Reagan made history by appointing O’Connor to the Court as its first female justice, although other women would gradually be appointed to the court over a number of years, ultimately reaching a total of four women justices on the current Court. O’Connor was perhaps better known for her opinions in abortion cases, but she also wrote or joined numerous opinions dealing with securities regulation and became an early critic of Basic v. Levinson’s fraud-on-the-market theory. With respect to one of her opinions regarding the CFTC’s reparations authority, the issues underlying that case have sprung back to life in the form of a recent challenge to the SEC’s authority to bring administrative proceedings. O'Connor served on the Court from 1981 until her retirement in 2006.

“A daughter of the American Southwest, Sandra Day O’Connor blazed an historic trail as our Nation’s first female Justice. She met that challenge with undaunted determination, indisputable ability, and engaging candor,” said Chief Justice John G. Roberts, Jr. “We at the Supreme Court mourn the loss of a beloved colleague, a fiercely independent defender of the rule of law, and an eloquent advocate for civics education. And we celebrate her enduring legacy as a true public servant and patriot.”

Securities cases. In the securities regulation setting, there is perhaps no more iconic Supreme Court opinion than the one in Basic (1988), in which four justices adopted the fraud-on-the-market theory of reliance in private securities fraud lawsuits. The court in Basic, however, was operating at less than full strength because Chief Justice Rehnquist and Justices Scalia and Kennedy did not participate in the decision.

Justice Blackmun, writing for the four justices backing the fraud-on-the-market theory, concluded that “[i]t is not inappropriate to apply a presumption of reliance supported by the fraud-on-the-market theory.” Earlier in the opinion, Justice Blackmun had cited another case explaining how the presumption of reliance works: “The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements…” (citation omitted).

The presumption of reliance has been criticized as having eliminated the reliance element from most private securities lawsuits because, when the presumption is available, a plaintiff need not directly prove he or she relied on the issuer’s misstatements. That critique was picked up by Justice White, and joined by Justice O’Connor, in Basic, where the two justices both concurred and dissented. Justices White and O’Connor agreed with the other four justices in Basic that the fraud-on-the-market theory adopted by the Court rejected any equivalence between “causation” and “reliance,” and that a securities fraud defendant should be able to rebut the presumption of reliance. “A nonrebuttable presumption of reliance—or even worse, allowing recovery in the face of ‘affirmative evidence of nonreliance”—would effectively convert Rule 10b-5 into ‘a scheme of investor’s insurance’” (citation omitted), said Justices White and O’Connor.

But Justices White and O’Connor saw other “pitfalls” in the Court’s approach to reliance, including whether courts generally were up to the task of applying the presumption. “Confusion and contradiction in court rulings are inevitable when traditional legal analysis is replaced with economic theorization by the federal courts,” posited Justices White and O’Connor. The two justices also believed that Congress should have weighed in on the issue of reliance in these cases.

The Basic presumption remains controversial for some justices, although a majority upheld the presumption in 2014 in Halliburton II (2014 )while clarifying the defendant’s ability to rebut that there was a price impact. A concurrence by Justice Thomas, joined by Justices Scalia and Alito, urged the Court to overrule Basic in a future case. “Today we are asked to determine whether Basic was correctly decided. The Court suggests that it was, and that stare decisis demands that we preserve it. I disagree,” wrote Justice Thomas. “Logic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption, and stare decisis cannot prop up the façade that remains. Basic should be overruled.”

Justice O’Connor also wrote for the Court in other types of securities cases. For example, in the 2004 case of SEC v. Edwards (2004), in which Justice O’Connor wrote for a unanimous court, she applied the Howey standard to a payphone business investment and held that an investment scheme promising a fixed rate of return can be an investment contract and, thus, a security. In reaching this conclusion, the Court rejected the lower court’s reasoning that an investment contract must include capital appreciation or a participation in the earnings of the enterprise and that the Howey prong requiring that profits be “derived solely from the efforts of others” could not be met if there was a contractual right to the return.

After explaining that investors seek profits on their investment and not the profits in the scheme in which they have invested, Justice O’Connor clarified why, for purposes of Howey, there is no difference between fixed and variable returns. “There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test, so understood. In both cases, the investing public is attracted by representations of investment income, as purchasers were in this case by ETS' invitation to ‘watch the profits add up.’ Moreover, investments pitched as low-risk (such as those offering a ‘guaranteed’ fixed return) are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors.”

Commodities case. The next area of Justice O’Connor’s writings for the Court requires some brief background. In recent years, respondents in administrative proceedings have repeatedly challenged the authority of federal agencies to conduct in-house proceedings. Many of these cases have been brought against the SEC in light of its expanded powers under the Dodd-Frank Act. It is pure coincidence, that oral argument before the Supreme Court in SEC v. Jarkesy, a broad-based challenge to SEC administrative authority, was held two days before Justice O’Connor’s passing because the following case in which she wrote for a majority upholding a CFTC administrative proceeding was cited numerous times by the SEC and the agency’s challenger at oral argument for widely divergent conclusions. In light of how the current Supreme Court has been remodeling federal administrative law, one could ask if the CFTC case discussed below was brought today, would the Court reach the same conclusion.

In CFTC v. Schor (1986), Justice O'Connor wrote for the court regarding the question of whether the Commodity Exchange Act (CEA) allows the CFTC to entertain state law counterclaims in reparation proceedings and whether such authority would violate Article III of the U.S. Constitution.

In Schor, the broker sued in federal court to collect from the customer a debit balance in the customer’s account. The customer alleged that the debit balance resulted from the broker’s CEA violations; the broker said the customer had racked up trading losses that produced the debit balance. The broker eventually voluntarily dismissed the federal court case and sought to collect the debit balance via a counterclaim in the customer’s reparations matter brought before the CFTC. A CFTC administrative law judge ruled for the broker and, after the Commission declined to review the ruling and it became final, the customer challenged the CFTC’s authority to hear counterclaims in reparations matters.

The D.C. Circuit would later hold in the case that the CFTC may hear counterclaims arising only from the CEA or CFTC regulations but not the state common law counterclaims asserted by the broker. The D.C. Circuit then denied rehearing en banc, although two judges dissented because they viewed the inability of the CFTC to consider state counterclaims in reparations proceedings would defeat the Congressional rational of efficiency that underlay reparations. The Supreme Court would grant, vacate, and remand the case, but the D.C. Circuit once again reached the same conclusion, prompting the justices to finally hear the case on its merits.

