The Business Economy–Hints

I was struck today by the flow of news that continually pours over my desk from myriad sources, including  from the NYTimes, the legal press, several data services, the SEC, as well as thinking from my clients who are investors or advisers.  Those who know me understand that I do not give  legal advice in this blog site, and surely not investment advice in any setting, but I confess I am having trouble understanding where the corporate/investment landscape is going.

Anecdotal input just today (I vouch for none of this data but set forth what I was told in person or by incoming information):

after a heady 2023 the stock markets are taking a pause (NYT) and are not a source of 2024 optimism (very sophisticated equity investor);

the stock markets are ahead of the Fed (NYT column);

DOJ increased enforcement cutting down on M&A activity (several sources today including but not limited to the super-market merger) [and see posts December 13 and 20]

M&A activity for 2023 was extremely low in volume at 19% below 2022 and 46% below 2021 (recognized data service to the legal community);

tightening standards for private investors to obtain accredited investor status (and thus be able to invest in typically better equity offerings) is being considered by the SEC [see post of December 15], which  will harm private investment markets in parts of the US and prevent investors from exercising their own investment judgment with their own money (SEC Commissioner addressing the Commission’s Small Business Capital Formation Advisory Committee) ;

public company ownership and filing of IPOs is severely down, as from 2016 to mid-2022 the number of public US companies almost halved and rate of IPOs in last ten years is in substantial decline (same SEC Commissioner address).

The only news (at least that I found interesting enough to comment upon) which suggests uptick in deal pace was contained in my recent post on market pressure leading to a robust 2024 of sales of positions by PE firms [February 13].

Obviously there is a connection between corporate deal cycles and the stock market, and obviously I am not the right person to speculate on those mechanics;  I just was struck by today’s input.  As Sergeant Joe Friday used to say, “just the facts.”

AI and the SEC

The SEC has pending a proposed regulation, anticipated for adoption before the end of this year, requiring brokers and advisers to remove data analytics which would put the firm’s interests before the interests of investors.  Separately, while speaking this week at Yale Law School, SEC Chair Gensler also admonished these firms to beware AI programs that might lead to spoofing or front-running.

Front-running effects a trade for the firm account (based in this case presumably on AI analytics) prior to affording that trade to clients, while spoofing may distort the market by placing buy or sell orders for future contracts and then withdrawing them prior to execution.

The SEC message is that firms need fully to test AI trading programs to ensure that what is generated is not only factual (not an hallucination) but also must work in the first instance to benefit customers and not the firm’s proprietary trading and to preserve a market driven by fair practices.  However, the requirements here have to do with discharging fiduciary obligations, do not address the purposeful release of false data (clearly a fraud), and relate more closely to avoiding negligence or recklessness on the part of the broker or advisor.  It is not certain, however,  that committing either of these SEC sins will in fact create harm to clients or other marketplace investors, an issue that Gensler himself  believes will be resolved by the courts in a manner he described as “unpredictable.”

And this doesn’t get to court without the SEC bringing suit so … you be the judge as to where this is heading.

When Private Equity Cashes Out a Fund….

The US economy in 2023 was not really soft, but it was perceived as such and market valuations of enterprises held by PE funds were depressed.  PE Fund refrained from cashing out their investments, hoping that values would rise in the future, that  buyers next year would be more willing to spend,  and that disposition of fund investments at 2024 higher prices would create better returns for fund investors.

According to Dealogic, PE exits in 2023 totaled c $333B; exits in the prior two years were c$6B and over c$893B.  2023 exits were the lowest since 2013.

Now comes 2024 and there will be greater pressure to exit as time will be running out on some funds and since hopefully valuations of positions to be sold will have increased.  Further, companies seeking acquisitions likely have enjoyed profitable 2023s and have not expended acquisition dollars last year, so it seems that fund managers may find willing and solvent buyers for the investments that the funds need to sell.

Strategic buyers looking to purchase PE fund assets may try to balance possibly higher market valuations by careful shopping, in light of the fact that there may be something of a glut of companies for sale given lack of company sales last year.

Interest rates have stabilized and may tick downward during the course of the year, also a factor which may lead to acquisition activity.

Finally, noting the overlay of greater anti-trust enforcement particularly against roll-ups, anti-trust clearance may take a long time to achieve, particularly in markets where there is product/customer overlap and/or in regulator-targeted industry sectors such as med-tech. (See prior anti-trust post to this blog site, dated December 20)

Overall, commentators expect a pretty interesting 2024 acquisition year.

