Thursday, March 28, 2024

Rule amendments address investment advisers operating exclusively over the Internet

By R. Jason Howard, J.D.

The SEC has voted to modernize a 22-year-old rule by adopting amendments that apply to when investment advisers who provide advisory services exclusively over the internet can register with the SEC.

In July 2023, the Commission voted 5-0 to issue the internet advisers proposal and, at that time, SEC Chair Gary Gensler explained that in 2002 the SEC granted a narrow exception allowing internet-based advisers to register with the Commission instead of with the states. But in 21 years a lot has changed, and the 2002 exemption created gaps in 2023. The changes, according to a recent statement by the Chair, better reflect what it means in 2024 to provide an exclusively internet-based service and will “better align registration requirements with modern technology and help the Commission in the efficient and effective oversight of registered investment advisers.”

According to the SEC press release, the final rule will require an investment adviser who relies on the internet adviser exemption “to have at all times an operational interactive website through which the adviser provides digital investment advisory services on an ongoing basis to more than one client.” In addition, the amendments will eliminate the current rule’s “de minimis exception for non-internet clients, thus requiring an internet investment adviser to provide advice to all of its clients exclusively through an operational interactive website.”

In connection with the adoption of the final rule, the SEC has released a Fact Sheet which, among other things, explains that compliance with the rule, including the requirement to amend Form ADV to include a representation that the adviser is eligible to register with the Commission under the internet adviser exemption, must be done by March 31, 2025.

Advisers that are no longer eligible to rely on the amended exemption and that do not otherwise have a basis for registration with the Commission must register in one or more states and withdraw registration with the Commission by filing Form ADV-W by June 29, 2025.

Wednesday, March 27, 2024

SEC urges Supreme Court to deny Musk cert petition

By Rodney F. Tonkovic, J.D.

In its response to Elon Musk's petition for certiorari, the SEC argues that Musk's argument fails on its own merits. Musk's argument is based on the unconstitutional-conditions doctrine, but the SEC points out that he forfeited that claim by not making that argument before the district court. Even so, the Court has consistently held that to resolve litigation, parties can choose to waive even fundamental rights. In this case, the SEC says, the settlement was reasonably designed to minimize the likelihood that Musk would violate the securities laws, and further review is not warranted (Musk v. SEC, March 22, 2024).

Tempest in a tweet-up. In October 2018, Elon Musk and Tesla entered into consent judgments with the SEC. Earlier, Musk had tweeted that he had secured sufficient funding to take Tesla private. This tweet, and some similar ones made on the same day, caused Tesla's stock price to jump even though, as the SEC alleged, any such deal was far from certain. Enforcement actions against Musk and Tesla were quickly brought and settled, with Musk, among other concessions, agreeing to comply with procedures designed to reign in his communications about material Tesla business matters.

In 2019, the SEC brought contempt proceedings when Musk made another questionable tweet, and the settlement was revised to specify what is considered material. Musk posted additional tweets concerning his possibly selling part of his Tesla holdings in late 2021, and the SEC served subpoenas on Tesla and Musk; he did not comply and filed a motion to be relieved from the judgment. In 2022, the Southern District of New York rejected Musk’s attempt to back out of the tweet-vetting settlement.

The Second Circuit affirmed in a brief summary order. The panel rejected Musk's argument that changed circumstances made compliance with the consent decree more onerous. There was also no evidence that the SEC used the decree to conduct bad faith, harassing investigations of Musk's protected speech. The panel also pointed out that Musk had voluntarily entered into the consent decree.

Cert petition. Musk's petition for certiorari challenged the constitutionality of the settlement, asking whether his agreement to abide by certain conditions violates the unconstitutional-conditions doctrine. According to Musk, the lower courts erroneously focused on the fact that Musk had waived certain rights when accepting the settlement. The petition argues that under the unconstitutional-conditions doctrine, such conditions are invalid even when the non-governmental party accepted a benefit in exchange.

SEC's response. At the outset, the SEC's response argued that the Second Circuit found that Musk waived his argument that any waiver of his First Amendment rights is unenforceable. Since this issue was not properly preserved or passed on by the lower courts, the Supreme Court should not grant certiorari to review this issue, the SEC says.

The SEC went on to contend that Musk's argument fails on its own terms because the Court has consistently held that to resolve litigation, parties may choose to waive even fundamental constitutional rights. Musk had the choice between forgoing the future exercise of certain rights or proceeding to trial, and his choice of the former reflected a rational judgment.

Even if the argument had merit, the SEC said, this case would be a poor vehicle for evaluating any unconstitutional-conditions argument. Even if Musk had not forfeited the argument, he failed to identify any decision applying the doctrine to the settlement of legal claims, and the cases cited by Musk were not analogous to the matter at hand. To accept Musk's expansive notion of the doctrine would call into question traditional law enforcement practices and deprive parties of the benefits of waivers in settlement agreements. Plus, the settlement was designed to minimize future securities-law violations by Musk: he is not precluded from engaging in any form of speech or required to obtain pre-approval from a government official.

The Commission admits that there are cases suggesting that the government's ability to obtain waivers of First Amendment rights is not unlimited. There is no support, however, for Musk's position that a promise not to engage in activities otherwise protected by the First Amendment can never be a valid settlement term.

Finally, the SEC maintains that review is unwarranted for lack of practical significance. The related Tesla consent judgment produces the "same operational result," and Musk would still be subject to the same pre-approval procedures. Plus, the provision at issue in this case is idiosyncratic and unlikely to affect other litigants.

The case is No. 23-626.

Tuesday, March 26, 2024

Chancery erred in applying MFW framework to cleanse merger

By Anne Sherry, J.D.

The Delaware Supreme Court, sitting en banc, restored a challenge to a squeeze-out merger. While the chancery court was right to dismiss a coercion claim, it erred when it assessed the failure to disclose certain conflicts of interest and management fees. Those disclosure failures meant that the minority stockholders were not adequately informed, and that the transaction was not eligible for the safe harbor of the MFW framework (City of Dearborn Police and Fire Revised Retirement System (Chapter 23) v. Brookfield Asset Management Inc., March 25, 2024, Valihura, K.).

In 2020, a subsidiary of Brookfield Asset Management proposed to acquire the remaining outstanding shares of TerraForm Power, Inc. (Brookfield already owned 62 percent of TerraForm). The subsidiary conditioned its proposal on the approval of an independent special committee and a majority of the minority stockholders. Under the Court of Chancery’s 2013 MFW decision, the business judgment rule applies to a controller-led transaction that employs these two cleansing devices.

The plaintiffs challenged the merger, but the chancery court granted the defendants’ motion to dismiss. The court held that the plaintiffs failed to adequately allege coercion under MFW or that the special committee breached its duty of care by failing to disclose conflicts of interest.