Justice O’Connor’s opinion for the Court first addressed Congressional purpose. Among other things, the Court found persuasive the language in Section 14 of the CEA, which created the reparations program, referring to “any counterclaim” (emphasis in Court’s opinion). Justice O’Connor summed up the legislative policy thus: “Our examination of the CEA and its legislative history and purpose reveals that Congress plainly intended the CFTC to decide counterclaims asserted by respondents in reparations proceedings, and just as plainly delegated to the CFTC the authority to fashion its counterclaim jurisdiction in the manner the CFTC determined necessary to further the purposes of the reparations program.”

With respect to Article III, the Court rejected the customer’s challenge to the broker’s attempt to have the CFTC consider his common law counterclaim. “We conclude that the limited jurisdiction that the CFTC asserts over state law claims as a necessary incident to the adjudication of federal claims willingly submitted by the parties for initial agency adjudication does not contravene separation of powers principles or Article III.”

Justices Brennan and Marshall dissented from Justice O’Connor’s majority opinion on the ground that, for purposes of Article III, the Court should recognize only a few exceptions regarding judicial authority of non-Article III federal tribunals for “territorial courts, courts martial, and courts that adjudicate certain disputes concerning public rights” (citations omitted).

In the latest SEC case currently pending before the Supreme Court, the government, speaking to the Seventh Amendment right to jury trial question, posited that the SEC case is squarely a public rights case and, thus, distinguishable from Schor. During questioning for the bench in the SEC case, Justice Kagan noted that the “easy cases” are those involving the government on one side of the case, meaning that the “hard cases” are those like Schor, where there are private parties on both sides of the case. Justice Kagan added that in those cases “we've held that public rights might be involved because their disputes are embedded in federal statutory schemes.”

Commissioners highlight promises and pitfalls of revising accredited investor definition

By Anne Sherry, J.D.

In remarks before an advisory committee meeting Wednesday, SEC commissioners expressed their hopes and concerns about the possible amendment of the accredited investor definition. While Chair Gary Gensler suggested that the SEC not erode the investor protections embedded in the securities laws, Commissioner Hester Peirce said that regulators, however well-meaning, should not impede investors’ freedoms. Commissioner Caroline Crenshaw drew a connection between the definition and the committee’s second topic, diversity, by warning that eroding investor protections may disproportionately harm underserved communities.

The Small Business Capital Formation Advisory Committee met to discuss the accredited investor definition and diversity and the investment process. Members of the Committee heard remarks from CorpFin’s Kenisha Nicholson on the current accredited investor framework, including background information on the accredited investor definition and how the definition interrelates with capital-raising rules, before sharing their own views and experiences. In the afternoon session on diversity in investment, the Committee heard from Anna Snider (Bank of America) on how diversity metrics are incorporated into the investment process.

Gensler. In remarks before the meeting, Gensler returned to a favorite topic: the “basic bargain” embedded in the securities laws, whereby public companies are required to disclose certain information, and investors are then free to decide whether to take on the risk of investing. Congress’s recognition that some investments should be exempt from registration gave rise to Regulation D and its accredited investor definition. Any discussion about this cornerstone definition raises the question of “when is it appropriate that investors get—or not get—that full, fair, and truthful disclosure that Roosevelt worked with Congress to embed in the securities laws,” Gensler said.

Gensler also tied the diversity topic to the SEC’s mission. All companies deserve access to the capital markets, and with respect to the SEC’s mission to maintain fair, orderly, and efficient markets, “fairness literally is embedded in our mission,” he noted.

Peirce. Peirce also couched her remarks in the context of larger goals. “Relevant to both of your discussions today is the way our capital markets intertwine with who we are as an American people,” she said, and this means a commitment to freedom. She cautioned that the SEC must not impede the freedom to build businesses and invest in others’ businesses. “Americans should be able to invest and build wealth without having to convince regulators—even those operating with a protective impulse—that they are sophisticated enough or rich enough.”

Peirce had several more concrete comments about the accredited investor definition. She observed that the SEC has previously suggested that qualifying professional credentials could provide a means of achieving accreditor investor status and asked the Committee to consider whether other marks of sophistication might be considered as well. As examples, she mentioned the completion of investor education certification programs, college courses on investment, and degrees in certain fields.

Crenshaw. Finally, Crenshaw highlighted two areas of particular interest for discussion. Despite a strong increase in wages, the accredited investor threshold has been the same since the 1980s. The Committee suggested 18 months ago that these financial thresholds should be indexed for inflation, and given the wage gains seen post-COVID, that suggestion is even more relevant now than it was only a year and a half ago. But this should not be done at the expense of basic investment protections, and requires balancing to “avoid creating an alternative that turns into an ever-widening loophole.”

Second, Crenshaw drew the Committee’s attention to another advisory committee’s recent report on firms’ use of digital engagement practices. In this report, the Investor Advisory Committee cited a study finding that increased participation in the markets by new investors, who are more racially and ethnically diverse, has led directly to increased losses. Crenshaw expressed concerns about exacerbating the already enormous wealth gap by exposing new investors to increased risks. Here, she quoted testimony from Professor Gina-Gail Fletcher, who told the House Financial Services Committee in February, “If the scope of the accredited investor definition is broadened, this will expand the opportunities for wealth extraction and amplify wealth inequality in the country.” In a similar vein, Michael Canning (LXR Group, LLC) recently asked the Investor Advisory Committee to be skeptical of arguments that relaxing investor protections will benefit underserved communities: “Often, underserved communities benefit significantly and even disproportionately from the protections afforded by regulation.”

Posting of token bond amount drives resolution of share certificate dispute

By Mark S. Nelson, J.D.

The Canadian company Crystallex International Corporation will take a further step forward in its efforts to execute an international arbitration award against Petróleos de Venezuela, S.A. (PDVSA) now that the Chancery Court has issued a ruling that paves the way for PDVSA to reaffirm its ownership of PDV Holding, Inc. (PDVH), the company that holds the oil refiner CITGO, by requiring PDVH to replace a stock certificate that PDVSA said was lost, stolen, or destroyed. The lever for advancing the matter will be the posting by PDVSA of a largely token bond of $10,000 in order to obtain the new share certificate (Petróleos de Venezuela, S.A. v. PDV Holding, Inc., November 28, 2023, Fioravanti, P.).

The bond amount ruling arose from a complex set of events set in motion by Crystallex’s attempts to execute a $1.2 billion international arbitration award against the Bolivarian Republic of Venezuela and the state-owned PVDSA. The District Court for the District of Columbia confirmed the award. Crystallex then sought to attach shares of PDVH, which is owned by PDVSA, on the theory that PDVSA is the alter ego of Venezuela. The District Court for the District of Delaware and then the Third Circuit affirmed Crystallex’s right to pursue the two state-owned businesses.

