Tuesday, June 28, 2022

SEC moves Advisers Acts filings onto EDGAR

By Rodney F. Tonkovic, J.D.

The SEC has unanimously adopted final rules requiring the electronic filing of documents by investment advisers, institutional investment managers, and others that had previously been filed on paper. In short, the amendments will require the filing or submission of: applications for orders under the Investment Advisers Act; confidential treatment requests for Form 13F filings; and Form ADV-NR. Other technical amendments are intended to enhance the quality of the date reported on Form 13F. The rules are effective upon publication in the Federal Register, except for the amendments to Form 13F, which are effective on January 3, 2023, and there will be a six-month transition period (Electronic Submission of Applications for Orders under the Advisers Act and the Investment Company Act, Confidential Treatment Requests for Filings on Form 13F, and Form ADV-NR; Amendments to Form 13F, Release No. 34-95148, June 23, 2022).

The new requirements are intended to minimize delay in receiving information and to increase the efficiency of the review process. The release also notes that electronic filing effectively addressed logistical and operational issues occasioned by the COVID-19 pandemic and would be similarly effective during future disruptive events. In a statement announcing the new rule amendments, Chair Gensler said: "In a digital age, it is important for filers to have easy, online methods to submit information to the Commission, and where appropriate for investors to have easy, online access as well. Electronic filing as opposed to paper filing makes this submission and disclosure more efficient, transparent, and operationally resilient. In light of this, these amendments benefit filers, investors, and the SEC."

The rule and form amendments were proposed in November 2021. While the proposal did not generate many comments, those received were generally supportive of the Commission's aims while offering suggested refinements mainly to the approach to Form 13F filings. The amendments have been adopted largely as proposed.

Advisers Act. The final rules require the electronic filing through EDGAR of applications for orders under any section of the Advisers Act for which a form with instructions is not specifically prescribed. Before these amendments, applicants were required to file the application, plus a proposed notice of application, in paper and in quintuplicate. Once EDGAR accepts an application, on the other hand, it is immediately available to the staff and public, allowing for easier search and review of filed applications. The Commission said that it chose EDGAR over IARD for a number of reasons, including cost and the use of readily available technology. Significantly, these changes will make the application process under the Advisers Act consistent with the process for orders under the Investment Company Act (which has used EDGAR since 2009), and applications for orders under both acts may be made jointly in a single submission.

Form 13F. Under Exchange Act Section 13(f), managers are required to file a report on Form 13F if they exercise investment discretion over accounts holding certain equity securities having an aggregate fair market value of at least $100 million. Filers may request that the Commission delay or prevent disclosure of certain information that could have harmful market effects, however. The paper confidential treatment requests were subject to a time-consuming, manual receipt and distribution process, the Commission observed, and faults in the process were highlighted by the challenges of the coronavirus pandemic.

The new amendments for Form 13F and related rules require managers to file requests for confidential treatment via EDGAR. An amendment to the form's instructions requires filers to demonstrate that the information is customarily and actually kept private and that failure to grant the request for confidential treatment would be likely to cause harm to the manager. In addition to existing requirements, filers must provide additional identifying information such as a Central Registration Depository number and SEC file number, if any. Each reported security's CUSIP number must still be disclosed, but managers will also be permitted—but not required—to disclose the security's share class level Financial Instrument Global Identifier ("FIGI"). Technical amendments will simplify the form's rounding convention and otherwise account for the change to the XML-based structured data language.

Form ADV-NR. Finally, Form ADV-NR will be required to be filed electronically through the through the Investment Adviser Registration Depository system. This form must be filed by non-resident general partners and non-resident managing agents of SEC-registered investment advisers and exempt reporting advisers to appoint an agent for service of process in the United States. The filing must be made in connection with an adviser's initial Form ADV application or report (also filed via IARD). The form will be available in a fillable format and require signatures in electronic format. Members of the public will be able to view Forms ADV-NR through IARD's public interface.

The release is No. 34-95148.

Monday, June 27, 2022

CII supports reopening of Commission’s clawback proposal

By Joanne Cursinella, J.D.

The Council of Institutional Investors expressed support for the SEC’s proposal to reopen, for a second time, the comment period for listing standards for recovery of erroneously awarded compensation (the June release) in a June 24, 2022 letter to the Commission. The CII noted and commented specifically on three issues identified in a memorandum of the SEC’s Division of Economic and Risk Analysis regarding the June release (the DERA memo), an increase in voluntary adoption of compensation recovery policies by issuers, the number of additional restatements that would trigger a compensation recovery analysis, and potential implications for the costs and benefits of the proposed rule.

Voluntary adoption of compensation recovery policies. CII generally agrees with the DERA Memo data and analysis that many companies have voluntarily adopted compensation recovery provisions since the 2015 proposing release and this may reduce the anticipated benefits and mitigate the anticipated costs of the proposed rules. This finding, however, does not diminish in any way CII’s strong support for the issuance of a final rule. In fact, CII said that is agrees with SEC Chair Gary Gensler that a final rule, as described and supplemented, would strengthen the transparency and quality of corporate financial statements and accountability of corporate executives to their investors.

Additional restatements that would trigger a compensation recovery analysis. CII generally agrees with the DERA memo’s finding that “if the final rules were to encompass both [“little r” and “Big R”] types of restatements, it would increase the total number of restatements that could potentially trigger a compensation recovery analysis that may result in recovery.” But this finding is not surprising to CII and the organization continues to believe that encompassing both types of restatements in the final rule is not only consistent with the intent of Section 954 of Dodd-Frank but increases the benefits to investors that would result from the issuance of a final rule.

Further, in addition to being inconsistent with the intent of Section 954, CII believes it would be harmful to investors and the capital markets for the SEC to narrowly limit the required clawback policy to exclude little r restatements. CII believes excluding little r restatements from the required clawback policy would serve to reduce transparency to investors, but, more importantly, according to CII, limit the ability of the required clawback policy to recover for shareowners the executive pay that was unearned and erroneously awarded.

Potential implications for costs and benefits. CII generally agrees with DERA memo findings regarding potential implications for the cost and benefits of the proposed rule as a result of the increase in the number of companies with voluntarily adopted compensation recovery provisions since 2015. Those findings were that:
  • The benefits of the proposed rules, including increased incentives to improve financial reporting and business practices, as well as costs of incentive-based compensation, may be reduced if companies have already adopted strong compensation recovery provisions;
  • The cost of the proposed rules and potential shifts in executive compensation would likewise be mitigated under such circumstances; and
  • To the extent that companies are already disclosing information about voluntarily adopted recovery policies, the benefits and costs from the proposed disclosure requirements may be mitigated.
And CII also generally agrees with the DERA memo findings regarding potential implications for the cost and benefits of the proposed rule as a result of the inclusion of “little r” restatements:
  • To the extent that companies may recover additional erroneously awarded compensation with the inclusion of little r restatements, the company may benefit from the availability of those additional funds, and the implementation costs associated with those recoveries may also increase.
  • The inclusion of little r restatements might increase the benefits associated with incentives for high quality financial reporting, and incentives for value-enhancing business practices; and
  • That the inclusion of little r’ restatements may also increase the benefits and costs associated with potential shifts in managerial compensation.
CII believes that on the whole, the potential implications for the costs and benefits of the proposed rule as a result of the increase in the number of companies with voluntarily adopted compensation recovery provisions since 2015, and inclusion of “little r” restatements as put forth earlier provides a net benefit to investors and the capital markets and further supports the organization’s view that the Commission should promptly issue this rule.

Friday, June 24, 2022

Deadlock among eight-member Aerojet Rocketdyne board requires stockholder election to resolve

By R. Jason Howard, J.D.

In a case that the Delaware Chancery Court described as a cautionary tale about the perils that can befall a board with an even number of directors, in 2022, with a director nomination on the table, the eight-member board of Aerojet Rocketdyne Holdings, Inc., deadlocked on a company slate of nominees, leaving a pending acquisition of the company in limbo and resulting in litigation (In re Aerojet Rocketdyne Holdings, Inc., June 16, 2022, Will, L.).

Deadlock. The deadlock caused a rift between the company’s CEO and its Executive Chairman following a disagreement on how to approach the then-potential acquisition, with each claiming the other had ulterior motives or failed to undertake proper contingency planning, which led to differing outlooks on the company’s strategic direction.

The Executive Chairman initially proposed that seven of the eight incumbents be named as the company’s nominees in the event the merger failed as the eighth incumbent had decided not to seek reelection. The CEO objected and the FTC sued to block the acquisition of the company. The Executive Chairman then proposed an agreement between Steel Partners, a longtime Aerojet stockholder controlled by the Executive Chairman, but no agreement was reached.