Reviewing this dismissal de novo, the Supreme Court agreed with chancery that the plaintiffs did not state a claim for coercion. The plaintiffs theorized that Brookfield’s presentation of a “no growth” projection for TerraForm amounted to an implicit threat to let TerraForm “wither on the vine” if the special committee recommended against the transaction. But this theory rested on attenuated and unreasonable inferences.

However, the merger proxy’s failure to disclose conflicts of interest and a non-ratable upside for Brookfield rendered it misleading—and the stockholder vote not fully informed. Chancery had considered immaterial an undisclosed conflict of interest centering around Morgan Stanley, which both advised the TerraForm special committee and had $470 million in holdings in Brookfield.

The high court called chancery’s analysis “problematic.” Chancery had concluded that the conflict was not material because of the small size of Morgan Stanley’s stake in Brookfield relative to its overall portfolio, but the materiality determination has to consider the perspective of the stockholder. Delaware law prioritizes transparency in the special committee’s reliance on advisors, and it was reasonably conceivable that Morgan Stanley’s holding nearly half a billion dollars in Brookfield would be material to a stockholder assessing the advisor’s objectivity.

Similarly, the fact that another advisor had represented Brookfield in the past and concurrently represented a Brookfield affiliate should have been disclosed. This ongoing relationship raised the concern that the advisor would not want to push Brookfield too hard.

Furthermore, the proxy was deficient in its failure to disclose certain management fees Brookfield expected to realize from the merger. Knowing that Brookfield expected to gain $130 million in management fees would have helped stockholders evaluate whether Brookfield paid a fair price and whether the special committee leveraged the added value.

The case is No. 241, 2023.

Monday, March 25, 2024

Stay of SEC climate regulation dissolved for now

By Mark S. Nelson, J.D.

The Fifth Circuit today transferred the petition for review filed in that circuit challenging the SEC’s climate risk disclosure regulation that had prompted the court to stay the regulation to the Eighth Circuit and, at the same time, dissolved the administrative stay the court had issued. That order perhaps gives the SEC some temporary relief but under the applicable rules, the Eighth Circuit will have an opportunity to decide whether to re-instate the stay of the regulation (Liberty Energy Incorporated v. SEC, March 22, 2024).

Under 28 U.S.C. 2112(a)(4), a court can stay a matter pending the outcome of a random drawing held by the Judicial Panel on Multidistrict Litigation to designate a federal appeals court to hear multiple, consolidated petitions for review of an agency order. The transfer court may then modify, revoke, or extend the stay.

The Fifth Circuit’s order to dissolve the stay was issued per curiam but, significantly, one judge appeared to disagree with that portion of the order. A footnote to the order said, without any further explanation, that “Judge Jones believes the docket should stay as is pending transfer.”

The SEC also has provided the required notice to the Eighth Circuit that the MDL panel had designated that court to hear the consolidated petitions for review, which total nine. The petitions had been filed in the Second, Fifth, Sixth, Eighth, Eleventh, and D.C. Circuits with petitioners filing in circuits they believed most likely to rule in their favor. Although most of the petitioners are business groups, individual companies affected by the SEC’s regulation, or conservative state attorneys general, two environmental groups, believing the SEC’s final regulation fell short of what had been proposed, also filed suit in the Second and D.C. Circuits.

The case is No. 24-60109.

Friday, March 22, 2024

House committee hearings target SEC ‘overreach,’ escalate push for agency reform

By Suzanne Cosgrove

As the title of the hearing suggested, “SEC Overreach: Examining the Need for Reform,” the House Subcommittee on Capital Markets provided a two-hour forum Wednesday for its mostly Republican members to vent their displeasure with the SEC generally, and Chair Gary Gensler in particular.

In a pre-meeting memorandum, the GOP-led committee said it had “significant concerns” about Gensler’s “rapid push to propose and finalize numerous new rules, insufficient comment periods, neglecting bipartisan congressional concerns, and finalizing new rules that exceed the SEC’s statutory authority.”

The committee is currently reviewing about a dozen pieces of legislation related to the Commission, including H.R.78 – the SEC Regulatory Accountability Act.

A “flood” of rules. “Since taking office in 2021, Chair Gensler has flooded the marketplace with roughly 60 new proposals and more than 30 final rules,” commented Rep. Ann Wagner (R-Missouri).

“Democrats might argue that Chair Gensler has acted in the interest of investors,” Wagner said. “However, investors and companies in both the public and private markets know otherwise and have been raising the alarm through both public comment and the courts.

“Many of these proposed and final rules include sweeping new changes that were advanced without the requisite statutory authority; without a comprehensive cost-benefit analysis; or without satisfying the requirements of the Administrative Procedure Act,” she added.

The best example of this overreach was the SEC’s climate disclosure rule, adopted on March 6, Wagner said.

Her criticism was countered by Rep. Brad Sherman (D-Calif.), who asserted the SEC was just catching up and “is finally doing what we told them to do in Dodd-Frank in 2010.” As for criticisms that comment periods for new SEC rules are too short, they have been averaging about 67 days when measured from the date published on the SEC’s website rather than in the Federal Register, Sherman said.

Think tanks testify. The committee heard testimony from four representatives of think-tank and industry groups, including David Burton, senior fellow in economic policy from the Heritage Foundation and John Gulliver, executive director, Committee on Capital Markets Regulation.

Burton told the committee he believes the SEC does a poor job of informing policymakers of their actions. Further, he claimed the SEC exercises inadequate oversight of self-regulatory organizations and is pursuing “political and ideological objectives, unrelated to its core mission,” when it touched on regulation involving climate and DEI (diversity, equity and inclusion) disclosures.

His sharp critique was followed by comments from John Gulliver, executive director, Committee on Capital Markets Regulation, who said over the last three years, under Chair Gensler, “the SEC has embarked on an unprecedented rulemaking agenda … without a new statutory mandate or a market crisis presenting a need for holistic reform.

“Now is therefore precisely the right time to consider if reform of the SEC’s regulatory processes is needed,” Gulliver added.

Other controversial rules. In addition to heated debate over climate disclosure regulations and concerns that public comment periods are too short, the hearing touched on the SEC’s private fund advisor rule and requirements of the Administrative Procedure Act.

The House is considering legislation that calls for congressional disapproval of the private fund advisor rule. And as reported by Securities Regulation Daily earlier this week, several trade associations have sued the SEC over its dealer rules, alleging the agency has exceeded its statutory authority and has imposed an unnecessary burden on competition.

The trade associations, which represent managers of private funds that will be subjected to an expanded definition of “dealer” and will have to register with the SEC, asked a Texas judge to vacate the rule.

In testimony related to the private fund rules, Alexandra Thornton, senior director, Financial Regulation for Inclusive Economy at the Center for American Progress, noted private funds have grown in size, complexity and number in the past decade since Dodd-Frank Act required private fund advisors to begin registering with the SEC.

The private fund rule “takes on heightened importance given the rapid growth of private markets, generally,” with more capital now raised in the private market than in public markets, leaving pension and other funds materially exposed, she said.