The one wrinkle in the path of Crystallex’s goal was that PDVSA claimed to have only a photocopy of the original stock certificate indicating its ownership of PDVH, which meant PDVSA needed to have PDVH reissue the certificate. That part of the dispute landed in the Delaware Chancery Court because PDVH is a Delaware corporation.

Under 8 Del. C. § 168, a new stock certificate can be issued by a company if the owner of the certificate shows to the court’s satisfaction that the original certificate was lost, stolen, or destroyed. The court may compel the issuance of the new certificate if: (1) the corporation refused to issue the certificate; (2) the plaintiff is the lawful owner of the certificate that was in fact lost, stolen, or destroyed; and (3) the corporation has not demonstrated good cause not to issue the certificate.

These Delaware law requirements were easily met, according to the Vice Chancellor, who spent the bulk of the opinion mulling the bond issue. That was important because 8 Del. C. § 168 also states that the court must require the plaintiff seeking reissuance of a stock certificate to post a bond, which then serves as the cap on the re-issuing corporation’s liability for the share certificate.

PDVH had argued that a large bond was needed. Although PDVH proposed various amounts, its latest request was for at least a $1.2 billion bond. PDVSA never stated a specific amount, but PDVSA did tell the court that PDVH’s request was “excessively high.”

The court also looked to an amicus brief filed with the court by a group of creditors of PDVSA or Venezuela that urged the court to compel PDVH to reissue the stock certificate. Amici argued that PDVSA and PDVH had “aligned interests” such that a nominal bond amount would be appropriate.

The court’s analysis began with the conclusion that the court cannot waive the bond and security requirements, but that the court otherwise has discretion regarding the form and sufficiency of the bond. The court also noted that it would consider the fact that no one else had come forward with a claim to the certificate.

With respect to the potential interplay between 8 Del. C. § 168 and UCC Article 8, the court suggested that it was unlikely that a protected purchaser was quietly maintaining an interest in the certificate. That meant this possibility was “merely theoretical” and did not favor the imposition of a large bond.

Moreover, the court observed that there had been no request to register a transfer of shares on PDVH’s books and that Venezuela, or anyone else, seeking to pledge or transfer the certificate would violate sanctions imposed by the U.S.’s Office of Foreign Assets Control.

As a result, the court determined that a nominal, unsecured bond in the amount of $10,000 would be sufficient. PDVH was ordered to issue a replacement stock certificate to PDVSA once PDVSA has posted the bond.

The case is No. 2023-0778-PAF.

SEC adopts new ABS conflicts of interest rule

By Rodney F. Tonkovic, J.D.

The SEC adopted a rule prohibiting conflicts of interest in certain securitizations. Securities Act Rule 230.192 will implement Securities Act Section 27B and bar transactions in asset-backed securities that involve or result in material conflicts of interest. For one year after closing, specified securitization participants will be barred from engaging in certain transactions where there is a conflict between the participant and an investor in that asset-backed security. The rule is effective 60 days after publication in the Federal Register, and compliance will be required for sales closing 18 months after that date (Prohibition Against Conflicts of Interest in Certain Securitizations, Release No. 33-11254, November 28, 2023).

Dodd-Frank implemented. The new rule will implement Securities Act Section 27B, which was added in 2010 by the Dodd-Frank Act. The section prohibits certain persons who create and distribute asset-backed securities ("ABS") from engaging in any transaction that would involve or result in a material conflict of interest with any investor within one year of the closing of the sale of the ABS. Section 27B, however, mandates Commission rulemaking implementing this prohibition. A new rule incorporating the section's text was proposed in 2011, but the proposal lay dormant until it was unanimously re-proposed during the Commission's first open meeting of 2023.

SEC Chair Gary Gensler said that he was pleased to support the rule: "As directed by Congress, today's rule prohibits securitization participants—including those who sell or facilitate the sale of an asset-backed security—from engaging in transactions that involve or result in any material conflict of interest with investors in that ABS. Further, as required by Section 621 of the Dodd-Frank Act, the final rule provides exceptions for risk-mitigating hedging activities, bona fide market making, and certain liquidity commitments. Such a rule benefits investors and issuers alike."

Rule 192. The heart of new Rule 192 is the prevention of ABS sales that are tainted by material conflicts of interest. The rule provides strong investor protections against transactions that are effectively a "bet" against the ABS's performance while leaving routine transactions unhindered, the release says. To that end, the rule prohibits entering into a "conflicted transaction" for one year after the date of the first closing of the sale of the ABS. For the purposes of the rule, a "conflicted transaction" means:

• A short sale of the ABS;
• The purchase of a credit default swap entitling the securitization participant to receive payments upon the occurrence of a specified adverse event with respect to the ABS; or
• The purchase or sale of any financial instrument (other than the relevant ABS) or entry into a transaction that is substantially the economic equivalent of a short sale or credit derivative, other than, for the avoidance of doubt, any transaction that only hedges general interest rate or currency exchange risk.

There is also a materiality standard: there must be a substantial likelihood that a reasonable investor would consider the transaction important to the investor's investment decision, including a decision whether to retain the ABS.

Exceptions. Rule 192 also puts into effect the exceptions outlined in Section 27B for risk-mitigating hedging activities, bona fide market-making activities, and liquidity commitments. The exception for hedging activities and bona fide market-making activities are accompanied by specified conditions, including the establishment and enforcement of an internal compliance program including reasonably designed written policies and procedures. The release notes that the Commission believes that no additional exceptions are necessary in order to implement Section 27B and that there is no need to include a mechanism to provide additional exceptions in the future.

The final rule also addresses evasion of the exceptions. A securitization participant may not engage in a transaction that is in technical compliance with the exceptions while being part of a scheme to evade the prohibition on conflicts. In addition, there is a safe harbor for certain foreign transactions.

Peirce objects. Commissioner Peirce was the sole vote against the new rule. While Peirce supported the rule as proposed, she did so with reservations. Peirce would prefer that the rule be re-proposed to allow public comment on substantial revisions made after the comment period closed. She observed that the Commission has a "troubling recent pattern" of releasing unworkable rules with numerous questions and then substantially revising a rule after the comment period closes. Overall, the commissioner believes that the rule is broader than necessary and fails to implement the Dodd-Frank mandate in a way that would stop conflicted transactions.

The release is No. 33-11254.