With only days left until the deadline for the stockholder nomination, Steel nominated a slate of seven candidates that included the Executive Chairman and three of the incumbents. The CEO called upon the company’s executives and outside advisors to assist with a response to Steel’s nomination.

One aspect of that response took the form of a press release filed with the SEC and sent by the CEO to the company’s largest stockholders. The release purported to express the company’s disappointment in Steel’s nomination, attributed ulterior motives to the Executive Chairman, and disclosed an ongoing investigation. Another aspect involved the company’s longtime outside counsel threatening litigation against the incumbent directors nominated on Steel’s slate.

Litigation. The Executive Chairman and three incumbents (plaintiffs) brought claims against the CEO and the other three incumbents which concerned whether either half of the board was authorized to act for the company in connection with the election and whether the entity must stand neutral. The plaintiffs also sought a temporary restraining order (TRO) preventing either faction from using the company’s name or resources to advantage itself in the election. The TRO was granted, and a three-day trial followed.

The plaintiffs maintained that the purpose of the trial was to level the playing field and asked the court to declare that certain of the defendants’ actions were unauthorized and contrary to a principle of corporate neutrality in a control dispute. In addition, the plaintiffs were seeking final relief on their declaratory judgment claims, various forms of equitable relief, and argued that the defendants should be held in contempt.

For their part, the defendants argued that they acted in good faith and that their actions were authorized. They further contended that the Steel slate constituted a threat to the company and thus, the corporation was not required to stand neutral on that basis.

Findings. The court, being driven by the core tenants of Delaware law, found that the plaintiffs were entitled to a declaration that the approval of the press release and disclosures, the defendants’ threat of litigation, and the payment of the retainer to represent the defendants, were actions for which the defendants’ lacked authorization. With the board deadlocked, the court continued, the defendants could not deploy the company’s resources in support of their slate or to discredit the plaintiffs’ slate.

Stockholders, and not the court or either subset of directors, must decide which faction’s vision will become that of the company and, to preserve the ultimate goal of a fair and balanced election, neither half of the divided board has a superior claim to the company’s resources in the interim, the court stated.

Conclusion. The court's ruling was for the plaintiffs on their claims for declaratory judgment and it found that the plaintiffs are also entitled to certain additional equitable relief. The court also declined to make a finding of contempt. According to the memorandum and opinion, corrective disclosures shall issue by June 20, 2022.

The case is No. 2022-0127-LWW.

Thursday, June 23, 2022

SEC releases Spring rulemaking agenda, draws criticism from Peirce

By John Filar Atwood

The extent of SEC Chair Gary Gensler’s ambitious agenda came into clear view today as the Commission released its Spring 2022 regulatory flexibility agenda with 27 items in the proposed rule stage and 26 matters in the final rule stage. Gensler emphasized that a dynamic market is not well-served by static rules, and expressed his hope that through the proposed rulemakings the agency will drive efficiency in the capital markets and modernize its rules for today’s economy and technologies.

Commissioner Hester Peirce immediately took issue with the agenda, saying that it has the SEC pursuing flawed goals at a dangerous pace. In her view, the agenda is troubling both for the content of some of the proposals and for the rate at which the SEC plans to address them.

Peirce believes that the Commission’s agenda shuns matters that are core to the agency’s mission in favor of pursuing hot-button issues. Rather than protecting retail investors, she said, the SEC is working to aid professional investors, and instead of helping small companies raise capital it is making their work more costly. She urged the Commission to recalibrate its agenda to focus on core investor protection and market operation issues.

Some appropriate agenda items. Peirce acknowledged that the agenda does include several matters that are in keeping with the agency’s core mission. These include updates to the investment adviser custody rules, data security rules for the Consolidated Audit Trail, updates to the electronic recordkeeping rules for broker-dealers, and rules to shift from paper to electronic filings, she said.

However, in her view other important issues have been dropped or postponed. As examples she cited transfer agent rules, a joint project with the CFTC to develop uncleared swap portfolio margining rules, rules on investment company securities lending arrangements, and rules to reform proxy plumbing infrastructure.

Peirce also decried the use of agency resources to revisit rules that were only recently finished, such as resource extraction, proxy voting, shareholder proposals, and the whistleblower rules. She believes the SEC does not have enough new information on these matters to justify revisions at this time.

Process concerns. Along with concerns about the substance of the agenda items, Peirce is troubled by the speed with which the agency is moving to implement the proposals. The proposed rules contemplate far-reaching changes, she noted, and interested parties must be allowed adequate time to comment.

She believes that even those agenda items that are core to the SEC’s mission are not likely to get comprehensive public feedback. Issuing three to five rule proposals each month is not consistent with affording the public time to thoughtfully consider the impact of such changes, she stated.

Peirce expressed concern that the volume of comment requests will give even greater weight to the views of larger stakeholders since smaller players do not have the resources to give each proposal the attention it deserves. In addition, the comments the SEC does receive are less likely to include key data, in-depth analyses, and the consideration of how the rules will interact with one another, she noted.

She commended Gensler for recently extending the comment periods for some already-issued proposals including the amendments to the fund names rule and the proposed ESG rules pertaining to investment companies and investment advisers. She asked that in the future the Commission provide more reasonable comment periods at the time new rules are proposed. Providing longer comment periods up front would help the public determine how to best spend its time and resources in providing comments to the Commission, she concluded.

Wednesday, June 22, 2022

Gag order case will not reach the Supreme Court's ears

By Rodney F. Tonkovic, J.D.

The Supreme Court has declined to hear a petition asking it to review the constitutionality of the SEC's "gag orders." The petition, filed by former Xerox CFO Barry Romeril, asserted that the lifetime agreement not to deny the allegations against him violated his First Amendment and Due Process rights. The Second Circuit's holding that there was no basis to upset the consent decree stands, and the decades-old "Gag Rule," a longstanding standard part of settlements with the SEC, will remain in place.

Xerox settlement. In 2002, Xerox entered into a $10 million consent agreement settling SEC charges about its accounting practices. In June 2003, the SEC filed a complaint against then-CFO Romeril alleging that he allowed Xerox to file financial reports that did not conform with GAAP. Romeril settled, and agreed "not to take any action or to make or permit to be made any public statement denying, directly or indirectly, any allegation in the complaint or creating the impression that the complaint is without factual basis."

Gag order challenged. Citing FRCP 60(b)(4), Romeril moved for relief from the judgement sixteen years later in 2019. He argued that the gag order was an unconstitutional prior restraint that deprived him of his right to speak about the events leading to his prosecution, defend himself in the media, and to petition for reform of the securities laws. The district court concluded that the motion was untimely and that Romeril failed to allege a jurisdictional defect or violation of due process that would render the judgment void

The Second Circuit affirmed, noting that FRCP 60(b)(4) authorizes relief from a final judgment in two situations: (1) a jurisdictional error; and (2) a failure of due process because the movant was not given notice or an opportunity to be heard. In this case, the district court in Romeril’s case did have both subject matter jurisdiction and personal jurisdiction, and, further, there was no legal error because Romeril was free to reject the offer and litigate and defend against the charges. With respect to Romeril’s due process argument, the panel said that he had notice and an opportunity to be heard and that he willingly agreed to the consent order.

Petition. With the support of the New Civil Liberties Alliance, Romeril took his case to the Supreme Court. As before the Second Circuit, the petition argued that the SEC's requirement that settlements contain a lifetime gag order violates the First Amendment. In addition, the petition continued, the gag orders violate due process of law by requiring defendants to waive their rights if they settle. The petition also took issue with the Second Circuit's application of Rule 60(b)(4), arguing that Romeril could obtain relief because the district court in 2003 lacked any power to enter a judgment violating the First Amendment and due process: when a court so far exceeds its authority, Rule 60(b)(4) provides a remedy.

For its part, the SEC contended that the Second Circuit correctly rejected Romeril's "attempt to use Rule 60(b)(4) to make a unilateral change to the 2003 consent agreement." No circuit court, the SEC said, has found Rule 60(b)(4) to be applicable in analogous circumstances. Even so, the brief continued, parties can choose to waive fundamental constitutional rights, and no other circuit has found a no-deny provision to be unconstitutional. The Commission added that Rule 60(b)(4) has no mechanism for raising substantive challenges to a judgment, so Romeril's arguments about the lawfulness of the no-deny provision were not properly before the Court.