Thornton estimated 5,000 private funds advisors now manage about $18 trillion in private fund assets.

APA requirements. Further, the processes required by the Administrative Procedure Act do not require an agency to make changes in response to every public comment, Thornton said, but rather to solicit relevant information so it can make a “rational connection between the facts found and the choice made.”

However, through numerous challenges to the SEC rulemaking, in court and otherwise, opponents are making the process more burdensome and impeding the ability of the agency to do its job, Thornton said.

Thursday, March 21, 2024

MDL process will decide where SEC climate rule challenge is heard

By Mark S. Nelson, J.D.

The SEC filed the required notice to the Judicial Panel on Multidistrict Litigation informing the MDL panel that the agency had received multiple petitions for review of its recently adopted climate risk disclosure regulation that were filed in multiple federal appeals courts. The next step will be for the MDL panel to hold a random drawing to determine which of the six U.S. Courts of Appeal in which petitions for review have been filed will hear the consolidated petitions for review. Following a ten-day race to court, nine petitions for review have been filed, although four of them were filed in the Fifth Circuit, where two of the petitioners had already sought to join the petition filed by Liberty Energy Inc. that resulted in the Fifth Circuit issuing a stay of the SEC’s regulation (IN RE: Securities and Exchange Commission, MCP No. ___ The Enhancement and Standardization of Climate-Related Disclosures for Investors, Release Nos. 33-11275, 34-99678 (issued Mar. 6, 2024), March 19, 2024).

MDL designation process. The MDL panel becomes involved under 28 U.S.C. §2112 in selecting the federal appeals court to hear a petition for review of an agency order or rule when petitions for review of that rule are filed in multiple federal appeals courts within 10 days of the issuance of the rule. The agency, in this instance the SEC, must then notify the MDL that such a situation exists, and that will trigger a random drawing by the MDL by which it will designate one federal appeals court to hear the consolidated petitions for review.

Specifically, MDL Rule 25.5(a) states: “Upon filing a notice of multicircuit petitions for review, the Clerk of the Panel shall randomly select a circuit court of appeals from a drum containing an entry for each circuit wherein a constituent petition for review is pending. Multiple petitions for review pending in a single circuit shall be allotted only a single entry in the drum.”

The second sentence of Rule 25.5(a) would appear to apply regarding the SEC’s climate risk disclosure regulation because four petitions for review were filed in the Fifth Circuit. The circuit courts that could hear the consolidated petitions for review are the Second, Fifth, Sixth, Eighth, Eleventh, and D.C. Circuits.

Looking ahead. As the designation and appeal process unfolds, look for several issues to arise. First, the applicable statute governing the review of agency orders allows a court to issue a stay, which the Fifth Circuit granted regarding the climate risk disclosure regulation late last week. However, the federal appeals court designated by the MDL panel can modify, revoke, or extend the stay.

Second, expect the SEC to assert that at least some of the petitioners lack standing to bring their petitions. The SEC hinted at this approach in its opposition to Liberty Energy’s request for an administrative stay or stay pending appeal before the Fifth Circuit. There, the SEC said Liberty Energy neither resides nor has its principal place of business within the Fifth Circuit and that the final climate risk disclosure regulation does not require Liberty Energy to investigate another, related, petitioner in which Liberty Energy is a more than 10 percent shareholder, because the regulation grants companies leeway to define their organizational boundaries for purposes of emissions metrics, provided they disclose how they chose the boundaries. Article III standing issues also can arise regarding whether states can challenge federal agency regulations.

Beyond the procedural issues to be worked out in the days and weeks ahead, expect the petitioners’ substantive arguments to focus on the Supreme Court’s major questions doctrine and whether the SEC is seeking to displace EPA regulations that mandate similar GHG emissions disclosures. Also expect the petitioners to argue that the SEC’s regulation ran afoul of the Administrative Procedure Act and that at least portions of the regulation violate the First Amendment. This much has been previewed in the filings made by Liberty Energy and the SEC regarding the stay that was eventually issued by the Fifth Circuit (See, Liberty Energy’s request for stay and SEC’s opposition).

The case is No. Pending MCP No. 8.

Wednesday, March 20, 2024

CFTC Commissioner Johnson highlights potential and risks of AI at MRAC’s Future of Finance Subcommittee meeting

By Elena Eyber, J.D.

The Market Risk Advisory Committee’s (MRAC) Future of Finance subcommittee held a meeting on March 15, 2024, at the CFTC’s Washington, D.C. headquarters. The CFTC Commissioner Kristin N. Johnson's issued an opening statement, highlighting the significant potential and associated risks of artificial intelligence (AI) in various sectors, including finance. Johnson emphasized AI's positive impact on fields such as medicine and agriculture, as well as its efficiency in financial markets for trade execution, pricing prediction, and risk management.

However, Johnson warned about the potential perils of AI integration, citing a real-world example of a scam involving deep fake technology. Johnson stressed the need for proper oversight and regulation to address concerns such as governance, bias, transparency, and ethical considerations.

Further, Johnson discussed the White House's Blueprint for an AI Bill of Rights, outlining principles to guide safe AI deployment, and the establishment of an AI Safety Institute within the Commerce Department to develop guidelines and standards for AI risk management. Additionally, Johnson mentioned international efforts and standards regarding AI governance.

Commissioner Johnson advocated for a principles-based regulatory framework, greater transparency in AI adoption by financial institutions, and heightened penalties for AI-related fraud. Johnson proposed creating an inter-agency task force to facilitate information sharing and support the AI Safety Institute.

The meeting included panels on AI in financial markets, implications of AI on current market regulations, AI-related risks, and future trends in AI adoption and regulation. Various experts from both public and private sectors participated in these discussions, addressing key aspects of AI's role in finance and regulatory responses.

Tuesday, March 19, 2024

Court grants stay of climate rule

By Anne Sherry, J.D.

The Fifth Circuit granted a request to stay the SEC’s climate risk disclosure regulation. The brief unpublished order does not give any reason for the decision to grant the stay, but its issuance signals that the court saw merit in the challenge. A lottery will be held soon to determine which appeals court will hear the various petitions against the rule (Liberty Energy, Incorporated v. SEC, March 15, 2024, per curiam).

The stay itself is likely to have little practical effect on companies due to the long compliance horizon in the rule, which doesn’t require reporting until 2026 at the earliest. The petitioners had argued, however, that they would need to begin compliance measures immediately in order to be ready to collect the required data.

The stay is also vulnerable to being lifted or revised by another court. So far, petitions for review of the climate rule have been filed in not just the Fifth but also the Eighth, Eleventh, and District of Columbia Circuits. Under 28 U.S.C. § 2112, when petitions are filed in multiple courts in the first 10 days of a rule, the Judicial Panel on Multidistrict Litigation randomly draws one of those courts to review the consolidated petitions. In this case, that ten-day period expires at the end of Monday, March 18.