SEC stays Repurchase Rule; court denies more time on remand

By Rodney F. Tonkovic, J.D.

The SEC issued an order postponing the effective date of its Share Repurchase Disclosure Modernization. At the end of October, the Fifth Circuit concluded that Commission acted arbitrarily and capriciously in adopting the rule and gave the agency 30 days to remedy the identified defects, or the rule will be vacated. On November 26, the court rejected the SEC's motion to extend the remand. The rule is currently stayed pending further Commission action (In the Matter of Share Repurchase Disclosure Modernization, Release No. 34-99011, November 22, 2023).

Repurchase rule. The Commission adopted the share repurchase disclosure modernization rule (Release No. 34-97424) by a 3-2 vote on May 3, 2023. The rule requires tabular disclosure of an issuer's purchases of its equity securities for each day that it makes a share repurchase and disclosure of the reasons for the share repurchase. The rule became effective on July 31, 2023, and the first filings governed by it would be due after the final quarter of 2023.

Arbitrary and capricious. On October 31, 2023, in response to a challenge brought by the U.S. Chamber of Commerce, the Fifth Circuit Court of Appeals found that the final rule was arbitrary and capricious. The matter was remanded to the SEC to fix the identified deficiencies by November 30, 2023 or the rule will be vacated on December 1. The court retained jurisdiction to consider the SEC's decision made on remand.

According to the court, the Commission violated the APA by failing to respond to petitioners' comments and to conduct a proper cost-benefit analysis. The court also said that the rule's primary benefit—decreasing investor uncertainty about motivations underlying buybacks—was inadequately substantiated, and this error infected the entire rule.

Stay. On November 22, 2023, the Commission announced that it has stayed the repurchase rule "pending further Commission action." The order notes that the APA provides that an agency may postpone the effective date of an action pending judicial review if "justice so requires." In light of the Fifth Circuit's decision, the Commission has found "that it is consistent with what justice requires" to stay the effectiveness of the rule.

Thirty days for the whole. Recognizing that there was a possibility that the SEC could substantiate its decision, the court gave the agency 30 days to correct the defects in the rule. On November 22, 2023, the Commission filed a motion seeking to extend the remand period. The motion indicated that Commission staff was working diligently to comply with the remand order but needed additional time. The motion requested an extension of the remand, noting that the stay order issued on the same day would facilitate this relief. If the extension was granted, the Commission would provide a status update within 60 days.

The Chamber of Commerce opposed the motion, arguing that there was no basis to extend the remand period. The SEC's motion, the Chamber said, did not explain what the Commission has done since October 31 or what remains to be done. The Commission also has not proposed a new deadline—with no deadline, the SEC enjoys the benefit of the rule for as long as it refuses to act, the Chamber remarked. The SEC's "bare-bones motion" does not justify an extension of the remand period, and the Chamber asserted that the Commission effectively admitted that it cannot timely correct the defects. Vacatur will not prejudice the SEC, the Chamber said.

In a terse, unpublished order issued on November 26, 2023, the panel denied the SEC's motion.

The release is No. 34-99011.

Lawmakers implore banking regulators to clarify reach of staff accounting bulletin

By Kathleen Bianco, J.D.

On Oct. 31, 2023, the Government Accountability Office (GAO) issued a decision finding that the Securities and Exchange Commission’s Staff Accounting Bulletin 121 (SAB 121), published on April 11, 2022, is a “rule” for purposes of the Congressional Review Act. As a result of this determination, a bipartisan group of congressional members led by Rep. Patrick McHenry (R-NC), the Chairman of the House Financial Services Committee, and Senator Cynthia Lummis (R-Wyo) have now reached out to the prudential regulators asking them to take action to clarify that SAB 121 is not enforceable in light of the GAO decision.

SAB 121, as issued, requires banks holding crypto assets to recognize a liability and a corresponding offset on their balance sheets, measured at the fair value of the customer custodial digital assets. The lawmakers note in their November 15 letter that SAB 121 was issued without any consultation with any of the prudential regulators—the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board of Governors (Fed), the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA). They further opine that “[t]his accounting approach, which deviates from established accounting standards, would not accurately reflect the underlying legal and economic obligations of the custodian, and places consumers at greater risk of loss.”

Because SAB 121 was deemed to have met the definition of a rule under the Administrative Procedure Act (APA), the SEC had an obligation to comply with the requirements of the Congressional Review Act by submitting SAB 121 to Congress or the GAO for review. As a result of the SEC’s failure to meet these obligations, SAB 121 “should have no legal effect and the Federal Banking agencies and National Credit Union Administration should not require banks, credit unions, and other financial institutions that provide custody services for digital assets to comply,” the letter indicated.

The letter goes on to state that, “[e]nforcing this noncompliant rule would set a concerning precedent that would facilitate regulatory gamesmanship to circumvent the APA, effectively allowing the SEC to have regulatory authority over institutions which Congress did not authorize.” It is for these reasons that the lawmakers’ who have signed the letter are encouraging the prudential regulators to act through guidance or other means to clarify that SAB 121 is not enforceable under the GAO findings.

Hacker reports own victim for not disclosing cyberattack

By Anne Sherry, J.D.

Beginning next month, public companies will be required to disclose material cyber incidents within four business days. A new development reveals a presumably unintended consequence of this new rule: a ransomware attacker using a victim’s nondisclosure as additional leverage to extract a payment.

“It has come to our attention that MeridianLink, in light of a significant breach compromising customer data and operational information, has failed to file the requisite disclosure … as mandated by the new SEC rules,” reads a whistleblower tip filed with the SEC by ALPHV/BlackCat. Plot twist: ALPHV was the attacker that caused the breach.

As reported by bleepingcomputer.com, ALPHV posted on its website screenshots of the tip it filed with the SEC. In a post entitled “MeridianLink fails to file with the SEC..so we do it for them + 24 hours to pay,” ALPHV warned that the victim had only 24 hours before the ransomware group would publish the stolen data. A timestamp on ALPHV’s post marks it as having gone up the evening of November 15.

As of the afternoon of the 17th, MeridianLink had not filed anything about the incident on EDGAR. However, a “cybersecurity update” on its website confirms the breach. “Based on our investigation to date, we have identified no evidence of unauthorized access to our production platforms, and the incident has caused minimal business interruption,” MeridianLink writes. “If we determine that any consumer personal information was involved in this incident, we will provide notifications, as required by law.”

Under new Item 1.05 to Form 8-K, public companies will be required to disclose a cybersecurity incident within four business days of determining that it is material (this determination should be made “without unreasonable delay”). Although ALPHV cited the new rule in its SEC tip, companies are not required to comply with the new requirements until December 18 at the earliest.