In reply, Romeril leaned heavily on his First Amendment arguments. "The notion of permitting the government to decide what may be said about its conduct is anathema to the First Amendment," he says, adding that silencing defendants like himself shelters the SEC from critique. Regarding the Due Process claims, the brief says that there cannot be a voluntary waiver when enforcement targets must surrender their rights "or else no settlement." Romeril also reiterated that the district court lacked jurisdiction to enter a judgment that violated the First Amendment and due process of law.

Amici. Romeril's petition also garnered a number of amici. Notably, Mark Cuban, Elon Musk, and others who have litigated against the SEC filed a brief in support of Romeril. In addition to Romeril's arguments, the amici added a new wrinkle, arguing that there is no compelling public policy reason to enforce gag orders because preventing settling defendants from speaking both deprives the markets of potentially material information and prevents scrutiny of the SEC's "unproven allegations." Other amici similarly pointed out that the gag rule works to withhold information from the public and stifles discourse regarding the conduct of government officials. Finally, a brief by the Pelican Institute for Public Policy took issue with the Second Circuit's reasoning, arguing that a court cannot enter an unconstitutional judgment simply because the parties have consented to it. In addition, under the same Second Circuit precedent, a judgment is void if a court grants relief that is beyond its authority to grant.

Read the Docket. Having denied certiorari in Romeril's case, there are currently no securities-related cases pending before the Court. Awaiting the Court's return in October is one granted petition, SEC v. Cochran. In this case, the Court will look at whether a separation of powers claim regarding ALJs can be heard in the district courts. This case has been yoked to another pending case concerning essentially the same issue: Axon Enterprise, Inc. v. Federal Trade Commission. On June 1, the Court ordered the parties to coordinate their briefs for these cases.

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

The petition is No. 21-1284.

Tuesday, June 21, 2022

Derivatives markets resilient amid geopolitical strains, climate change, CFTC’s Romero says

By Suzanne Cosgrove

Commodity markets have faced significant challenges in recent years, first from the pandemic and its related supply chain issues, and now from the geopolitical events that surround Russia’s invasion of Ukraine, said CFTC Commissioner Christy Goldsmith Romero.

Speaking Wednesday in an address to the Chicago Bar Association’s Futures and Derivatives Law Seminar, Romero added that the derivatives markets “are providing the risk management and price discovery that our market participants need” to weather the period. “These markets are global,” she said, and the CFTC is in close communication with international regulators.

Climate challenges. Romero also noted the CFTC is following current drought conditions, which have been particularly hard-hitting in the U.S. Southwest. Wildfires, flooding, droughts and other disasters have increased in number and severity, causing devastating losses, she said. The USDA reported 20 climate disasters in 2021 that each caused $1 billion in losses. “These, in addition to climate disasters that caused significant losses under $1 billion, could impact derivatives markets.”

Climate-related financial risk presents a unique set of risk management challenges because their historical patterns may not predict future events, Romero said. In addition, climate events may put strain on individual states or particular regions of the country, which could cause sub-systemic shocks. Goals set by the Paris Accord and commitments to net zero by a number of companies have accelerated the discussions about how derivatives markets can help mitigate that risk, she said.

Net zero calls for limiting global warming to no more than 1.5 degrees C as determined by the Paris Agreement in 2015, a goal that was reiterated at the 26th U.N. Climate Conference of the Parties in November 2021.

Many companies are challenged to meet net zero targets solely through the reduction of their carbon emissions, Romero said. “There has been a huge surge in demand for voluntary carbon markets and other products that would complement a reduction in emissions to help companies meet their targets,” she added.

Sustainability products. While there are more than 200 listed sustainability products on CFTC-regulated exchanges, the size of listed environmental derivatives markets is small when compared with over-the-counter carbon products, Romero said., which was estimated at a total of more than $1 billion last year.

“The opportunity to scale up the number of high-quality carbon products that are listed on exchanges could be a game changer in helping drive up supply to meet the surge in demand,” Romero told the group. Voluntary carbon markets face challenges in establishing pricing, and the CFTC can facilitate the exchanges’ introduction of new environmental products, she added.

The CFTC is currently gathering information and data in a push to understand climate risk in detail, how to assess that risk, and the steps market participants are taking to reduce risk, she said. To that end, CFTC published a Request for Information earlier this month in an effort get public feedback on climate-related market risk.

The information gathering process also included a public roundtable on voluntary carbon markets held by the Commission on June 2. Roundtable participants who came from the demand side of the voluntary carbon markets-–those seeking to invest in credits--voiced concerns about price transparency, as well as integrity-related issues like double-counting of credits and a need for independent verification, Romero said.

On the supply side, the agricultural community understands that climate risk is real, and it has been largely engaged in sustainability efforts for years, Romero said. But the roundtable also highlighted the community’s increased costs for fuel and fertilizer following Russia’s invasion of Ukraine. The agricultural community may not have the current resources to make certain sustainable investments that could become carbon credits, she said.

Also at the roundtable, “[w]e heard several participants say that the CFTC could help with standardization and taxonomy, as well as curbing greenwashing,” Romeo said. “One purpose of the Commodity Exchange Act is to promote responsible innovation,” she said. “To me that applies as equally in the ESG space as it does to technology.”

Monday, June 20, 2022

Crypto investors allege Elon Musk is manipulating Dogecoin

By Anne Sherry, J.D.

A suit against Elon Musk and his companies SpaceX and Tesla alleges that the defendants are engaging in a crypto pyramid scheme by manipulating the cryptocurrency Dogecoin. According to the class-action complaint, the class of crypto investors have lost $86 billion since the defendants began buying and talking about Dogecoin in 2019. For the defendants’ alleged buying, marketing, advertising, promoting, and manipulating Dogecoin, the complaint asserts claims for RICO violations, common law fraud, negligence, false advertising, deceptive practices, products liability, and unjust enrichment (Johnson v. Musk , June 16, 2022).

The complaint alleges that Musk and his companies are involved with Dogecoin in a variety of ways:
  • Musk began providing advice to, and sharing his contacts with, Dogecoin’s developers in 2019;
  • Musk and people in his circle began buying the currency;
  • SpaceX named a satellite after Dogecoin, while Tesla accepts it as payment for merchandise;
  • Musk has called on celebrities, influencers, and investors to boost the status of the cryptocurrency;
  • Musk himself has tweeted repeatedly about Dogecoin, with direct effects on Dogecoin’s price, market cap, and trading volume.
As an example of Musk’s influence on the price of Dogecoin, after users chose Musk as the “CEO” of Dogecoin on April Fool’s Day 2019, its price doubled from $0.0020 to $0.0040. By February 2021, Dogecoin was trading at $0.07. When Musk tweeted, “If major Dogecoin holders sell most of their coins, it will get my full support … I will literally pay actual $ if they just void their accounts,” the price of the coin dropped by 35 percent in 3 days. The complaint details other tweets and announcements from Musk that moved the price of Dogecoin. In April 2021, the plaintiff bought Dogecoin at $0.30 per coin; he sold in June 2022 at $0.08.

The plaintiff alleges that Dogecoin is a crypto pyramid scheme because it has no intrinsic or underlying value, it is not a productive asset, and the number of coins is unlimited. Investors buy in the hope, as described by Bill Gates and Warren Buffett, that a “greater fool” comes along to pay more. The complaint cites other prominent investors and economists as likening cryptocurrency in general, and sometimes Dogecoin specifically, to a Ponzi or pyramid scheme because purchasers only make money based on people who purchase after them.

The complaint describes Musk’s previous run-ins with the SEC: his false claim that he had secured funding to take Tesla private, an investigation into possible insider trading by Musk and his brother, and Musk’s delay in disclosing his stake in Twitter. The plaintiff also points to rumors that the FBI is investigating Musk for pumping and dumping Dogecoin. “Since cryptocurrency is not regulated by the SEC, Defendant Musk has tweeted numerous times over the past three years about Dogecoin to manipulate the price without consequence,” the complaint argues.

The case is No. 22-cv-5037.

Friday, June 17, 2022

SEC hints at expanding scope of 'investment adviser' to include index providers

By Anne Sherry, J.D.

The SEC is exploring whether certain “information providers” meet the definition of an investment adviser and thus are subject to the registration requirements and other regulations of the ’40 Acts. Specifically, the Commission issued a request for comment on the nature of activities performed by index providers, model portfolio providers, and pricing services. Chair Gary Gensler said that index funds have evolved to a degree that an index provider can influence users of the index to buy or sell securities, which raises questions about how the SEC can best protect the public (Request for Comment on Certain Information Providers Acting as Investment Advisers, Release No. IA-6050, June 15, 2022).