The real import of the stay is as a signifier that the Fifth Circuit sees merit in the petitioners’ arguments.

The court could have denied the motion for stay on procedural grounds. For example, Federal Rule of Appellate Procedure 18 states in part that “A petitioner must ordinarily move first before the agency for a stay pending review of its decision or order.” The SEC argued that it had not been given a chance to address the arguments for staying the final rule, but the challengers countered that they had requested a stay of the proposal back in 2022. The appeals court may have been satisfied that this request, as the petitioners argued, “easily satisfies FRAP 18.”

The petitioners also argued that they were likely to succeed on the merits of their challenge because the rule triggers the major-questions doctrine, lacks clear statutory authority, is arbitrary and capricious, and fails First Amendment scrutiny. As to that last point, the SEC’s conflict minerals disclosure rule was gutted through legal challenges largely grounded in First Amendment arguments.

The case is No. 24-60109.

Monday, March 18, 2024

Internal auditor awarded $1.25 million for reporting misconduct

By John Filar Atwood

The CFTC has awarded $1.25 million to a whistleblower whose responsibilities included compliance or internal audit functions at the subject company. Stricter whistleblower requirements apply to employees with compliance or internal audit responsibilities, but the CFTC said that the whistleblower satisfied those requirements by first raising the matter internally and then waiting at least 120 days to contact the agency.

It is the first CFTC whistleblower award that applied the 120-day safe harbor provision to a person who served in an entity’s internal compliance or audit function. The whistleblower contacted the CFTC only after the employer took no meaningful remedial action on the issues in question.

In its order, the CFTC noted that it normally does not consider information that a whistleblower obtains from his or her role as an internal audit or compliance employee to be derived from his or her independent knowledge. However, the exclusion from independent knowledge does not apply when the employee waits at least 120 days after reporting it to his or her supervisor, or the audit committee, chief legal officer, or chief compliance officer.

In granting the award, the CFTC noted that the whistleblower’s information by itself was responsible for the agency’s enforcement staff opening an investigation and taking action against the company.

The CFTC’s director of enforcement said that the award recognizes the risks that company insiders take in coming forward with information as well as the value of the specific information provided.

Friday, March 15, 2024

Supreme Court asked to decide if seized assets can be offset against disgorgement

By John Filar Atwood

A petition for certiorari asks the Supreme Court to determine whether seized assets can be credited against disgorgement and whether the district court’s nominee analysis on three discrete relief defendant assets was legally sufficient to satisfy the requirements of the nominee doctrine. The district court and Second Circuit found that the seized assets could not be offset against disgorgement because they were not ill-gotten gains from the misconduct. The petitioner contends that the disgorgement is punitive and that the Supreme Court’s holding in SEC v. Liu demands that disgorgement remain within equitable limits (Ahmed v. SEC, March 6, 2024).

The petitioner is the wife of Iftikar Ahmed who allegedly defrauded Oak Management Corp., his employer, and investors out of $65 million over a ten-year period. The SEC ordered Ahmed to disgorge $64.2 million. In connection with the action against Ahmed, Oak seized assets belonging to Ahmed and his wife, a relief defendant, in the amount of $35 million. Ahmed sought unsuccessfully to have the seized assets credited against the disgorgement total.

Limitations on disgorgement. The petitioner is seeking review on the grounds that the Second Circuit decision conflicts with the Supreme Court’s authority on equitable limitations inherent in disgorgement. She noted that in Liu the Supreme Court invalidated punitive measures in disgorgement remedies, ruling that a remedy grounded in equity must be deemed to contain the limitations upon its availability that equity typically imposes. In her view, the Circuit Court decision punishes her by charging her twice for disgorgement and providing the victim a double recovery.

The petitioner also disagrees with the district court’s ruling that the value of shares returned to the alleged victims in two specified transactions could not be offset against the calculation of disgorgement as Ahmed’s conflict of interest in one transaction and his position on both sides of the second deal precluded the credit of the value of shares against disgorgement. The petitioner asks the Supreme Court to consider that an equitable remedy presupposes a loss to the victims, but there was no loss in the two transactions at issue.

Nominee doctrine. The petitioner also asks the Supreme Court to consider the legal requirements necessary to declare a relief defendant a nominee of a primary defendant such that her assets are deemed equitably owned by the defendant and can be used towards satisfaction of the SEC’s judgment. In her view, the Second Circuit’s affirmance of nominee status of certain relief defendant assets conflicts with the Supreme Court’s precedents that mandate reversal when decisions are made on an erroneous basis of law. It also creates a circuit split on the legal sufficiency needed to satisfy the requirements of the nominee doctrine to conclude certain assets as nominees, she contends.

The petitioner concludes that the case provides the Supreme Court with an opportunity to weigh in on the government’s ability to avoid judicial scrutiny of its disgorgement calculations and on the proper application of the nominee doctrine.

The case is No. 23-987.

Thursday, March 14, 2024

CII urges SEC to prioritize agenda items

By Rodney F. Tonkovic, J.D.

The Council of Institutional Investors has written to the SEC in response to the agency's invitation to comment on its latest semiannual regulatory agenda. CII notes its continued support of long-deferred action on "proxy plumbing" regulations as well as a proposal to address non-GAAP financial measures. Other items covered by the letter include CII's recent petition for rulemaking on the traceability of shares and proposals on Regulation Best Execution and Regulation NMS.

Regulatory Flexibility Agenda. The SEC most recently published its agenda of rulemaking actions in August 2023. The Regulatory Flexibility Act requires each federal agency to publish in the Federal Register a list of the rules it expects to consider in the following year. The Commission invites comments on the agenda and the individual entries, and comments should be received 30 days after publication.

Penned by CII's general counsel, Jeffrey P. Mahoney, the letter reflects the organization’s priorities with respect to SEC rulemaking: investor rights and protections; corporate disclosure; and market systems and structure. The letter is, accordingly, divided into these three categories and under these headings addresses five subtopics.

Investor rights. The letter first urges the SEC to add a project to its agenda to protect investor rights to recover losses under Securities Act Section 11. CII itself recently petitioned the Commission for rulemaking on traceability of shares in part as a response to the Supreme Court's Slack decision affirming that shareholders must be able to "trace" their shares to a registration statement. One approach under consideration would be to amend Rule 144 to limit sales of unregistered securities for a certain period after the effectiveness of a registration statement. CII's petition suggests requiring the use of technology to facilitate tracing. There is no shortage of options, CII says, and the issue is "not whether, but how to do so."

Corporate disclosure. Under the rubric of corporate disclosure, CII notes its continued support of a new agenda item closing the regulation loophole governing non-GAAP financial measures. To that end, the letter reiterates a 2019 request that the Commission require disclosure of: quantitative reconciliation to GAAP of non-GAAP financial measures used to determine executive compensation; and a qualitative description of why the non-GAAP financial measures are better for determining executive pay than GAAP financial measures.