However, under existing SEC rules, companies are required to disclose material risk factors, and those disclosures can give way to enforcement action if the SEC deems them misleading or incomplete.

Last month, the SEC charged SolarWinds Corporation and its CISO for misleading investors about the company’s cybersecurity risks and vulnerabilities. The complaint specifically alleges that SolarWinds made an incomplete disclosure about a years-long cyberattack called SUNBURST that compromised the company’s “crown jewel” software platform.

This enforcement action signaled to companies that the SEC is taking a harder line on cybersecurity breaches and is likely to watch closely what companies disclose under the new Item 1.05—potentially leaving the door open for bad actors to leverage the new rules as ALPHV has done. Saying the action represented a “regressive set of views and actions inconsistent with the progress the industry needs to make and the government encourages,” SolarWinds’ CEO protested, “How we responded to SUNBURST is exactly what the U.S. government seeks to encourage.”

New SEC rule aims to reduce conflicts on clearinghouse boards

By Anne Sherry, J.D.

The SEC adopted new rules regarding the governance of registered clearing agencies. New Exchange Act Rule 17ad-25 fulfills a Dodd-Frank mandate to mitigate conflicts of interest for security-based-swap clearing agencies. The rules establish new requirements for board and committee composition, independent directors and committees, management of conflicts, and board oversight. Clearinghouses must abide by most of the rules starting a year from publication in the Federal Register, with an extra year for the board independence requirements (Clearing Agency Governance and Conflicts of Interest, Release No. 34-98959, November 16, 2023).

In a statement, SEC Chair Gary Gensler said the rule is meant to promote board independence, consider the views of relevant stakeholders, and reduce the potential for conflicts of interest within the board and senior management. The SEC first proposed the new regulation last August.

Independence requirements. Under the new rule, a majority of the board of a registered clearing agency must be independent directors (unless a majority of voting rights are held by participants, in which case the independence requirement is 34 percent of the board). An independent director is one who has no material relationship (either currently or looking back one year) with the clearinghouse or an affiliate. It is up to the clearinghouse to make an affirmative determination that a director is not precluded from being an independent director.

In addition to these definitions, the rule sets out some circumstances that preclude a director from being independent, again subject to a one-year lookback period. For example, a director is not independent if they are subject to rules that undermine their ability to act unimpeded, such as removal by less than a majority of shares. A director is not independent if they or a family member are employees of or receive payments from the registered clearing agency or an affiliate (other than compensation as a director). A director cannot be independent if they are an executive of another entity whose compensation committee includes executive officers of the clearing agency, or if they or a family member is a partner of the clearing agency’s outside auditor or an employee working on an audit of the clearing agency.

Committees. Each registered clearing agency must establish a nominating committee with a written process for evaluating director nominees. A majority of directors on the committee, and its chair, must be independent. A clearinghouse must also establish at least one risk management committee that includes representatives from the owners and participants of the clearinghouse.

If any committee has authority to act on behalf of the board, the committee must meet the same independence threshold as is required for the board.

Policies and procedures. The rule also requires clearinghouses to establish written policies and procedures to identify and mitigate conflicts of interest. Policies and procedures must require a director to document and inform the clearinghouse of a conflict of interest. Policies must also account for risks from relationships with third-party providers of core services. Finally, the clearinghouse must establish policies and procedures to require the board to “solicit, consider, and document its consideration of the views of participants and other relevant stakeholders of the registered clearing agency regarding material developments in its risk management and operations on a recurring basis.”

This is Release No. 34-98959.

Are crypto, carbon market reforms in the CFTC’s future?

By Mark S. Nelson, J.D.

In a speech delivered by CFTC Commissioner Kristin N. Johnson to an audience assembled by the Federal Reserve Bank of Atlanta and the Atlanta Economics Club, Johnson floated the possibility that the CFTC may soon issue additional guidance on crypto and carbon markets. Johnson said in her remarks that both markets suffer from a lack of transparency and corporate governance standards that are present in other, more stable markets. The commissioner also suggested that the CFTC already has tools at its disposal to address fraud in spot markets for these products.

Johnson began her remarks by noting the seeming incongruity of crypto and carbon markets, but she observed that some in the blockchain industry have posited the development of tokenized carbon credits, thus bringing the twin subjects of her speech closer together than previously hypothesized.

“In the coming weeks, I believe that the Commission will take important first steps introducing market structure reforms in both of these markets,” said Johnson. “These critical reforms will establish customer property protections in non-intermediated clearing markets (a reform that is increasingly important as market participants seek to adopt this approach to offer leveraged, crypto-products to retail investors) and long-awaited guidance on voluntary carbon markets.”

After noting how crypto and carbon markets might fuse in a future state of affairs, Johnson addressed each of these markets individually. Starting with crypto, Johnson provided “observations” about what she believes has gone wrong in crypto markets. She said many of the firms involved in the highest profile flops had sought bankruptcy protection, which put in jeopardy any recovery by harmed customers. She also said the lack of transparency about crypto firms’ risk management practices had resulted in bigger customer losses and had increasingly strained markets. Lastly, Johnson said that “imperial CEO[s]” at some crypto firms were able to flourish without traditional corporate governance mechanisms that might have checked their influence over the operations of their companies.

With respect to carbon markets, Johnson noted several early steps taken by the CFTC in recent years, including the issuance of a report on carbon markets by the CFTC’s Market Risk Advisory Committee’s Subcommittee on Climate-Related Financial Risks. Another key development was the CFTC’s hosting of a pair of carbon markets convenings. Yet despite these steps, Johnson suggested that more was needed in the form of new guidance and stepped-up enforcement.

Johnson explained that: “To ensure integrity in environmental commodities markets, we may need further reforms, including, among others, the creation of carefully developed registries; mitigation of vulnerabilities, such as double-counting, greenwashing, or the risk of leakage; and the introduction of a rigorous standard for demonstrating additionality and permanence.”

For Johnson, both crypto and carbon markets could benefit from similar reforms. For example, she suggested that without stronger guardrails, fraudsters will continue to exploit these markets because of their obscurity and complexity. Both markets, she said, could benefit from corporate governance and market reforms. But although Congressional action could help to clarify regulatory roles, Johnson said the CFTC already has tools it can deploy to improve both crypto and carbon markets.