The request for comment cites the growth in both size and scope of index providers, model portfolio providers, and pricing services. According to the SEC, the evolution of these “information providers” has transformed the asset management industry. The information providers may have the status of investment advisers under the Investment Advisers Act, implicating questions of Advisers Act registration and related questions about whether an information provider is acting as an investment adviser of an investment company under the Investment Company Act.

The SEC highlights the ways in which the three types of information provider may act as investment advisers:
  • Index providers typically determine the market the index measures, designs the index, creates the methodology, and determines the index’s level under that methodology—activities that leave room for significant discretion. The request for comment observes that while indexes tend to be associated with passive investing, index providers make active design decisions, particularly in the case of specialized indexes. “Whether or not an index is specialized, the index provider’s inclusion or exclusion of a particular security in an index drives advisers with clients tracking that index to purchase or sell securities in response.”
  • Model portfolio providers or model originators design allocation models, update or rebalance allocations over time, and provide customization. The SEC notes a growing demand for specialized models focusing on particular industries or strategy, like sustainability or ESG. Model portfolio providers also might tailor their analysis to the characteristics and goals of a general client type or create a customized analysis when creating a model portfolio through the use of direct indexing.
  • Pricing services exercise significant discretion, according to the SEC: determining a valuation methodology to use, developing model templates, determining inputs, adjusting valuations; and addressing pricing challenges raised by users. Different pricing services, or even the same pricing service, may determine different pricing levels for the same security.
Under the Advisers Act, an investment adviser is someone who meets three criteria: (1) the person provides advice, or issues analyses or reports, concerning securities; (2) the person is in the business of providing such services; and (3) the person provides such services for compensation. The advice does not have to relate to specific securities, the SEC notes, and does not have to be the primary business activity of the adviser.

The SEC also posits that the activities conducted by information providers may implicate related concerns under the Investment Company Act, which contains requirements and restrictions in investment advisers to a fund. Index providers could meet the definition of an adviser to a fund under the Investment Company Act if the index is tailored to the specific needs of a fund.

Gensler said that the request will help the SEC determine which information providers fall under the investment adviser definition. Registered funds that track indexes have over $10 trillion of assets under management and range from broad-based indexes to specialized funds designed for particular users. The corresponding influence means “an index provider’s decision to include a particular security in an index often influences users of the index to purchase or sell securities,” raising questions about whether the index provider is providing investment advice, Gensler said. Model portfolio providers and pricing services have also grown and evolved, raising questions about the SEC’s oversight and investor protection.

The request seeks comment on whether information providers are acting as investment advisers and how existing rules should apply to providers that do not currently fit neatly into the existing regulatory structure. Gensler said that given the changes in the asset management field since the bulk of SEC staff statements were issued in the 1980s and 1990s, “it is appropriate to seek comment on information providers to consider if regulatory action is appropriate. Some elements of the definition may not be interpreted consistently by market participants. Thus, I believe the market may benefit from further guidance with respect to their applicability to some information providers.”

The comment period will remain open for 60 days after the request was published on sec.gov or 30 days after it is published in the Federal Register, whichever is longer.

This is Release No. IA-6050.

Thursday, June 16, 2022

Securities law academics urge SEC to do more on human capital

By Mark S. Nelson, J.D.

According to a group of law professors, the SEC should adopt a new round of human capital disclosure rules in order to afford investors greater clarity about the accounting treatment companies employ regarding the costs of developing their labor forces. Specifically, the rulemaking petition would require companies to explain to investors which labor costs are treated by them as investments, as opposed to expenses. The petition was signed by 10 securities law professors, including former SEC commissioners Robert J. Jackson, Jr. and Joseph A. Grundfest, along with John C. Coates IV, who recently served as General Counsel and Acting Director of the SEC’s Division of Corporation Finance until returning to academia.

“We differ in our views about the regulation of firms’ relationships with their employees generally. But we all share the view that investors need additional information to examine whether and how public companies invest in their workforce—and that the Commission’s rules should therefore require that information to be disclosed,” said the petition’s authors. “Here, we focus on key elements of that information that we all agree are important.”

MD&A and tabular disclosure. The centerpiece of the law professors’ petition would be a combination of narrative disclosure made via the Management’s Discussion & Analysis section of Form 10-K and a tabular disclosure that would separate out key employee compensation metrics. According to the petition, discussion of human capital in the MD&A could elicit a company’s views on which labor costs it views as expenses and which labor costs it views as investments. Breaking out labor costs in this way, said the petition, could help investors decide which labor costs incurred by a company should be capitalized, with the added benefit of encouraging companies to treat their employees more as a source of value creation.

The law professors suggested that the proposed tabular disclosure would complement the qualitative disclosures proposed to be made in the MD&A. The law professors also said they agreed with statements made by Sen. Mark Warner (D-Va) in a 2018 letter he sent to then-SEC Chair Jay Clayton in which the senator cautioned that companies that elect to invest in their employees can be perceived by the marketplace under current accounting practices as incurring expenses with the result that investors punish such companies.

The tabular disclosure would emulate existing disclosures for executive compensation. As a result, a human capital chart would focus on items such as mean tenure, turnover, number of employees, salaries, stock options, and other employee compensation topics, including health care and training.

The petition’s authors said their proposal was designed to minimize the costs of regulation and that much of what they propose would fit well within existing accounting frameworks. The petition also asserted that more detailed human capital disclosures are needed because of a global shift in the types of assets companies have from physical assets to intangible assets, including employees.

Current human capital rule. In August 2020, the SEC adopted revisions to Regulation S-K that, among other things, mandate disclosure, to the extent material to understanding a company's business as a whole, information about human capital resources, including the measures or objectives the company uses to manage the business. The requirement covers the number of employees, but also suggests other metrics, such as measures or objectives that address the development, attraction and retention of personnel.

However, with respect to many of the metrics mentioned in the current rule, the Commission explained that they are treated as “examples,” and are not mandatory in nature. Said the commission: “We emphasize that these are examples of potentially relevant subjects, not mandates. Each registrant’s disclosure must be tailored to its unique business, workforce, and facts and circumstances. Consistent with the views expressed by some commenters, we did not include more prescriptive requirements because we recognize that the exact measures and objectives included in human capital management disclosure may evolve over time and may depend, and vary significantly, based on factors such as the industry, the various regions or jurisdictions in which the registrant operates, the general strategic posture of the registrant, including whether and the extent to which the registrant is vertically integrated, as well as the then-current macro-economic and other conditions that affect human capital resources, such as national or global health matters (footnotes omitted).”

Legislation. Legislation on further SEC human capital rules has tended to cover a wide range of topics from diversity and inclusion to offshoring. One of the more targeted bills, however, the Workforce Investment Disclosure Act (S. 1815; H.R. 3471), sponsored by Sen. Warner and Rep. Cynthia Axne (D-Iowa), would require disclosures on a range of topics similar to other bills but with an added emphasis on workforce metrics.

Specifically, companies would have to disclose information about: (1) workforce demographics; (2) turnover; (3) composition (e.g., racial, ethnic, and gender composition); (4) skills and capabilities (e.g., training); (5) health safety, and wellbeing; (6) compensation and incentives; (7) recruiting; and (8) engagement and productivity (e.g., mental well-being of employees and contingent workers as well as freedom of association and work-life balance initiatives). To the maximum extent feasible, data would have to be presented in disaggregated format by workforce composition, wage quintiles, and employment status (e.g., full time or part time). The SEC would be granted authority to exempt emerging growth companies from some of the disclosure requirements. The bill also would explicitly make it unlawful to make false or misleading statements about workforce disclosures but a person could avoid liability if they acted reasonably; however, the bill would bar private causes of action.

A prior version of the Warner-Axne bill (H.R. 5930) was reported on party lines by the House FSC on February 28, 2020 by a vote of 33-25. The current version was included in Title VI of the Corporate Governance Improvement and Investor Protection Act (H.R. 1187), sponsored by Juan Vargas (D-Calif), which passed the House on June 16, 2021 by a vote of 215-214.

Wednesday, June 15, 2022

Deutsche Bank CEOs undermined AML systems to keep ultra-rich, but risky clients

By Rodney F. Tonkovic, J.D.

A complaint alleging that top Deutsche Bank executives overruled compliance staff to keep or continue relationships with rich, but risky clients, such as Jeffrey Epstein and Russian oligarchs survived dismissal. According to the complaint, Deutsche Bank's former and current CEOs were personally involved in securing relationships with very rich but high-risk clients for the bank's wealth management business and that these clients were essentially not vetted at all. Despite this practice, the CEOs signed statements describing the bank's efforts to strengthen its anti-money laundering and know-your-customer processes. The court found that that the complaint adequately alleged that the CEOs know about the deficiencies in the banks practices that made their statements false and misleading (Karimi v. Deutsche Bank Aktiengesellschaft, June 13, 2022, Rakoff, J.).