CII states that the use of non-GAAP adjustments to determine incentive plan payouts is a common practice. Plus, recent research indicates that companies use non-GAAP earnings to justify higher executive compensation. The letter asks the SEC to promptly propose a rule requiring, at minimum, that companies include a hyperlink to a quantitative GAAP reconciliation for any non-GAAP financial measures contained in their CD&A.

Market systems and structure. CII also praises the Commission for its adoption of amendments updating Rule 605 disclosures. This should be followed by rules on Regulation Best Execution and Regulation NMS, the letter says. Concerning Regulation Best Execution, CII has concerns with two provisions (which it has discussed in-person with Chair Gensler): a proposed exemption for an institutional customer; and omission of a proposed requirement for order-by-order decision making.

The letter says that CII broadly supports the provisions of the Regulation NMS proposal. In particular, CII supports the proposed uniform reduction in the access fee cap set by Rule 610.

Finally, the letter expresses CII's continued disappointment that "Proxy Access Amendments" remain categorized as a long-term action on the agenda. CII believes that the SEC should prioritize improving "proxy plumbing," first by proposing the above-noted rulemaking to facilitate tracing. Secondly, the SEC should prioritize addressing end-to-end vote confirmation: this could be as simple as requiring all participants in the voting chain to provide issuers with access to voting record information for the limited purpose of confirming how a particular shareholder's shares were voted.

Wednesday, March 13, 2024

SEC ‘must’ adopt rules on crypto, Coinbase tells Third Circuit

By Lene Powell, J.D.

The SEC is “pursuing a power grab” over the crypto industry by engaging in enforcement while foregoing rulemaking, crypto giant Coinbase told the Third Circuit. In a new filing, Coinbase argues the SEC's “refusal to engage in rulemaking” is arbitrary and capricious and an abuse of discretion in violation of the Administrative Procedure Act (APA). Coinbase asked the court to vacate the SEC’s denial of petition for rulemaking and direct the SEC to commence rulemaking (Coinbase, Inc. v. SEC, March 11, 2024).

The new filing is the latest in a fierce exchange. Coinbase previously asked the Third Circuit to require the SEC to respond to its 2022 petition for rulemaking. The SEC responded by denying the rulemaking petition. The Third Circuit then dismissed the action as moot, and Coinbase filed the current challenge.

Coinbase’s lawsuit is also parallel to another action involving the parties. In an enforcement action in the Southern District of New York, the SEC has charged Coinbase with registration violations including failure to register as a national securities exchange, broker-dealer, and clearing agency. The SEC contends that the securities laws apply to Coinbase’s conduct, while Coinbase argues they do not.

“No workable framework.” Coinbase argues the SEC has performed an “about-face.” Earlier when the crypto industry was building up, the SEC indicated it had little statutory authority over digital assets and what authority it did have was unclear. Market participants responded by investing heavily in a what Coinbase says is a two-trillion-dollar industry. Then, the SEC pivoted and began a “scorched-earth, nationwide campaign” of enforcement.

Now, says Coinbase, it is caught in a catch-22: the SEC tells digital asset firms to “come in and register” under threat of enforcement suits, but registration is neither required nor possible under existing rules, which were designed decades ago for legacy financial assets and businesses.

Coinbase says it filed its petition for rulemaking because rulemaking is the only way for the agency to draw clear lines identifying them, to provide fair notice, and to create a workable regulatory framework that makes compliance with the securities laws possible.

Rulemaking needed. Coinbase is challenging the SEC’s denial of Coinbase’s petition for rulemaking. While the SEC communicated its decision in a letter, Coinbase calls the decision an “order.”

Coinbase argues:
  • The SEC must engage in rulemaking because it has adopted sweeping new views of the securities laws and existing laws do not work for digital assets;
  • The SEC cannot rationally regulate digital assets through ad hoc district court enforcement actions;
  • The SEC’s refusal to commence rulemaking should be vacated because the SEC offered no rational explanation for its inaction on Coinbase’s petition for rulemaking.
Remedies sought. Coinbase asked the court to grant the petition for review, vacate the SEC’s order, and direct the agency to begin a “long-overdue” rulemaking process.

This is case No. 23-3202.

Tuesday, March 12, 2024

Investor Advisory Committee recommends scaling down SEC’s predictive analytics proposal

By Lene Powell, J.D.

The SEC Investor Advisory Committee (IAC) adopted a recommendation for the SEC to scale back proposed rules on digital engagement practices. A majority of the committee recommended that the SEC narrow some proposed definitions and increase focus on disclosing conflicts of interest.

Some members voted against the IAC’s recommendation, believing that it unduly shifts the focus to disclosing rather than neutralizing conflicts of interest.

Proposed rules. The SEC’s predictive data analytics proposal, released last July, would require firms to identify and eliminate any conflicts of interest arising from the use of covered technologies, as well as implement policies and procedures and keep certain records.

According to the proposal, firms are increasingly using a type of artificial intelligence called predictive data analytics (PDA) to understand and direct individual investor behavior. Firms may also use digital engagement practices (DEPs) like behavioral prompts, differential marketing, game-like features, and other design features to engage retail investors when using a firm’s digital platforms for trading, roboadvice, and financial education.

These technologies can create conflicts of interest that place a firm’s interests ahead of investors’ interests, the SEC says. For example, firms could use PDA-like technologies to encourage investors to engage in activities like excessive or risky trading that are profitable for the firm but may increase investors’ costs, undermine performance, or expose investors to unnecessary risks.

The proposal has met intensely polarized feedback. Better Markets called the proposed rules “essential to protect investors,” while NASAA supported the proposal with some recommended changes. In contrast, major industry groups strongly criticized the proposal, including the U.S. Chamber of Commerce, Investment Company Institute, SIFMA, and Investment Adviser Association.

IAC recommendation. At a meeting on March 7, the IAC adopted a recommendation on the SEC’s proposal. Committee member Paul Roye, former SVP and senior counsel at Capital Research and Management Company, said the recommendation suggests these changes:
  • Narrow the scope of the definition of covered technologies to target the unique risk of predictive data analytics and artificial intelligence technologies;
  • Narrow the definition of investor interaction to include technologies that interact directly with investors or that aid in that interaction with investors;
  • Use the current definition of conflict of interest;
  • Use the existing framework to mitigate or eliminate conflicts of interest involving predictive data analytics and artificial and technology when disclosures are inadequate; and
  • Clarify the definition of what constitutes a recommendation under Regulation Best Interest.
Roye suggested the recommended changes would avoid unintended consequences and adverse effects on investors and not impede the adoption of new beneficial technologies.

Dissent. Two committee members said they could not support the IAC’s recommended changes.

SEC Investor Advocate Cristina Martin Firvida said if covered technologies were to be redefined to focus on the use of exceptionally complex and opaque technologies, then in her view firms should not be permitted to address conflicts of interest through disclosure alone. Rather, she supports requiring firms to eliminate conflicts or their effects when the conflicts are the result of covered technologies. This would build upon existing regulations and does not represent a dramatic departure from firms’ existing regulatory obligations, she said.