Johnson also offered some more specific types of reforms the CFTC could mull:

• Transaction reporting;
• Secondary market regulation (e.g., guidance regarding clearing and settlement);
• Accountability standards for intermediaries focused on integrity and reliability (for carbon markets, these reforms would include standards for additionality—In a previous speech (see, n. 5) on the topic, Johnson cited The Integrity Council for the Voluntary Carbon Market, Core Carbon Principles, Assessment Framework and Assessment Procedure, Draft for public consultation (July 2022) for the proposition that the impact of carbon credits would be “additional” if the impact “would not have occurred in the absence of the incentive created by carbon credit revenues”);
• Business conduct standards; and
• Guardrails to protect retail investors.

Johnson closed her remarks by calling for the CFTC to move beyond enforcement actions to offer more comprehensive guidance and regulations for crypto and carbon markets. “Similar to our leadership in bringing critical enforcement actions, the CFTC must lead in issuing advisories, guidance, and begin developing rule makings that introduce transparency and market structure reforms in crypto and environmental commodities markets,” said Johnson.

Big investors warn chemical companies to phase out ‘forever chemicals’ as litigation risk grows

By Lene Powell, J.D.

Institutional investors representing over $10 trillion in assets under management or advice called on the 50 largest stock-listed chemical companies to phase out PFAS chemicals, citing a “flood” of litigation, insurance risks, and costs running into the hundreds of billions. PFAS are the “new asbestos,” the Investor Initiative on Hazardous Chemicals (IIHC) said.

“Not only do PFAS—or forever chemicals—negatively impact human health and ecosystems; we have also seen the effect that group litigation, such as the $10.3bn settlement by 3M this year, can have in eroding shareholder value,” said Victoria Lidén, co-chair of the IIHC and senior sustainability analyst at Storebrand Asset Management.

PFAS. Per- and polyfluoroalkyl substances (PFAS) are a group of thousands of manufactured chemicals widely used in industry and consumer products that break down very slowly over time, according to the U.S. EPA. They have been found in the blood of people and animals all over the world, as well as in food and the environment. Studies show that PFAS exposure may be linked to harmful health effects.

Risks and costs. In a letter to the CEOs of the 50 largest stock-listed chemical companies, IIHC compared the risk to asbestos.

“Manufacturers and users of PFAS chemicals are exposed to deep liability and insurance risks, reminiscent of those historically linked to asbestos, which could materially adversely harm the long-term value of companies involved in their manufacture and sale,” the group said.

The group cited significant financial risks:

• More than 2,400 PFAS-related lawsuits have been filed since 2005, according to Bloomberg.
• Litigation is expanding beyond producers to PFAS users in the auto, food, textiles, cosmetics and paper sectors.
• The first bankruptcy occurred this year, and more are expected.
• 3M reached a €500m settlement last year in Europe, but new lawsuits have begun in the Netherlands and Belgium.
• US states and the European Union are drafting PFAS bans.

Costs from cleanup and injuries may reach hundreds of billions of dollars.

• Full clean-up costs could exceed $400B.
• Additional costs to remove PFAS from drinking water across the United States range from $64.5B to $248B.
• US PFAS bodily injury estimates covering all production to date range from $10B to $41B at 5% probability.

Requests. IIHC asked the chemical companies to take three actions:

• Disclose. To help investors appraise relevant risks at the company, disclose both the share of revenue and production volume of products that are, or contain, hazardous chemicals.
• Phase out. Publish a realistic time-bound phase-out plan of products that are, or contain, persistent chemicals.
• Develop alternatives. Conduct a robust evaluation and substantially ramp up R&D and investment in the development of safer alternatives.

The group added that five chemical companies that produce PFAS frequently rank near the bottom in ChemScore sustainability rankings, but two others score relatively well due to more sustainable processes and better transparency, among other things.

Article explores Executive Order and other legislative options for regulating artificial intelligence in the U.S.

By Mark S. Nelson, J.D.

The release of OpenAI’s Chat-GPT nearly one year ago not only captivated the public imagination but, by summer 2023, also had captured the attention of lawmakers who fear a regulatory repeat of perceived errors made when Congress took a more hands-off approach to the Internet and social media platforms. Much of the legislative efforts on artificial intelligence (AI) thus far have centered on national security, the military, and elections. The Biden Administration’s executive order on AI, by contrast, includes eight substantive sections addressing a range of issues, including national security, but also AI safety, innovation and competition, job displacement, equity and civil rights, consumer protection, privacy, and the government’s own use of AI to deliver services to the public.

A new Vital Briefings article reviews key components of the AI executive order and outlines the legislative streams taking shape in Congress to bring government oversight to AI. The article notes, however, that existing guidance and frameworks should not be overlooked, nor should practitioners ignore developments in the European Union and in individual U.S. states, both of which could implement AI rules of the road that may apply to a significant number of U.S. entities.

The Vital Briefings article, “AI regulation in the U.S.: what it means for corporate and financial services practitioners,” is available here.

Appeals court rejects purpose-specific approval requirement for short-swing exemption

By Anne Sherry, J.D.

The Court of Appeals for the Ninth Circuit held that a short-swing transaction is exempt from clawback if it had board approval, even if that approval was not given for the specific purpose of the exemption. The holding agrees with an amicus brief filed by the SEC. The court remanded the case to allow further proceedings on the fact issue of whether the defendant is a “director by deputization” (Roth v. Foris Ventures, LLC, November 13, 2023).

Exchange Act Section 16(b) allows the clawback of profits from securities transactions between an issuer and an insider that occur within a six-month window. But under Rule 16b-3(d)(1), transactions that are “approved by the board of directors of the issuer” are exempt from clawback. Relying on a nonbinding 1999 SEC staff interpretive letter, the district court for the Northern District of California held that defendants must show that the board approved the transaction for purposes of invoking the Rule 16b-3 exemption. The SEC repudiated this position a few years later, and the Second Circuit held that there was no such purpose-specific approval requirement.

The Ninth Circuit did not spend much time coming to its conclusion in this “rare case where all parties involved agree that we must reverse.” As the Second Circuit observed in 2002, the text of the rule does not include a purpose-specific approval requirement or say anything about the board’s motivations. The Ninth Circuit likewise held that Rule 16b-3 does not include such a requirement.

The district court did not err, however, in finding that the board knew of a beneficial owner’s indirect pecuniary interest in the transactions when it approved them. The only remaining fact issue was whether the defendant was entitled to the Rule 16b-3 exemption as a “director by deputization.” Because a company may incur Section 16(b) liability by deputizing a natural person to perform its duties on the board, such a company may also invoke the exemption if the board is aware of the deputization. The record at the motion-to-dismiss stage was insufficient to resolve this question of fact, making remand necessary.