Risky business. This securities fraud suit arises from the requirement that Deutsche Bank maintain anti-money laundering ("AML") and know-your-customer ("KYC") systems to prevent money laundering. The complaint alleged that several recent Deutsche Bank CEOs and CFOs misrepresented the bank's AML and KYC processes between March 2017 and May 2020. Specifically, allegations from eleven confidential witnesses working in the bank's compliance department describe that the procedures did not work as described, or, in the case of certain rich and risky clients, were effectively nonexistent.

According to the confidential witnesses, Deutsche Bank executives routinely overruled the AML and KYC staff when it came to doing business with high-risk and politically-exposed clients. These clients included convicted sex trafficker Jeffrey Epstein, notorious Russian oligarchs, founders and funders of terrorist organizations, and people associated with Mexican drug cartels. Despite identified risks, the complaint says, the decision to take these risky clients on board through the bank's wealth management business was made at the highest levels. These clients were then given special exceptions from the KYC procedures because of the amount of business they generated. Despite internal audits finding AML and KYC deficiencies, the Deutsche Bank defendants made public statements that the bank was exiting risky relationships while strengthening its on-boarding process for higher-risk clients, including specifics about strict KYC procedures. When Deutsche Bank's relationships with these clients were revealed, its stock lost value and harmed the investor plaintiffs.

Beyond puffery. Deutsche Bank first argued that the challenged statements were merely aspirational or puffery. The court disagreed, finding that the statements went beyond mere puffery because they provided specific descriptions of the bank's client-vetting processes and continuous monitoring that the complaint alleged were routinely ignored or did not exist in practice for certain high-net-worth and politically connected clients. And, this failure to apply policies was material because these clients were a likely source of problems.

Deutsche Bank then asserted that its failures were already well-known to investors. The bank argued that the complaint relied on a number of news articles and government reports revealing that its AML and KYC processes had failed to stop criminals from laundering money and that Deutsche Bank itself had acknowledged "weaknesses" over the years. The court rejected the suggestion that Deutsche Bank's general disclaimers could be used to substantively mitigate the effect of specific alleged misrepresentations. Plus, as a procedural matter, the "truth-on-the-market" defense is generally inappropriate for dismissal on the pleadings because of its fact-specific nature.

Falsity alleged. Deutsche Bank then contended that the complaint failed because it did not allege that the bank never reviewed or attempted to improve its processes. The court acknowledged that there was something to this argument because some of the challenged statements spoke only about the bank's efforts to improve. But even these statements could be misleading where the efforts to improve screening were systematically undermined by executives seeking to on-board ultra-rich clients; the allegations in this case went beyond mere mismanagement. The court therefore concluded that the complaint adequately alleged falsity because the challenged statements allegedly misrepresented the bank’s AML and KYC practices, not just that its management failed to successfully implement in all cases policies that were generally adequate and appropriately described.

Scienter for CEOs. Finally, the court found that the complaint alleged scienter against Deutsche Bank's CEOs, but not against its CFOs. During the time at issue, John Cryan was Deutsche Bank's CEO until April 2018, and he was succeeded by Christian Sewing, who still holds that position. The complaint identified several reports of investigations by government regulators and settlements that provided red flags pointing to deficient AML and KYC practices as applied to high-risk clients. It was sufficiently plausible at this stage to the court that the CEOs, by virtue of their positions, were aware of these proceedings, and Sewing was specifically alleged to have been aware of them. In addition, there were news reports of internal audits to which Deutsche Bank replied by publicly denying that its systems were deficient, and such denials are sufficient to support an inference of scienter. Allegations by confidential witnesses that the top executives were personally involved in the decisions surrounding high-risk clients bolstered the inference of scienter. However, the court found that the complaint alleged no connections between Deutsche Bank's CFOs and the deficiencies at issue and dismissed the claims against them.

The case is No. 22-cv-2854.

Tuesday, June 14, 2022

CII supports SEC’s call for enhanced disclosure by SPACs

By John Filar Atwood

The Council of Institutional Investors (CII) has thrown its support behind the SEC’s proposed rule addressing special purpose acquisition companies (SPACs), calling it “meaningful reform” that addresses gaps in transparency between the SPAC route to the public markets and other routes. CII said that there is an urgent need to adopt a final rule in this area given that nearly 600 SPACs are now actively searching for private company merger partners.

The SEC’s proposal includes measures to strengthen investor protections in initial public offerings by SPACs and in business combinations between SPACs and private operating companies (de-SPACs). In a comment letter on the proposal, CII agreed with the Commission’s proposals to:
  • clarify the obligation of SPAC sponsors and their affiliates to disclose all material conflicts of interest;
  • bring greater clarity to dilution under various SPAC share redemption scenarios;
  • ensure that underwriter status and liability under 1933 Act Section 11 apply to SPAC underwriters who participated in the distribution of shares by taking steps to facilitate the de-SPAC (but not to private investment in public equity (PIPE) investors in SPACs);
  • establish private operating companies merging with SPACs as co-registrants; and
  • clarify that the Private Securities Litigation Reform Act (PSLRA) safe harbor with respect to forward-looking statements does not apply to the de-SPAC merger proxy.
CII has no objection to there being more than one avenue for private companies to go public since more paths to the public markets promotes capital formation. However, it is critical that those paths—traditional IPO, de-SPAC merger, or direct listing—offer consistently robust investor protections, the group stated.

Misalignment of interests. In addressing some of the proposing release’s specific questions, CII said that it supports improving and codifying disclosure to clarify the misalignment of interests between the sponsor or its affiliates or the SPAC’s officers, directors or promoters, and unaffiliated security holders, as proposed. The group believes that there should be mandatory disclosures of conflicts of interest among SPAC directors, SPAC officers, target company directors, and target company officers.

CII also supports disclosure that would shed light on how compensation arrangements and other financial incentives create fundamental differences in outcome priorities among participants. In CII’s opinion, the de-SPAC proxy should describe the differences in priorities and how they may impact voting decisions on the business combination.

Dilution. CII also said that it favors including disclosure of net cash per share after taking into account all sources of dilution and dissipation of cash, under various redemption scenarios. The group feels that given the complexity and contingencies involved in the de-SPAC process, investors—particularly SPAC investors who are considering declining the redemption opportunity—need clear information about potential consequences to inform their understanding of the true cost of the business combination.

CII supports requiring tabular disclosure in the de-SPAC proxy that illustrates net cash per share after taking into account all sources of dilution and dissipated cash under 25 percent, 50 percent, 75 percent, 90 percent, and 100 percent redemption scenarios. Citing a recent study by three securities experts that recommended using a 90 percent redemption scenario, the group said that it would not object if the SEC’s proposal were modified to adopt the methodology outlined in that study.

Accountability. CII would like to see the SEC require that the SPAC and the target company act as co-registrants upon filing of the registration statement in connection with the de-SPAC. In CII’s view, treating both the SPAC and the target as an issuer under 1933 Act Section 6(a) would help to align investor protections with those of a traditional IPO.

The group advised the SEC that a narrow interpretation exempting the target company as a registrant is inappropriate given that the de-SPAC serves the same practical purpose as a private company entering the public markets through a traditional IPO, and the extent to which private companies have embraced the de-SPAC option.

CII also favors the proposed amendments to the signature instructions of Form S-4 to require that officers and a majority of the board of the target company are liable for any material misstatements or omissions in the S-4. This would ensure that they are accountable for the accuracy of the registration statement under 1933 Act Section 11, the group said.

Safe harbor. On the question of whether clarifying that the safe harbor under the PSLRA is unavailable would improve the quality of projections in connection with de-SPAC transactions, CII offered its view that uncertainty surrounding the availability of the safe harbor may have contributed to the proliferation of unreasonably optimistic forward projections that would not have been made if liability had more clearly paralleled the traditional IPO regime. Accordingly, CII supports the proposal’s revision to the definition of “blank check company” to ensure that the safe harbor against a private right of action for forward-looking statements under the PSLRA is not available.

CII also stated that it favors the enhanced investor protection that would result from assigning underwriter status for the de-SPAC transaction to a person who has acted as an underwriter in a SPAC IPO and participates in the distribution by taking steps to facilitate the de-SPAC transaction. The group supports limiting the application of proposed Rule 140a so that PIPE investors in the SPAC are excluded. CII believes that PIPE investors do not fit the traditional function of an underwriter, and that including PIPE investors in Rule 140a could significantly reduce investor appetite to backstop this route to entering the public markets.