Leslie Van Buskirk, administrator of the Division of Securities, State of Wisconsin Department of Financial Institutions, said she “firmly opposes” elements of the recommendation. She outlined concerns including that the recommendation would undermine the primary benefit of the SEC's approach—that it would transition industry practices to addressing associated conflicts at the earliest opportunity.

Commissioner statements.
SEC Chair Gary Gensler said that while the use of AI can promote greater financial inclusion and enhanced user experience, it can also raise conflicts of interest, which the proposed rules address. Gensler has previously said that under current rules, brokers and advisers cannot address conflicts of interest through disclosure alone.

Commissioner Hester Peirce questioned why the recommendation was changed from an earlier draft, particularly regarding the earlier version’s emphasis on disclosure versus mitigation of conflicts.

Monday, March 11, 2024

SCOTUS asked to weigh in on scienter, falsity pleading requirements

By Anne Sherry, J.D.

A petition for certiorari asks the Supreme Court to resolve two circuit splits concerning pleading scienter based on internal reports. Nvidia, the petitioner, argues that the decision against it deepened a circuit split by allowing a case to proceed to discovery based on speculation about what internal reports might have said. The ruling also created a new circuit split as to whether a plaintiff’s expert opinion can alone satisfy the falsity element of a securities fraud action (NVIDIA Corp. v. E. Ă–hman J:or Fonder AB, March 4, 2024).

Circuit splits. Last August, a Ninth Circuit panel narrowly revived some claims alleging that Nvidia Corp. and three of its officers defrauded investors by downplaying the extent to which Nvidia’s gaming revenues relied on the demand for cryptocurrency. The district court had held that the plaintiffs failed to prove scienter, but the appeals court found the complaint pleaded that one of the individual defendants both made materially false and misleading statements and did so with scienter.

Judge Sanchez dissented from the Ninth Circuit opinion. He observed that the complaint’s central falsity allegation was based entirely on a post-hoc analysis by an outside expert (Prysm) that relied on generic market research and questionable assumptions. The complaint did not put forward any internal report or data source that would have put executives on notice that their statements were false or misleading when made, nor did it cite any internal source corroborating Prysm’s revenue estimates. On the contrary, the only specific allegation of an internal study supported the defendants’ statements.

Further, Judge Sanchez noted, “We have never allowed an outside expert to serve as the primary source of falsity allegations where the expert has no personal knowledge of the facts on which their opinion is based, for example by corroborating their conclusions with specific internal information or witness statements.”

Petition. Nvidia argues in its cert petition that for the reasons Judge Sanchez noted, the panel opinion creates one circuit split (using an expert opinion to prove falsity) and deepens another (allowing scienter to rest on speculation). It asks the Court to consider two questions:
  1. Whether plaintiffs alleging scienter under the PSLRA based on allegations about internal company documents must plead with particularity the contents of those documents, as held by the Second, Third, Fifth, Seventh, and Tenth Circuits; and
  2. Whether plaintiffs can satisfy the PSLRA’s falsity requirement by relying on an expert opinion to substitute for particularized allegations of fact. The Second and Fifth Circuits have answered this question in the negative.
Nvidia writes that the Ninth Circuit is wrong on both issues and that its decision erodes the purpose of the PSLRA to end abusive securities litigation. The divergence from the Second Circuit is especially problematic, Nvidia asserts, because together the Second and Ninth account for a significant majority of securities fraud suits.

Two aspects of the PSLRA’s heightened pleading standards show why the Ninth Circuit’s analysis of the scienter element is incorrect. Congress has required scienter to be pleaded with particularity, which demands detail—“omissions and ambiguities count against inferring scienter” (Tellabs, Inc. v. Makor Issues & Rights, Ltd. (U.S. 2007)). Second, the PSLRA imposes another, even stricter demand on scienter: the plaintiff must plead facts giving rise to a strong inference that the defendant acted with the requisite state of mind.

Nvidia argues that the Ninth Circuit’s falsity analysis is also incorrect. The falsity element requires particularized allegations of fact, but an expert opinion is not a fact at all, much less a particularized one. “Allowing plaintiffs to evade that obligation by retaining an expert—who then turns to generic market data to speculate about what might have happened—eviscerates the PSLRA,” Nvidia writes.

The case is No. 23-970.

Friday, March 08, 2024

New paper analyzes how lawyers, judges view GenAI

By Mark S. Nelson, J.D.

Senior Legal Analyst Mark S. Nelson examines how lawyers think about and use generative artificial intelligence (GenAI) in their professional work and how the use of GenAI is being perceived by the courts. Specifically, this latest paper covers:
  • The promise and risks of GenAI in law practice.
  • Recent disciplinary cases.
  • Comments on the Fifth Circuit’s proposed GenAI local rule.
  • Legal ethics rules and GenAI.
To read “We’re lawyers, not luddites: GenAI in law practice and the courts,” please click here.

Thursday, March 07, 2024

SEC expands scope of Rule 605 reporting entities

By Rodney F. Tonkovic, J.D.

By unanimous vote, the SEC has adopted amendments modernizing the disclosure requirements of Rule 605 of Regulation NMS. Significantly, the amendments expand the scope of entities subject to the rule requiring monthly execution quality reports to encompass larger broker-dealers. The amendments will also modify the categorization and content of order information reported under the rule to capture a larger range of data. Finally, market centers and broker-dealers will now be required to produce summary reports on execution quality. The amendments will be effective 60 days after publication in the Federal Register and the compliance date will be 18 months after that date (Disclosure of Order Execution Information, Release No. 34-99679, March 6, 2024).

Disclosure of order execution information. Since its adoption in 2000, Rule 605 of Regulation NMS has required market centers to disclose order execution quality statistics in national market System stocks. A ”market center” was defined in Rule 600 to include any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association.

There have been no substantive changes to Rule 605 since its adoption. During the meeting, Chair Gensler observed that the Rule 605 reports resemble the numbers and symbols that make up the opening credits to "The Matrix." He quipped that there have been three sequels to "The Matrix" since 1999, so it's about time for a sequel to Rule 605.

Larger broker-dealers. The final rule amendments expand the scope of entities subject to Rule 605 to include larger broker-dealers that introduce or carry at least 100,000 customer accounts. The Commission's analysis found that approximately 85 larger broker-dealers combined handle over 98 percent of customer accounts and that this threshold will balance the benefits of having broker-dealers produce execution quality statistics with the costs of implementation and continued reporting.

Larger broker-dealers that are also market centers must produce separate reports for each function. This will allow interested parties to view the firm's execution quality from the perspective of how it operated in each role, the Commission says. The Commission also specified that NMS stock ATSs must report separately from their broker-dealer operators and adopted a separate reporting requirement for single-dealer platforms.