The district court will also have to contend with the related argument that Rule 16b-3 exempts entire transactions rather than specific defendants. This potentially dispositive issue—which would bring the exemption back into play even if the defendant was found not to be a director by deputization—was never squarely addressed by the district court, and the appeals court is “a court of review, not first view.”

The case is No. 22-16632.

New York's LLC Transparency Law follows in the footsteps of the CTA

By Matthew Garza, J.D.

As smaller companies prepare to comply with the federal Corporate Transparency Act (CTA), businesses in New York will also have to contend with the LLC Transparency Act, which would amend New York’s Limited Liability Company Law and the New York Executive Law to require disclosure of beneficial ownership of LLCs. The law, passed in June and awaiting the Governor’s signature, is discussed in New York Leglislature Targets Real Estate Owners in Passing LLC Transparency Law, by Polsinelli PC partners Jeanne Solomon, William Quick, and Adam Green. In this Strategic Perspective they compare the LLC Transparency Act with the CTA in detail and discuss its impact on the state’s beleaguered real estate industry.

House OKs Appropriations Act amendment to halt funding of SEC crypto enforcement actions

By Suzanne Cosgrove

In a brief but fiery speech to pitch his amendment to the Appropriations Act to House members, Congressman Tom Emmer declared that “regulation by enforcement is a practice all too common with this administration.” Emmer was particularly damning when he referred to SEC Chairman Gary Gensler, calling him “ineffective and incompetent.”

H.R. 4664 allocates funding for financial services and general government for fiscal year ended September 30, 2024. Emmer’s one-sentence addition to the Act states that “none of the funds made available by this Act may be used by the Securities and Exchange Commission to carry out an enforcement action related to a crypto asset transaction.”

“My amendment seeks to put an end to Chair Gensler’s pattern of regulatory abuse, a pattern that is crushing American innovation and capital formation, without undermining our ability to go after criminals and fraudsters,” Emmer said. “Specifically, my amendment prohibits the SEC from using funds for enforcement activities related to digital asset transactions until Congress passes legislation that gives the SEC jurisdiction over this asset class.”

Deadline redux. Although Congress is facing an imminent U.S. budget deadline, House members, including Emmer, this week tinkered with the appropriations measure, which has some 100 amendments to its spending package, including the one that prohibits the SEC from using funds for enforcement activities related to digital assets. Any spending proposals also would have to be passed by the Senate.

U.S. government services will be interrupted if Congress does not pass a budget bill or another stopgap spending package by Nov. 17. Congress last averted a government shutdown less than two months ago, in October, when it pushed through a 45-day stopgap spending measure.

Crypto defender. In his remarks made Wednesday on the House floor, Emmer cast himself as a backer of the nascent digital asset scene. “The unique characteristics of digital assets make it hard to fit this asset class into any existing regulatory framework,” he said. “That doesn’t mean crypto is up for grabs by whatever federal bureaucratic agency has the most taxpayer-funded enforcement resources to burn.”

He said Congress is working on legislation to establish a framework for how specific digital assets are classified, as a security or a commodity, which will dictate the regulator of jurisdiction.

“Chair Gensler has developed a track record of going after actors like Coinbase, a publicly traded company desperately trying to survive and innovate right here in the United States instead of going offshore like many are forced to do,” Emmer said. “Gensler has done this while missing the bad actors, like FTX and Terra/Luna.”

Enforcement alternates. And while Emmer ruled out the SEC’s enforcement efforts, he said the Department of Justice, the Treasury, and the Office of Foreign Asset Control “have the existing and sufficient authority” to prosecute criminal acts of fraud.

“This (amendment) will keep Chair Gensler … in check while Congress continues working to give this industry a chance to grow and develop right here in the United States,” Emmer said. “Congress will hold unelected bureaucrats accountable,” he said.

Petition asks SEC to amend 'smaller reporting company' definition

By Rodney F. Tonkovic, J.D.

A petition for rulemaking asks the SEC to amend Rule 12b-2's definition of "smaller reporting company." Specifically, the petition requests a change to an instruction accompanying the definition to accommodate smaller foreign private issuers. To avail themselves of an exemption from the rule's auditor attestation report requirement, smaller foreign private issuers must accept significant compliance costs and administrative burdens involved in reporting as currently required. The petitioner believes the suggested addition to the instruction would eliminate a deterrent for these issuers to list on a U.S. stock exchange.

Background. Exchange Act Rule 12b-2 contains the definitions of terms used in Regulation 12B, 13A, and 15D and forms filed pursuant to Sections 12, 13, and 15D. In March 2020, the Commission amended the definitions of "accelerated filer" and "large accelerated filer" in Rule 12b-2. As relevant to the petition, the effect of this change was to exempt certain smaller issuers with little revenue or float from the obligation to file an auditor attestation report under SOX Section 404(b). This action, the release says, will reduce unnecessary burdens—compliance costs, in particular—on certain smaller issuers.

After the 2020 amendment, an issuer that qualifies as a "smaller reporting company" is not an accelerated filer if it meets certain revenue and public float requirements (the "revenue test"). The petitioner, however, believes that this current formulation of the rule effectively discriminates against smaller reporting foreign private issuers ("FPIs") versus smaller reporting domestic companies.

Instruction 2. Instruction 2 to Rule 12b-2's definition of "smaller reporting company" says: A foreign private issuer is not eligible to use the requirements for smaller reporting companies unless it uses the forms and rules designated for domestic issuers and provides financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles. The petition seeks to add a sentence to this definition stating that for purposes of the revenue test, "a foreign private issuer may rely upon the definition of 'smaller reporting company' without using the forms and rules designated for domestic issuers or providing financial statements prepared in accordance with U.S. Generally Accepted Accounting Principles."

Compliance costs. To illustrate, the petitioner, a law firm, describes the plight of an Australian client. Absent the added sentence to Instruction 2, the client must report on domestic forms and prepare financial statements using U.S. GAAP, regardless of the compliance burden, if it wants to avail itself of the exemption from the auditor attestation report requirement. Whether the FPI submits an attestation report or uses forms for domestic issuers prepared under GAAP, there are significant compliance burdens that could pressure a smaller FPI to delist its securities from its U.S. stock exchange. This results in disparate treatment against FPIs, the petition says, because they cannot feasibly report as required by Rule 12b-2 while complying with different, even conflicting, requirements in their home country.

In addition to the costs, conflicting requirements, and administrative burdens, the petitioner believes that having an FPI report as a smaller reporting company would cause investor confusion. An FPI could, for example, be required to report the same information under two different reporting regimes on different days. This duplicative and inconsistent reporting would confuse investors.