Monday, June 13, 2022

Appeals court affirms SEC subpoena order in digital assets investigation

By Joanne Cursinella, J.D.

The Second Circuit affirmed a district court order requiring compliance with SEC investigative subpoenas for documents from appellants Terraform, a Singapore-based company, and Do Kwon, a foreign national, as well as testimony from Kwon, that were served as part of an SEC investigation into whether the appellants violated federal securities laws in their participation in the creation, promotion, and offer to sell various digital assets related to the "Mirror Protocol," a blockchain technology (SEC v. Terraform Labs Pte Ltd., June 8, 2022, per curiam).

According to the appellate court's summary order, the appellants had argued on appeal that the SEC violated its Rules of Practice when it served the subpoenas by handing copies to Kwon, Terraform's CEO, while he was present in New York, and that the district court lacked personal jurisdiction because Kwon and Terraform had insufficient contacts with the United States. The appeals court rejected the arguments and found first that the method service of the subpoenas was in compliance with the rules, as the district court had held, and also confirmed that personal jurisdiction over the appellants was proper.

Service. According to the order, the appellants had agreed to provide certain information to the SEC voluntarily but after attempts at voluntary compliance, the SEC prepared the investigative subpoenas. A process server hand-served the subpoenas on Kwon on behalf of the SEC while he was in New York and emailed copies to the appellants’ counsel.

This court found that the method of service under the circumstances was in compliance with the Commission’s rules. The SEC could serve the corporate entity Terraform through Kwon, the company’s CEO and authorized agent. The appellants had also argued, alternatively, that the copies of the subpoenas emailed to their counsel did not satisfy the rules because the email “did not purport to have effected service” via their counsel and was therefore not valid service.

But the court rejected this, saying, among other things, that their reading of the rules is contrary to the text and would produce absurd results by allowing a party to insist on service through counsel, but allow the party to block the service by not authorizing their counsel to receive any filings.

Personal jurisdiction. This court also confirmed that the district court properly concluded that it had personal jurisdiction over the appellants. The lower court’s specific personal jurisdiction determination rested on seven contacts with the U.S., this court noted. Further, the appellants purposefully availed themselves of the U.S. by promoting the digital assets at issue in the SEC’s investigation to U.S.-based consumers and investors. They also retained U.S.-based employees to promote digital assets in the U.S, entered into agreements with U.S.-based entities to facilitate the trade of the digital assets, and, while seeking to enter into an agreement with a U.S.-based company, the appellants indicated that 15 percent of its Mirror Protocol users are within the U.S.

Finding that the district court’s jurisdiction over the appellants arose from such "purposeful and extensive U.S. contacts” and that the district court’s exercise of jurisdiction was reasonable and would not “offend traditional notions of fair play or substantial justice” because the conduct was “purposefully directed” toward U.S. residents and the suit arose from and related directly to those contacts, the appeals court affirmed the lower court’s decision.

The case is No. 22-368-cv.

Friday, June 10, 2022

PCAOB’s newly reconstituted Investor Advisory Group meets for first time since 2018

By John Filar Atwood

The PCAOB yesterday began to follow through on Chair Erica Williams’ promise to be more transparent and to actively seek engagement with stakeholders with its first public-facing Investor Advisory Group (IAG) meeting in four years. Williams reiterated the importance of having a dedicated forum for investor advocates and expressed her hope that the IAG will provide ongoing feedback on the PCAOB’s oversight activities.

The IAG had not met since 2018, and ultimately was dissolved in March 2021 by former Chair William Duhnke III in favor of a standards advisory group whose meetings were not open to the public. Williams reestablished the IAG and the Standards and Emerging Issues Advisory Group in January after taking over as PCAOB Chair.

IAG members seemed to welcome the PCAOB’s renewed focus on stakeholder engagement. Lynn Turner, a member of the previous IAG who is now with Hemming Morse, said that recently the Board has garnered a reputation of being a “bastion of darkness” and expressed his hope that the advent of the new IAG will begin to change that. PCAOB Member Kara Stein assured Turner that with the IAG’s help the new Board intends to be a “bastion of transparency.”

In addition to organizational matters, at the meeting IAG members began to offer recommendations on what they believe should be Board priorities as it seeks to enhance its role in protecting investors.

Audit quality indicators. Jack T. Ciesielski, president of R.G. Associates, believes the PCAOB should focus on providing, in machine-readable format, audit quality indicators (AQIs) to provide some color on how an audit firm is doing. The current pass/fail model is insufficient in his opinion. Investors will not be engaged unless you give them data to work with, he added.

Turner agreed with Ciesielski, noting that AQIs were first raised as a possibility in the 2008 Treasury Department report prepared in the wake of the global financial crisis. Turner’s advice for the current Board is that it go back and review the recommendations in that report, and work toward adopting some of the initiatives that were never acted upon, including AQIs.

He noted that several years ago there was a push for AQIs, including a 2015 concept release, but the effort ultimately went nowhere. He recalled that at that time the Standing Advisory Group discussed how the Board should go about determining audit quality and to his surprise some people argued that the PCAOB could not define or measure audit quality. IAG member Sandra Peters, head of global advocacy at the CFA Institute, recalled that debate and said it is time to push past those objections and put AQIs in place.

Gina Sanchez, CEO of Chantico Global, believes it is imperative that the PCAOB focus on the usability of its data, especially its inspection reports and enforcement actions. Those are currently provided as PDF documents, which is an extremely search-unfriendly format, she said. She asked the Board to consider putting its information into a data architecture that is more easily searchable. Bill Ryan, deputy director in the PCAOB’s Division of Enforcement and Investigations, responded by noting that the search feature has improved in recent months but the staff is discussing how to further improve accessibility in the future.

Climate concerns. David Pitt-Watson, a visiting fellow at the Cambridge Judge Business School and former chair of the U.N. Environment Program’s Finance Initiative, recommended that the PCAOB take steps to require climate disclosure. For all of the advantages of the U.S. auditing system, this is one area where it is lagging behind its international peers, he said.

Pitt-Watson said that for many companies climate is already a clear financial risk. The International Auditing Assurance Standards Board has been clear that it wants companies to report material issues in their disclosure, he noted, and the PCAOB should move in that direction. It is a critical issue for investors, and the risks need to be disclosed and the assumptions shown, he stated.

Jeff Mahoney of the Council of Institutional Investors asked the Board to consider that disclosure surrounding critical accounting matters (CAMs) is much better in the U.K. than in the U.S. He recommended that the PCAOB study why the U.K. CAM disclosure is so much closer to what investors want than what is being reported by U.S. firms. Mahoney suggested that one underlying reason is that U.K. auditors report what they found in an audit, while U.S. auditors report what they did in an audit.

Independence. Mary Bersot, CEO of Bersot Capital Management, pointed out that there is still a prevailing perception that auditors are not independent. They work many years with the same companies and same personnel, she said, noting that auditor rotations were never implemented in the U.S. She asked the PCAOB to explain what independence is, especially as the Big Four firms have returned to a business model where consulting services are driving their revenues.

Kara Stein concluded the forward-looking discussion by reiterating that the PCAOB and the new IAG are starting with a clean slate, and the Board is open to any and all ideas. Technology and data are revolutionizing the way people invest, she said, so should the PCAOB change the way it regulates? Stein said the Board eagerly anticipates out-of-the-box discussions with IAG members on key issues going forward.

Thursday, June 09, 2022

Gensler outlines likely approach to updating national market system rules

By John Filar Atwood

Certain elements of the national market system rules such as those related to order handling and execution have not been updated since 2005, and SEC Chair Gary Gensler intends to change that. Citing issues exposed by the GameStop meme stock events of 2021, including imbalances created by dark pool and wholesale trading, he has the Commission staff working on proposals to update national market system rules.

In remarks at the Piper Sandler Global Exchange Conference, Gensler outlined the many questions he posed to the staff to help it construct effective market system rule changes. It is a complex and multi-faceted area, so his questions were spread across the following six topics: (1) minimum pricing increment; (2) national best bid and offer (NBBO); (3) disclosure of order execution quality; (4) best execution; (5) order-by-order competition; and (6) payment for order flow, exchange rebates, and related access fees.

Minimum pricing increment. He is concerned about the disparities among the different trading venues over the minimum increments at which securities are priced, or tick size. In transparent markets, he noted, investors see prices in one-penny increments while wholesalers can fill orders at sub-penny prices and without open competition. In his view, all venues should have an equal opportunity to execute at sub-penny increments.