NMS Stock ATSs and single-dealer platforms will also be subject to reporting under the rule.

In a change from the proposal, the Commission will not require separate reports for orders that a market center receives for execution from a qualified auction. At the same time the amendments to Rule 605 were proposed, the Commission proposed an order competition rule that contemplates qualified auctions. Since the Commission is still considering this proposal, the qualified auctions do not yet exist.

Categories and content. The amendments will also change the scope and content of the execution quality reports. Rule 605's reporting is limited to "covered orders," and the definition of that term has been expanded to include certain orders submitted outside of regular trading hours (that become executable after the opening or reopening of trading during regular trading hours), certain orders submitted with stop prices, and non-exempt short sale orders, i.e., those where a short sale price test is not in effect.

The amendments change how orders are categorized both by size and type. Rule 605's existing order categories will now be based on both notional dollar value and whether an order is for a fractional share, for an odd-lot, or for a round lot or greater rather than number of shares. The Commission has also added four new order types and replaced three existing categories of non-marketable order types with four new categories. The information required to be reported under the rule has been amended to include: modified time-to-execution reporting categories; realized spread time horizons with new statistical measures of execution quality; and new statistical measures of execution quality.

Summary reports. Finally, the amendments require entities subject to the rule to make a publicly available summary report. The Commission noted that the detailed report contains a large volume of statistical data that many market participants will be unable to directly analyze. Summary reports will be more readily accessible and will provide "human-readable information" that any investor can assess without needing technical expertise or relying on an intermediary.

The release is No. 34-99679.

Wednesday, March 06, 2024

Lawyers who won case against Tesla compensation grant seek percentage of shares rescinded

By Mark S. Nelson, J.D.

Gregory V. Varallo of Bernstein Litowitz Berger & Grossman LLP, attorneys for plaintiff Richard J. Tornetta, who had sued Tesla claiming that CEO Elon Musk’s executive compensation grant of several hundred million vested options, among other things, amounted to breach of fiduciary duty, seek attorney fees and an expense reimbursement equal to 11.0145 percent of the 266,947,208 shares freed up and returned to Tesla because the Delaware Chancellor concluded, after a trial, that CEO Elon Musk’s record stock grant should be rescinded. The fee request is the result of adjustments made to an initial request of 15 percent that was based on a prior large Delaware fee award (Tornetta v. Musk, March 1, 2024).

Tornetta’s attorneys won the trial after 4.5 years of discovery and a 5-day trial that featured testimony from multiple fact and expert witnesses. According to the plaintiff’s brief in support of the fee request, only two other U.S. cases produced larger recoveries and those cases involved the additional award of punitive damages.

The fee request asserts that a large award would mirror the benefit obtained from taking the case to trial at great risk to the plaintiff. More than 303 million vested options were cancelled and can now be used by Tesla for any corporate purpose, said the plaintiff’s brief. Lawyers for Tornetta also argued that Tesla will not have to pay a large cash amount and that Tesla may even enjoy tax benefits under the proposed award scheme. The proposed fee, said the brief, was consistent with other cases where fees were paid out as a percentage of shares and that the valuation employed in crafting the fee request would avoid having to explain whether the value of winning the rescission was the same or different from the value of the shares.

According to the plaintiff’s attorneys, the proper starting point for an award is 15 percent, the amount awarded in Southern Peru Copper, after a downward adjustment for the delay brought about by plaintiffs in that case. Here, Tornetta’s attorneys purport to seek a “conservative” recovery of a “fee awarded in kind” such that they would adjust the 15 percent baseline by a liquidity adjustment of 26.57 percent, ultimately yielding and a requested recovery of 11.0145 percent of 266,947,208 Tesla shares. Footnote 82 to the plaintiff’s brief spells out the math used to arrive at the fee request. The attorneys for Tornetta noted that, unlike the plaintiff in Southern Peru Copper, Tornetta and his counsel in the Tesla case had acted with “alacrity.”

The case is No. 2018-0408-KSJM.

Tuesday, March 05, 2024

Investors group petitions Commission for new rulemaking regarding traceability of shares

By Suzanne Cosgrove

The Council of Institutional Investors (CII) has urged the SEC to initiate new rulemaking that will make it easier to trace shares sold into the marketplace through both direct listings and initial public offerings and, in the process, protect investors’ rights under Section 11 of the Securities Act of 1933.

The CII said the urgency of its petition is in part a response to the Supreme Court decision Slack Technologies, LLC v. Pirani. The Court’s ruling affirmed that shareholders must be able to “trace” their shares to the registration statement covering them.

“Until recently, traceability was not an issue, given that underwriters generally imposed a lockup period for insiders and early investors after a registration statement became effective,” the CII stated in a letter sent to the Commission on February 29. “A lockup period prevented insiders and early investors from selling unregistered shares acquired before the public offering.”

Slack case offers context. As reported by Securities Regulation Daily last June, the Supreme Court backed corporations’ growing preference for direct listings over IPOs in a ruling involving the instant-messaging company Slack, which went public in 2019 through a direct listing. By bypassing the IPO process, holders of pre-existing unregistered Slack shares were able to sell them to the public immediately. The plaintiff in the related case bought shares on the day Slack went public and later, but his complaint did not allege the purchases were traceable to the registration statement that he claimed was misleading.

The Supreme Court concluded that the statutory context of Securities Act Section 11 required the plaintiff to trace his shares to the allegedly misleading registration statement. The Court’s decision resolved a prior split ruling created by the Ninth Circuit when it held 2-to-1 that the plaintiff had standing despite not tracing the shares to the registration statement in the defendant’s direct offering.

Proposed share tracing options. The CII noted a working group of academics and former SEC officials previously recommended that the Commission amend SEC Rule 144 to limit sales of unregistered securities for a certain period after the effectiveness of a registration statement.

But in its recent letter, the CII suggested three other technology-based options that would update and enhance the protections afforded under Section 11. Those technology-based solutions included:
  • Requiring that registered and exempt shares are offered in a direct listing trade with differentiated tickers, at least until expiration of the relevant Section 11 statute of limitations.
  • Migrating the clearance and settlement system to a distributed ledger system or to other mechanisms to allow the tracing of individual shares as individual shares, and not as fractional interests in commingled electronic book entry accounts.
Lastly, the CII referenced research by Professors John C. Coffee, Jr., and Joshua Mitts that advocated using computing power to trace the purchase of shares. As the study points out, broker-dealers, exchanges and FINRA all maintain detailed, timestamped transactional records that show when securities in one account are transferred to another account. The records are kept and stored electronically and are all contained within the Consolidated Audit Trail, the authors noted.

The existence of the data makes it possible to trace transactions using either first-in-first-out (FIFO) or last-in-first-out (LIFO) accounting assumptions for determining the cost of inventory. Those accounting assumptions could be adapted to provide for tracing all shares without relying on other methodologies, such as probability analysis that some courts view as inadequate, the CII said.