Policy reasons. The petitioner believes that the policy goals of the amendment apply equally to smaller reporting FPIs. If the goal is to reduce unnecessary burdens, the petition elaborates, there is no reason to discriminate against smaller reporting FPIs and impose significant costs and administrative burdens that outweigh any benefits of the exemption from the auditor attestation requirement.

The petition is No. 4-816.

SEC argues crypto crackdown is in line with authority on Binance motion to dismiss

By Lene Powell, J.D.

In a new filing, the SEC defended its enforcement action against crypto giant Binance, outlining fundamental registration failures and a secret scheme to evade the law. The SEC countered Binance arguments invoking due process, the major questions doctrine, and the “invented requirement” of a contractual relationship (SEC v. Binance Holdings Limited, November 7, 2023).

SEC allegations. The SEC’s enforcement action against Binance entities involves several sets of allegations.

Broadly, the SEC alleges:

• Binance and its U.S. affiliate BAM Trading operated unregistered national securities exchanges, broker-dealers, and clearing agencies;
• Binance and BAM Trading engaged in the unregistered offer and sale of Binance’s own crypto assets, including a so-called exchange token BNB, a so-called stablecoin Binance USD (BUSD), certain crypto-lending products, and a staking-as-a-service program;
• To evade regulation and operate in the U.S., Binance and founder Changpeng Zhao used the so-called “Tai Chi Plan” to secretly control the Binance.US platform’s operations and allow U.S. customers to continue trading, against Binance public claims to the contrary.

Howey and contract law. In separate motions to dismiss, Binance and BAM Trading argue the SEC has not adequately pleaded that any digital assets traded on Binance platforms are securities. The defendants argue the transactions at issue are not “investment contracts” because they do not involve contracts. As such, they are not securities under the Howey test.

Not so, said the SEC. Under Howey, an “investment contract” is a “contract, transaction, or scheme” that contains the three characteristics outlined in the test. Further, the D.C. Circuit has held that an investment contract is “anything that investors purchase” that meets the prongs of Howey’s test.

The idea that Howey requires a contract is an “invented requirement” unsupported by law, said the SEC.

“These arguments elevate form over substance and seek to turn the federal securities laws into matters of contract law in contravention of decades of well-established law … Critically, Defendants do not cite one case holding that these nebulous requirements are part of the analysis,” wrote the SEC.

The SEC added, “No court has adopted Defendants’ tortured interpretation of the law. To the contrary, courts have consistently rejected it, and this Court should as well.”

Due process. Binance and Zhao argued that the SEC failed to provide fair notice that their conduct was illegal under federal securities laws.

According to the SEC, the fair notice argument ignores the “over one hundred actions” the SEC has brought with respect to crypto assets securities, as well as guidance from SEC staff as to how it analyzes the question of whether a crypto asset is a security. Courts have consistently rejected the argument that the term “investment contract” fails to provide constitutionally required notice, the SEC said.

The SEC also disputed that its position on crypto assets has “shifted” or that it is applying the law retroactively.

Major questions doctrine. Both sets of defendants argued that the SEC lacks authority to regulate the “nascent, transformative, trillion-dollar” digital asset industry under the “major questions doctrine” articulated by the Supreme Court.

“Where, as here, an agency asserts authority over a question of major ‘economic and political significance’—particularly where the agency has not done so before—the major questions doctrine provides that an agency must “point to ‘clear congressional authorization for the power it claims,” wrote BAM Trading.

This argument was echoed by the Digital Chamber of Commerce in an amicus brief.

“[G]iven the size of the blockchain economy, the SEC’s attempt to treat tokens as investment contract securities presents a ‘major question’ under the U.S. Supreme Court’s Major Questions Doctrine. The SEC should have sought proper authorization from Congress rather than attempting to capture a bigger piece of the regulatory and enforcement pie via actions such as this one,” the Digital Chamber of Commerce wrote.

The SEC contested this, saying courts have refused to extend this doctrine to an agency’s exercise of enforcement authority.

Even if it were applicable in the enforcement context, said the SEC, the circumstances warranting its application are absent here. The economic issues involved in the crypto industry would not affect 80 percent of the country, as in Alabama Ass’n of Realtors v. HHS, or force a nationwide transition away from coal, as in West Virginia v. EPA.

Finally, the SEC argued that enforcing the federal securities laws here thus does not represent the exercise of a “newfound power” but the exact type of enforcement action that Congress expected the SEC to bring.

This is case No. 1:23-cv-01599-ABJ-ZMF (docket).

AFR, allies make case against anti-woke financial bills

By Mark S. Nelson, J.D.

Americans for Financial Reform (AFR) and 32 other organizations sent a pair of letters (Letter 1 and Letter 2) to the House Ways and Means Committee leadership as well as to Speaker Mike Johnson and Minority Leader Hakeem Jeffries urging Congress not to move forward on a slate of Republican-led bills that AFR says could protect public companies from outside scrutiny, curb shareholder proposals, and potentially hinder bank regulators from responding to future economic crises. AFR also called on Congress not to pursue legislation that would emulate Trump-era DOL policies on ESG investing (The Biden Administration has already taken steps to roll back those policies).

The several bills singled out by AFR were part of the Republican majority’s July 2023 “ESG Month” in which the House Financial Services Committee marked up numerous bills aimed at combatting “woke” corporate policies. Republicans claim that legislation is needed to prevent workers’ retirement savings from being diverted into funds that may follow socially themed investment objectives to the detriment of investment returns.

AFR sought to make the case that polling showed a continued trend in favor of at last some ESG investment goals by citing data from two studies. The first study was conducted by ROKK Solutions and Penn State University’s Center for the Business of Sustainability. “For example, 63 percent of voters do not believe the government should set limits on corporate ESG investments,” AFR noted about the study’s conclusions.

The other study was a poll that appeared in an article in Fortune. A footnote in each of AFR’s letters indicated that the Fortune poll posed questions about anti-ESG efforts to 1,261 voters (a link to the Fortune article was not working and further information about the poll was, thus, unavailable).

AFR observed that the Fortune article noted a trend showing significant support for corporate social responsibility across political lines. AFR specifically cited a part of the article noting that: “And when it comes to how companies should operate in our society, ‘most voters (76 percent) feel companies play a vital role in society and should be held accountable to make a positive impact on the communities in which they operate.’ This includes both the majority of Republicans (69 percent) and the majority of Democrats (82 percent), reflecting strong bipartisan support.”