Whistleblowing for the Feds

The Sarbanes Oxley Act provides that the Federal Government can grant payment to individuals who report illegal actions in connection with securities offerings, and where the government finds that in fact illegal actions occurred.  The statute is often invoked to reward employees who advise the government of employer improprieties and awards can reach into the millions of dollars. .In 2017 a Manhattan jury found that a certain Mr.. Murray had been fired for refusing to alter his research relating to a mortgage-backed security.

The employer claimed that although they did in fact fire Mr. Murray, it was not because of his advising the government of any misdeeds, but rather for other reasons, and that Mr. Murray needed to prove that the firing was in fact retaliatory.  The Federal Government appeared in support of Mr. Murray and confirmed that the bare sequence of events, the reporting of the wrong and the firing, entitled Mr. Murray to his recovery.

While there is surface logic to the decision of the  Department of Labor to make the payment, thus not requiring an employee to in fact prove the state of mind of the employer, the ramifications of this decision are a bit scary.  If an employee turns in their guilty employer, can they then never be fired?  That clearly is not what this case stands for, but it does create a substantial burden on employers in connection with what is normally the prerogative of a business: except for clearly protected groups of employees who have special and express statutory protections relating to firings (labor organizing activity, age, race, military service leap to mind), employers have always assumed they were free to deal with employment without apology.

Add Federal whistleblowers to the list of protected employee groups!.

 

 

 

SEC Regulation of Dealers and Advisers– New Frontiers

Last week the SEC promulgated two new rules which are of great impact on large-scale securities investors and the firms that advise them.  The below merely touches certain highlights and, I must emphasize, as with all things posted here, does not constitute legal advice.  The regulations and releases are vast (the adopting release for the regulation redefining securities dealers is 247 pages long, has 805 footnotes and is subject to well-reasoned dissents by the two outvoted Republican SEC Commissioners).  Thus forewarned (and if you a registered RIA or a large investment vehicle please call your attorney), here is the broadest of outlines:

DEALERS: A dealer under federal law is defined as an entity or person in the business of buying and selling securities for its own account through a broker or otherwise. BUT it excludes those for which such activity is NOT part of a “regular business.”   We  used to refer to such excluded entities as “investors” or “customers,” who had certain protections under law.  The new Rule requires certain customers, those which regularly invest and trade in securities for its own account with frequency at large scale, to register as a dealer.  The reason is that, according to the SEC, such a trader fulfills the same function as a traditional dealer, funding in the marketplace by creating liquidity for others in the trading markets.

The result of being a dealer is that you must register with the SEC and FINRA (the self-regulatory dealer organization) and file reports with the SEC and comply with regulations that are largely  irrelevant.  While registered investment companies are exempt (they would otherwise have to register with the SEC twice), the new Rule covers private funds and pension funds.  In ways not yet clear at least to me, coverage also does not exclude investment advisers.

In an interesting aside, the SEC Release makes clear that a crypto automated market maker might have to register, which as Commissioner Peirce points out seems tantamount to registering a software protocol.

RIAs: Starting in about a year, registered investment advisers which advise PRIVATE unregistered fund vehicles must  include, in their SEC filings on Form PF, private information about the strategies that such advisers and funds utilize in their securities transactions.  The purpose is better to understand and thus regulate the trading markets, the same rationale for the above dealer regulatory rule.

AI Rides Again

Yesterday I posted briefly about AI and promised to avoid the blitz of AI posts to this site (there were so many AI articles posted prior to the New Year).  My thought was that now there are so many sources of AI information that readers of this site do not need to be awakened to what is going on through what is basically a secondary information source.

However, yesterday and last night, after I posted, there followed a mini-deluge of things you should at least checklist as part of your AI information bank:

  1. SEC, together with NASAA (association of securities regulators in State governments ) and FINRA (the national regulatory self-regulatory association of brokers), yesterday issued a four-page warning relative to AI impact on investment and financial decisions: ignore claims of unregistered brokers offering securities investment advice based on their superior AI systems which made selecting stocks foolproof; beware of fake (“deepfake”) communications based on AI (AI impersonating friends or relatives, sometimes for example claiming in a call to grandparents that they are a grandchild in distress); don’t invest based just on AI advice as AI can generate incorrect conclusions (known generally as hallucinations).