Monday, March 04, 2024

House FSC advances disapproval resolution on SEC’s SAB No. 121

By Mark S. Nelson, J.D.

The House Financial Services Committee, during an abruptly abbreviated markup last week, succeeded in advancing a Congressional Review Act (CRA) resolution that, if enacted, would disapprove the SEC’s Staff Accounting Bulletin (SAB) No. 121 on custody of crypto assets. The action comes just weeks after a bipartisan and bicameral group of lawmakers announced their intention to overturn the SEC’s guidance. The House FSC vote on H. J. Res. 109 was 31-19 to approve the resolution, with three Democrats joining Republicans in support of the resolution and with one Democrat and one Republican not voting. The Senate version of the resolution has not been acted on since being introduced.

The contents of SAB No. 121 are three Q&A-style sets of guidance, although it is the first question regarding how to account for the safeguarding of crypto assets that has drawn the most attention. The SEC stated that a crypto firm should enter a liability and asset on its balance sheet for any custodied crypto and that the value of the safeguarding liability and the asset should be the fair market value of the crypto assets held for platform users. The remaining Q&As deal with disclosure and the time frame for applying the guidance to financial statements.

“After Chair Gensler tried to tuck a major policy change into so-called staff guidance, the GAO ruled SAB 121 constitutes a rule,” said House FSC Chair Patrick McHenry (R-NC) in his opening remarks at the markup. “So now, our Committee is taking action to rescind this misguided rule and ensure Americans can custody digital assets in one of the safest ways possible—through highly regulated banks.”

According to an opening statement form House FSC Ranking Member Maxine Waters (D-Calif), Republicans on the committee risked stripping away clarity on crypto accounting rules by pursuing the CRA resolution. Said Waters: “This bulletin is non-binding SEC staff guidance intended to help clarify how a company should account for its customers’ cryptocurrencies. We often hear Republicans and the crypto industry complain about a lack of clarity from the SEC, but ironically, the resolution before us effectively blocks the SEC staff from providing that clarity around crypto.”

The GAO ruling mentioned by McHenry in his opening remarks was supposed to provide clarity on the status of a document the SEC typically considers to be guidance. Although the Administrative Procedure Act and the CRA may not provide a clear answer on this topic, the GAO and other sources suggest that the definition was intended to have a broader meaning that just notice and comment rulemaking.

Stephen Hall, Legal Director and Securities Specialist at Better Markets, issued a statement in advance of the markup questioning the wisdom of Congress overturning financial accounting guidance.

“It is therefore critical to consider whether Congress has the expertise to second-guess the judgment that the SEC has made in the bulletin regarding some highly technical accounting issues,” said Hall. “And wouldn’t the CRA resolution set a dangerous precedent of nullifying accounting requirements that are designed and intended to protect investors, customers, markets, and financial stability—especially given the extraordinary and demonstrated risks that the crypto markets pose?”

The Chamber of Digital Commerce also issued a blog post in early February when the CRA resolution was first announced. “Today’s bipartisan resolution represents a decisive action to ensure the SEC operates within its designated rulemaking authority,” said the Chamber of Digital Commerce. “By failing to issue SAB 121 in adherence with the rulemaking process, the SEC bypassed established procedures, compromising the integrity of the regulatory framework, and violating principles of transparent and inclusive governance.”

Friday, March 01, 2024

Commissioners offer guidance for advisory committee’s discussion of accredited investors, IPOs

By John Filar Atwood

As the SEC’s Small Business Advisory Committee prepared to discuss the definition of “accredited investor,” Chair Gary Gensler asked the committee members to consider when it is appropriate that investors get, or not get, full and fair disclosure about a securities offering. Regarding the committee’s second agenda item, the state of the IPO market, Gensler touted the recently adopted SPAC rules noting that just because a company uses an alternative method to go public does not mean that its investors do not deserve the same protections as a traditional IPO.

Commissioner Peirce. Commissioner Hester Peirce focused her remarks on the importance of letting investors decide how to invest their money. Investor protections that come in the form of prohibitions, such as the limitations included in the accredited investor definition, run contrary to persons’ right to decide for themselves how and where to invest.

Peirce also worried about the potential negative impact that changes to the accredited investor definition could have on angel networks that help new businesses get off the ground. She acknowledged that investing in young companies is very risky but said that empowering decision making with education is better than taking away one’s right to invest.

With respect to the IPO market, Peirce asked committee members to help identify the causes for the decline in the number of listed companies in the U.S. over the past 25 years. Some of the causes are outside the Commission’s control, she noted, but added that the SEC has a role in the rising costs of being a public company. She cited reports indicating that external reporting costs for public companies have outstripped inflation since 2000, and warned that they could rise further if the Commission moves forward with the climate rule.

Peirce encouraged the committee members to consider what are the most substantial regulatory cost-drivers for public companies, and what regulations dissuade them from going public. She also asked them to help the Commission decide how to better scale regulations to encourage companies to go public earlier in their life.

Commissioner Uyeda. Commissioner Mark Uyeda spoke about the accredited investor definition, suggesting that the SEC move away from an “all or nothing” approach where an accredited investor can invest 100% of his or her assets in a single private offering, but if he or she falls a dollar short of qualifying as an accredited investor, they cannot invest at all. He suggested that the Commission consider allowing an individual to invest up to certain percentages of a personal financial metric, like the aggregate dollar value of his or her securities investments, in private offerings.

Uyeda encouraged committee members not to be restricted by the past. Some have called for the net worth and annual income thresholds to be indexed to inflation from the levels established in 1982, he noted, but pointed out that this assumes that these levels were correct to begin with. That approach also assumes that net worth and annual income are the appropriate metrics for assessing an individual’s ability to invest in private offerings, he said. He advised committee members to develop recommendations free from decisions made over 40 years ago.

Uyeda also suggested that any regulatory approach to private offerings should focus on opportunity rather than paternalism, where the ability of more individuals to participate in private offerings is seen as a benefit, not a detriment. The paternalistic approach in which the government decides who can and cannot invest may harm the exact persons who it is trying to protect, he stated.

Uyeda noted that the Commission’s rules do not limit investments in public companies to only investors who meet certain wealth or income thresholds. Investors have their own tools to protect themselves from the risks of private investments, he said, including diversifying or just walking away from an investment. He encouraged committee members to remember that these other tools exist as they develop their recommendations.

Commissioner Lizarraga. Commissioner Jaime Lizarraga discussed how venture capital’s reach into disadvantaged communities remains very limited. In 2022, he said, Latino, African American, and women-only founders each received less than two percent of venture capital dollars.

Many of the small businesses included in those statistics lack access to traditional entrepreneurial ecosystems, or to the friends-and-family networks that can provide access to needed capital, he said. Due to the essential role these small businesses play in job creation, and in the success of their communities, it is essential that they benefit from the Commission’s capital formation tools and resources, Lizarraga concluded.