Accordingly, he asked staff to make recommendations around leveling the playing field with respect to two facets of tick size. The first is possibly harmonizing the tick size across different market centers so that all trading occurs in the minimum increment. The second is potentially shrinking the minimum tick size to better align with off-exchange activity given the sheer volume of off-exchange sub-penny trading.

NBBO. Gensler said that he has asked the staff to consider three issues related to the NBBO, which is a quote designed to aggregate information across different exchanges. The NBBO provides important pre-trade transparency to investors, he added.

One key issue, he said, is that the NBBO only includes round lots of 100 shares or more. Recent staff calculations indicate that in March 2022, 55 percent of trades were executed at odd lots. Gensler noted that retail investors, the investors most likely to buy or sell at odd lots rather than in 100-share lots, are unable to see the odd-lot prices.

To address this issue, the Commission adopted a new market infrastructure rule in March 2020 that created a new round lot definition of between 100 shares and one share and added odd-lot information to core market data. The problem, according to Gensler, is that under the transition schedule for the rule implementation of the new definition could be years away. Accordingly, he has asked the staff to consider whether the Commission could accelerate implementation of the new round lot definition.

Gensler also asked the staff to consider whether it can move up the transparency rules surrounding odd-lot trading data. He said that he also has asked the staff to think about whether the SEC should create an odd-lot best bid and offer so that investors would know the best price available in the market regardless of share quantity.

Order execution quality. Another problem with the national market system rules is that retail investors cannot compare execution across brokers, such as how much price improvement they provide to their clients, he said. The problem stems from the fact that only market centers such as dark pools, wholesalers, and exchanges are required to provide those disclosures in monthly Rule 605 reports.

Gensler would like the staff to make recommendations around how the Commission might update Rule 605 so that investors receive more useful disclosure about order execution quality. He also requested recommendations on whether to require that all filers of 605 reports provide summary statistics of execution quality, such as the price improvement as a percentage of the spread.

Best execution. On the issue of best execution, Gensler believes it is time for the SEC to consider proposing its own best execution rule. At the moment, only FINRA and the Municipal Securities Rulemaking Board have rules on best execution requiring broker-dealers to exercise reasonable diligence to execute customer orders in the best market so that customers receive the most favorable prices under prevailing market conditions.

In addition to asking the staff to consider a new best execution rule, he also believes that broker-dealers and investors might benefit from more detail around the procedural standards brokers must meet when handling and executing customer orders.

Order-by-order competition. Gensler is interested in a regulatory approach that best promotes as much competition as possible for retail investors on an order-by-order basis. Standing in the way is market segmentation, including the movement of a majority of retail marketable orders to wholesalers who pay for that order flow. The segmentation isolates retail orders and may not benefit the retail public as much as orders being exposed to order-by-order competition, he said.

He asked the staff to propose an approach to enhance order-by-order competition, which may be through open and transparent auctions or other means. In considering any recommendations for stock auctions, Gensler suggested that the staff draw upon lessons from the options market, which has been operating auctions for retail orders for many years.

Payment for order flow. Finally, Gensler addressed the issues of payment for order flow, exchange rebates, and related access fees. The staff’s GameStop report said that payment for order flow may incentivize broker-dealers to use digital engagement practices such as gamification to increase customer trading, he noted, adding that the European Union is actively considering banning payment for order flow.

He asked the staff to draft recommendations on how to mitigate conflicts surrounding payment for order flow, and to address the payment of rebates to traders by exchanges. Specifically, he suggested that the staff consider is whether exchange fees—what someone pays to access a quotation on an exchange—and rebates should be more transparent. He also requested a staff analysis of how the access fees might change in light of a potentially lower minimum tick size, noting that a lower minimum pricing increment might require proportionately lower access fee caps.

Wednesday, June 08, 2022

Senators introduce bill proposing federal scheme to regulate digital assets

By Mark S. Nelson, J.D.

The presumed purpose of the Lummis-Gillibrand Responsible Financial Innovation Act, sponsored by its namesakes, Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-Wyo), would be to bring unified federal oversight to bear on digital asset markets in the U.S. but without crushing the blockchain industry. At this point, many such bills have been introduced but they have tended to deal with discrete issues and discrete federal agencies. Earlier this year, a group of House lawmakers introduced a bill to grant the CFTC primary authority over digital assets and that bill will inevitably invite comparisons to the Lummis-Gillibrand bill (FAQ), which more broadly and simultaneously addresses securities, commodities, tax, and banking aspects of digital asset markets. Another, somewhat more focused bill, also introduced in the House, would target some of the same topics as the Lummis-Gillibrand bill but with a narrower scope.

Bipartisan efforts. The Lummis-Gillibrand bill is the Senate response to bipartisan House legislation introduced in late April 2022. “The United States is the global financial leader, and to ensure the next generation of Americans enjoys greater opportunity, it is critical to integrate digital assets into existing law and to harness the efficiency and transparency of this asset class while addressing risk,” said Sen. Lummis via press release.

“Digital assets, blockchain technology and cryptocurrencies have experienced tremendous growth in the past few years and offer substantial potential benefits if harnessed correctly,” said Sen. Gillibrand. “It is critical that the United States play a leading role in developing policy to regulate new financial products, while also encouraging innovation and protecting consumers.”

This article will focus on the SEC and CFTC provisions in the Lummis-Gillibrand bill, although there are also significant provisions dealing with taxation and banking. Moreover, the following provisions in the bill would address a variety of issues:
  • An interstate regulatory sandbox.
  • Annual reporting by the Federal Energy Regulatory Commission to Congress regarding, among other things, energy consumption for mining and staking of digital asset transactions.
  • Cybersecurity standards for digital asset intermediaries.
  • An SEC/CFTC study and report to Congress regarding the appropriate principles for establishing a registered digital asset self-regulatory organization.
With respect to comparisons, this article will focus on the Lummis-Gillibrand bill and the Digital Commodity Exchange Act of 2022 (H.R. 7614), sponsored by House Agriculture Committee Ranking Member Glenn “GT” Thompson (R-Pa), and co-sponsored by fellow Agriculture Committee member Rep. Ro Khanna (D-Calif), and non-committee members Rep. Tom Emmer (R-Minn) and Rep. Darren Soto (D-Fla), which purports to offer a federal regulatory alternative to firms that would otherwise have to comply with multiple state money transmitter laws. The comparison is especially relevant regarding the CFTC. For further comparison, readers also may wish to examine the Digital Asset Market Structure and Investor Protection Act (H.R. 4741), introduced by Rep. Don Beyer (D-Va), which would address the treatment of digital assets by the SEC and CFTC, central bank digital currencies (CBDCs), and anti-money laundering regulations.

Securities provisions. The Lummis-Gillibrand bill would establish a presumption that what the bill calls an “ancillary asset” is a commodity and not a security, although the SEC would retain some enforcement authorities over ancillary assets. In order to take advantage of the presumption, an issuer of an ancillary asset would have to meet certain SEC disclosure obligations that address information related to the corporate structure and history of the ancillary asset’s issuer and the risk factors affecting the ancillary asset.

More specifically, if an issuer contemplates an offering that would involve an investment contract related to an ancillary asset and the issuer furnishes the required SEC disclosures, the ancillary asset would be presumed to be a commodity and not a security. “Ancillary asset” would be defined to mean an “intangible, fungible asset that is offered, sold or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract.” The term, however, would not include certain equity, debt, liquidation, dividend, and profit and revenue sharing arrangements.

For comparison, the Lummis-Gillibrand bill would define “digital asset” to mean a natively electronic asset that: (i) confers economic, proprietary, or access rights or powers; and (ii) is recorded using cryptographically secured distributed ledger technology, or any similar analogue; the term would include: (i) virtual currency and ancillary assets, (ii) payment stablecoins; and (iii) other securities and commodities. The Thompson bill would define “digital commodity” to mean “any form of fungible intangible personal property that can be exclusively possessed and transferred person to person without necessary reliance on an intermediary” (the definition provides for exclusions similar to those contained in the Lummis-Gillibrand bill’ definition of “ancillary asset”).

The presumption regarding an ancillary asset, however, could be lost if a “court of the United States” (presumably only federal courts) finds that there is no substantial basis for the presumption. Elsewhere, the proposed bill would not deny the presumption solely because an issuer failed to meet its SEC disclosure obligations.

The SEC disclosure obligation itself would be subdivided into three separate obligations regarding initial disclosure, ongoing disclosure, and a transition rule for disclosures regarding ancillary assets provided before January 1, 2023. Each of the three disclosure obligations has a time-frame built into it regarding the fiscal years covered but otherwise comes into effect for an issuer of an ancillary asset based on the average daily aggregate value offered or traded on all spot markets (must be greater than $5 million) and whether the issuer (or a 10 percent owner of the issuer’s equity securities) engaged in entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset.