2. Today’s New York Times reports appearance of AI-generated social media posts which inaccurately depict Taylor Swift in apparently sexual settings (let alone giving away cooking pans!).

3. The revival of the long-standing TV Series Law and Order last night aired a new program wherein key evidence in a murder trial was a surveillance camera shot of the crime which perhaps was created willfully by someone using AI to cover up guilt of another person; the TV lawyers speculated that you could never know, in the future, if evidence was true or AI-invented.

If you have had a “bad” AI experience and are willing to share (without identification of your name if I were to recount the fact pattern in a post), I would be interested in hearing about it as part of learning the various ways in which AI is creating problems in real life.  I have a feeling that we are moving into dangerous and fascinating territory both for individuals and for businesses alike….

 

Posted in AI

SEC vs SPACs

To review: a SPAC is an entity formed with the intent of acquiring an emerging private company which it will then operate, paying for that acquisition in stock.  The cash previously raised from investors in the empty (shell) SPAC is retained to finance the operations of that acquired business.  For years prior to the pandemic, SPACs were a way quickly to make acquired early-stage companies solvent and public, with less cost and regulation than going through a full SEC registration process (IPO).

The principal problems with prior SPAC practice: promoters of the SPAC took a lot of equity, diluting public investors; the regulatory structure controlling the SPAC process by which public investors ended up owning a public operating company were not as rigorous (relative to accounting and disclosure of the nature of the operating company) as would obtain if that company filed its own IPO (a lack of consistent regulation being applied to two transactions ending up with the same result once the dust settled); historically high compensation for the deal promoters–all against a backdrop that a disproportionately large number of SPACs performed poorly or went bust.  This last important point, not surprising given that early stage companies were financed via SPACs when they would not be commercially acceptable to investors in an IPO, caught the attention of the SEC, which is concerned with protection of the retail investor.

This past Wednesday, the SEC issued new regulations designed to make the SPAC process substantively equal in terms of disclosure to that which the public would receive in an IPO.  Not intending here to summarize over 500 pages of SEC output, suffice it to say that these new regulations require SPACs to: make clear the dilution suffered by public investors at the hands of the promoters; disclose the detailed bases of financial projections; and, remove an SEC rule that previously protected SPACs from all liability even if financial projections proved massively over-optimistic.

Preliminary lawyer reaction from the SPAC bar is that these new regulations (effective in about four months) will make SPAC deals slower and more expensive, but will not destroy the practice; in the future, only larger SPAC transactions will make economic sense.

Note: yet again the two Republican SEC Commissioners (out of five) voted against tightening SEC regulations. While no doubt the Democratic majority on the Commission is activist and thus seemingly always in favor of more regulation, it is hard in this instance to agree that regulation here is not warranted; past inconsistent regulation of similar business transactions is facially difficult to justify, and there is no doubt but that the failure rate (from the standpoint of the public investor) in SPAC companies was significantly worse than with IPO offerings.  You can rationally believe that IPO procedures are expensive and disadvantage small emerging companies, as seems to be the Republican viewpoint, but absent reform of the IPO process (which is not going to happen during a Democratic administration), the SPAC really was just an end-run around the regular standards for raising public equity.

AI and Copyright

Welcome to our first post of 2024; we had a robust holiday season, and further: now that AI has become the topic-de-jour, with articles and programs abounding, we will have less to say about AI as the world has caught up with our focus and view of AI’s importance, risks and transformative power.

Highlights of recent AI events: litigation by news sources and publishers, claiming that the use by AI in absorbing those publications into their database constitutes a copyright violation;  announcement from the US Copyright Office that they have received 10,000 comments in advance of anticipated issuance of regulations about  AI use (digestion) of prior published work and whether or not what AI produces based on such activity is a violation of copyright but rather permitted utilization under the “fair use” doctrine (per the New York Times today the typical number of comments in advance of similar (non-AI) announcements is less than a dozen); a startling visual in the press showing an AI generated image of “Joker” being an absolute copy of  the clearly trademarked “Joker” movie image.

Seems what is at stake here is whether your computer can get away with something that you, personally, clearly cannot do.  Yet another hint that robots will at some point rule our world?  (Just kidding–I think….)

 

Posted in AI

New Anti-Trust Guidelines

Two days ago, the Federal Trade Commission and the Department of Justice issued new and more restrictive guidelines for when the government will challenge business combinations in various categories.  These new guidelines define when the government will take action, and do not constitute law, but the government hopes they will impress the courts as the expression of agency expertise which the courts should follow.  These guidelines certainly define cases where businesses will find themselves being investigated and sued.

The new guidelines are extensive and nuanced; below are just a few highlights. Generally, the new guidelines shift some focus from protecting the consumer from high prices set by monopolies to a goal of both nipping that risk in the bud while considering impact of business concentration on the labor force (which has never been seen as a goal of anti-trust enforcement before).

High points:

*Focus on healthcare and roll-ups generally, with an eye on PE firm platform models (see prior post foreshadowing this focus, December 13, 2023)

*Lowering the level of concentration in a relevant market that will trigger either an investigation of a deal OR declaration of presumption of violation (and increased risk of litigation)

*Focus on coordination between competitors by reason of use of AI such as  pricing algorithms which will lead competitors to the same pricing decision (the risks of such an approach are interesting–what if independent examination of  available facts does lead to similar pricing?)

*How will a deal affect labor when competitors merge (a good question of public policy, but not contained in anti-trust laws which were mostly crafted at a time when even the legitimacy of unions themselves was being questioned)?

*Concerns over, or presumption of, illegality when a deal eliminates a potential competitor, or ties up access to a key component used by competitors

*Examination of effect of acquisition of partial or minority stakes in other companies

*Removal of several statements suggesting lack of problem with certain defined  mergers; now the focus can be based on a series of small deals, and a new deal can open inquiry into prior completed and presumable acceptable deals.

Final observation: anti-trust risk disappeared on many fronts over the last few decades, but has come roaring back in this Administration.  While it is a pleasure for a lawyer to say that companies doing deals need to consult anti-trust counsel, it is also correct advice in an increased number of cases, even of relatively small size.  Deals no longer need to be “big” to be “bad.”

 

Blockbuster SEC Release on Accredited Investors

Today the SEC issued its report on the definition of an “accredited investor” under the Securities Act of 1933.  This report is not only a cautionary tale for the future of capital raises exempt from substantial SEC regulation, but also the most interesting work of social commentary I have ever read.  Please ignore what you suspect is hyperbole and download today’s report (“Review of the ‘Accredited Investor’ Definition under the Dodd-Frank Act” from  http://www.sec.gov 

This 53 page report is replete with analysis of two things:

*the regulatory scheme presently in place which permits companies to raise money from individuals who are “accredited” (people we described pre-Regulation D as “rich and smart” and who now are defined by their income, net worth or professional qualifications as not needing protection of an SEC registered offering)  and

*a startling economic analysis of the distribution of wealth in the United States over the past two decades and the next three decades.

I may post fascinating details in the coming week, but here is the crux of the matter:

*inflation has made the economic criteria for being accredited as an investor far too low (as an example of various measures of wealth, an individual today need earn $200,000 per year to be accredited which captures a surprisingly large share of the US population, far more than contemplated when the current standard was set up and grossly inadequate over the next 30 years per projections) and

*although the amended standard for measuring wealth now excludes home equity in the net worth test of $1,000,000, much personal wealth today is tied up in benefit plans or IRAs not invested by the individual but by professional designees, and the individuals lack financial sophistication in investments which were presumed, in the beginning, to be a proxy for someone who was knowledgeable in investing and risk evaluation.

Speculation from the tone of the Report:  if I were the SEC, I would radically increase the financial standards for declaring a person accredited, increasing income requirements, or the alternate definition of net worth to exclude certain retirement accounts.  The effect of such action would sharply reduce capital available for emerging companies.  Note that 99% of all investors in Regulation D offerings (by far the most popular fundraising vehicle for early stage enterprises) are, per SEC estimates, defined as accredited. (There is also, it should be noted, a movement to DECREASE the threshold as a matter of equity, to afford investment opportunity to certain areas of the country or certain historically deprived segments of the population where reaching the present standards of wealth are not being met.)

Finally, a spoiler alert culled from the plethora of data in the Report to highlight the disconnect between the SEC current standard for “accredited” status and the concept that such status is a proxy for wealth and sophistication: using the $200,000 individual threshold, in 1983 one half of one percent of US households would be accredited; in 1989, 1.5%; in 2022, 13.8%; in 2032, projected as 23.9%; in 2042, projected 41.1%; in 2052, projected 58.5%.

I offer no comment on the impact on retirement planning that these projected numbers suggest for people whose life horizon reaches far into the future– a subject for another day.