An issuer of an ancillary asset would be able to voluntarily furnish information to the SEC about the ancillary asset if the issuer believes it is reasonably likely that it will become subject to the disclosure requirement in the future.

The SEC also would be granted authority to exempt an ancillary asset from the disclosure requirement if it determines that the public policy goals of disclosure and of consumer protection are not satisfied by requiring such disclosure. The SEC also could issue rules and guidance to implement the disclosure requirement.

The bill would provide that the disclosure requirement for an ancillary asset would end 90 days after an issuer files (and not merely furnishes, as would be the case for the disclosure obligation) a certification supported by reasonable evidence after due inquiry that the average daily aggregate value of all trading for the preceding 12 months was equal to or less than $5 million or that the issuer did not engage in that same period in any entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset. The SEC could deny an issuer’s certification if the certification was not based on substantial evidence, although an issuer could try again to certify that it may end its disclosure obligation.

The remaining securities provisions in the bill concern the modernization of Exchange Act Rule 15c3-3 regarding customer protection and clarifying what is a satisfactory control location while also clarifying the role of broker-dealers in the trading of digital assets.

Commodities provisions. The commodities provisions in the Lummis-Gillibrand bill largely mirror those contained in portions of the Thompson bill regarding the treatment of digital asset exchanges, although with some minor semantic differences. In this context, the Thompson bill contains a number of CFTC provisions that do not have precise counterparts in the Lummis-Gillibrand bill. Other provisions regarding CFTC transaction fees appear only in the Lummis-Gillibrand bill.

With respect to segregation of customer digital assets, the Lummis-Gillibrand and Thompson bills both provide generally that, regarding the holding of customer assets that “[e]ach futures commission merchant [FCM] shall hold customer money, assets, and property in a manner to minimize the customer’s risk of loss of, or unreasonable delay in the access to, the money, assets, and property.” The Lummis-Gillibrand bill would require customer property to be held by a licensed, chartered, or registered entity regulated by the CFTC, the SEC, federal or state bank regulators, or an appropriate foreign bank authority. The Thompson bill would provide for an FCM to hold customer property in a qualified digital commodity custodian. The Lummis-Gillibrand and Thompson bills have nearly identical provisions regarding the related topic of the segregation of customer funds.

Both the Lummis-Gillibrand and Thompson bills provide that a registered FCM cannot act as a counterparty in any agreement, contract, or transaction involving a digital asset that has not been listed for trading on a registered digital asset exchange. That suggests the main provision in both bills regarding the registration of, as the Lummis-Gillibrand bill calls them “digital asset exchanges,” while the Thompson bill calls them “digital commodity exchanges.” Thus, both bills provide that any trading facility that offers or seeks to offer a market in digital assets may register with the CFTC as a digital asset exchange by submitting the prescribed application. Both bills also provide that a registered designated contract market (DCM) or registered swap execution facility (SEF) that meets certain requirements may elect to be considered a registered digital asset exchange/digital commodity exchange.

Both the Lummis-Gillibrand and Thompson bills further provide that a registered digital asset exchange/digital commodity exchange may make available for trading any digital asset that is not readily susceptible to manipulation. This provision would address some of the issues identified by the SEC, for example, in that agency’s earlier disapprovals of exchange-traded products. Both bills likewise provide that registration as a digital asset exchange/digital commodity exchange would not permit a trading facility to offer any contract of sale of a commodity for future delivery, option, or swap for trading without also being registered as a DCM or SEF.

A digital asset exchange/digital commodity exchange would be required to comply with a set of core principles. Moreover, both bills would define “not readily susceptible to manipulation” in nearly identical fashion. Specifically, the phrase “not readily susceptible to manipulation” would mean that a digital asset’s transaction history can be fraudulently altered or its functionality or operation can be materially altered. In making such determination, both bills provide for consideration of the following factors:
  • The purpose and use of the digital asset;
  • The creation or release process of the digital asset;
  • The consensus mechanism of the digital asset;
  • The governance structure of the digital asset;
  • The participation and distribution of the digital asset;
  • The current and proposed functionality of the digital asset;
  • The legal classification of the digital asset; and
  • Any other factor required by the CFTC.
Both the Lummis-Gillibrand bill and the Thompson bill address bankruptcy issues in the context of digital assets. The Lummis-Gillibrand bill would do this through a series of discrete statutory amendments, while the Thompson bill would do this via a provision stating that all assets held on behalf of a customer by a registered digital commodity exchange and all money of any customer received by such exchange is considered customer property for bankruptcy purposes.

The CFTC also would be authorized to collect fees to fund the agency’s regulation of digital asset cash and spot markets under the bill and to recover the costs to the federal government of the annual congressional appropriation to the agency. The CFTC, however, could not impose fees on registered entities relating to leveraged, margined, or financed transactions, including activities relating to digital assets.

The CFTC’s authorization to collect fees would be capped at $30 million absent further congressional authorization. Moreover, the CFTC’s authority to impose and collect fees would only be in effect during a period that a legislative authorization of the CFTC is in effect. That latter provision could raise questions about the CFTC’s current status because the agency has not for many years been formally reauthorized by Congress, despite attempts in recent Congresses to reauthorize the agency but which faltered over political disagreements about the scope of derivatives reforms.

Lastly, much like the SEC already does, the CFTC would have to periodically issue fee rate orders setting the amount or rate of any authorized fees. The CFTC would be able to continue to collect fees at the prior fiscal year’s rate even if there were a lapse in congressional appropriations because of a government shutdown, a scenario that has occurred several times in recent years. Presumably, to the extent the CFTC could collect fees, that part of its appropriation would be to some degree deficit neutral, as is the case for the SEC, which collects transaction fees to offset its entire congressional appropriation.

Tuesday, June 07, 2022

SEC adopts amendments to require glossy annual reports, Forms 144 to be filed electronically

By John Filar Atwood

The SEC voted unanimously to adopt rule amendments that will require 10 documents, including the “glossy” annual report and Forms 144, to be filed electronically through the EDGAR system. The Commission also agreed to mandate the use of inline eXtensible Business Reporting Language (inline XBRL) for filing financial statements and the accompanying schedules to the financial statements required by Form 11-K (Updating EDGAR Filing Requirements and Form 144 Filings, Release No. 33-11070, June 2, 2022).

Citing Form 144 as a prime example, Chair Gary Gensler said that the amendments will make the filing process more efficient and cost-effective. He noted that in 2021 more than half of the 30,000 Forms 144 received by the Commission were filed on paper. Those will now have to be filed electronically, a change that will result in easier access for investors and will reduce processing costs for both filers and the SEC, he said.

The SEC pointed out that electronic filing capabilities have helped address logistical and operational issues raised by the spread of COVID-19. By expanding electronic submissions through the new amendments, the agency believes that filers will be able to more easily navigate any future disruptive events that make the paper submission process unavailable or impractical.

Mandated electronic filing. In all, the amendments mandate the electronic filing of ten documents. They are:
  • “glossy” annual reports,
  • Form 6–K (foreign private issuers),
  • notices of exempt solicitation,
  • notices of exempt preliminary roll-up communications,
  • Form 11–K (employee benefit plans),
  • filings made by multilateral development banks,
  • certifications of approval of exchange listing,
  • Form 144 for reporting issuers,
  • certain foreign language documents, and
  • documents filed pursuant to Investment Company Act Section 33.
The Commission is providing a transition period for compliance with the new requirements to give filers time to prepare to submit the documents electronically in accordance with the EDGAR Filer Manual, including applying for the necessary filer codes. The compliance date is six months after the effective date of the amendments for filers to submit their “glossy” annual reports electronically in accordance with the EDGAR Filer Manual and, other than for Form 144, for paper filers who would be first-time electronic filers. For Form 144, the compliance date is six months after the date of publication in the Federal Register of the Commission release that adopts the version of the EDGAR Filer Manual addressing updates to Form 144 for filing Form 144 electronically on EDGAR.

Form 11-K requirements. The amended rules will require the use of inline XBRL for the filing of the financial statements and accompanying notes to the financial statements required by Form 11-K. The SEC also voted to make certain technical updates to Form F-10, Form F-X, and Form CB to remove outdated references.

According to the SEC’s fact sheet, the compliance date for structured data reporting for Form 11-K is three years after the effective date of the rule amendments. The Commission believes this will give registrants time to transition to a structured data language enabling filings that are both human-readable and machine-readable.

The release is No. 33-11070.