Take That, SEC!

Violators of various laws enforced by the Securities and Exchange Commission long have been subjected to in effect a trial on the merits of alleged violations conducted by judges working within the SEC itself.  And indeed the whole systems always has had the unfortunate overtone of constituting one agency as both prosecutor and judge.  In 2010, the Dodd Frank Act nonetheless expanded the powers of SEC administrative judges, part of the effort to facilitate enforcement following the economic meltdown of 2008.

A few days ago, a panel of judges in the Federal Fifth Circuit (one of many circuits but the senior appeals court level in the Federal system before you end up in the Supreme Court) declared they SEC administrative judge system unconstitutional as violating the right to a jury trial, let alone by judges who cannot be removed from office.

This will be appealed, as it strikes at the core of the SEC matrix of enforcement and is a bell-weather case for many other governmental agencies.  The underpinning of the decision is a theory known as “non-delegation”: it is imporoper for Congress to delegate its legislative powers.

These issues already are on the SCOTUS docket for next session, and there is great uncertainty as to expected results given the conservative bent of the Supreme Court.  This is the third consecutive post by me this date admonishing readers to “stay tuned” in significant areas of legal practice.

A word of apology for failure to post for a bunch of weeks; the law racket is pretty busy, we had a viral visitor in our house, the college kid returned spreading expected chaos.  As Bogie once said: “destiny takes a hand.”  I will try to do better….

DEI Takes a Hit in California

The State of California garnered great praise a couple of years ago for advancing the cause of diversity on boards of business corporations by requiring public companies with a principal office in California to include specific numbers of minority community members on their boards.

A recent decision by a Los Angeles judge has struck down the law as unconstitutional, although the State pointed out that no company had ever been fined for a violation and that no tax dollars ever were used to enforce the law.  Fines were permitted, up to $300,000 for multiple violations. In fact, about half of the affected companies did file required compliance reports, which means about half did not.

This may not be the last word in California, and California is not the only jurisdiction with some sort of law seeking to achieve board diversity (not to mention several foreign countries with similar national legislation).  But conservative groups long have opposed such laws favoring minorities and women as a discriminatory quota.

Many companies have adopted efforts to diversify boards even absent legislation, for business reasons or for the poor public optics of failing to diversify; and, for public companies the pressure for diversity can be intense from the public and from the proxy consulting firms that often advise institutional investors as to how they should vote their shares at annual meetings.  Again, this is one arena in which future battles clearly will be joined.

Massachusetts Employees Beware

Every employee knows that it owes a duty of loyalty to an employer, must abide by agreements with an employer (in non-com0petition, provided Massachusetts law is observed), and certainly that an employee cannot steal the files, secrets and data of a former employer to start a competing business.

Most people in business in Massachusetts also are aware of “Chapter 93A,” a statute designed to protect consumers against unfair or deceptive practices in the conduct of any trade or in commerce.  Given the purpose of the statute, courts over the five-plus decades this statute has been on the books have refrained generally from applying 93A to intra-corporate matters, including claims by companies against former employees for breach of employee agreements or fiduciary duties.

However,, in a recent case (Governo) involving (of all things) a group of lawyers departing their old firm, these attorneys copied files and papers from that firm and used them in their new law practice.  Perhaps outraged that lawyers would ever (gasp!) do such a dastardly thing, the Massachusetts Supreme Court did allow the old firm to make a claim under 93A, holding that where a defecting employee uses purloined materials, that use “is not purely an internal matter; rather it comprises a  marketplace transaction” falling under the statute.

Since 93A provides extraordinary recoveries (legal fees and double or triple actual damages), the price of using a former employer’s information has just gone way up.   Short of actual litigation, this ruling also may change the balance of power in negotiations wherein a former employer is threatening a claim against a business accused of using stolen information.  Stay tuned….

SPAC Attack: the SEC Acts

After months of SEC warnings that SPAC regulation was coming, and after numerous SPAC deals lost investor value post-deal, the SEC has proposed rules (subject to comment and amendment) that are a combination of traditional SEC disclosure requirements and imposition of substantial penalties if a deal goes South.  Highlights follow (but the proposals, all 372 pages of them, are worth a read at least if you are a SPAC investor).

Disclosure is required in great detail as to the profits being taken by the promoters of the deal which, of course, take investor cash off the table and dilute retail investor equity (the idea seems that if it is clear how much the promoters rake off the top then those promoters will have to cut back on their returns).  Disclosure is also directed at possible conflicts of interest (the promoters and management of the companies the SPAC acquires are richly rewarded if the SPAC actually proceeds and buys the target company, presumably inspiring a lack of care).

Enforcement teeth also are sharpened here.  Under current practice it is the promoters, the people who collect funds into the SPAC to attract an operating company into a merger, who are responsible under the Securities Laws for the accuracy and completeness of the disclosures to investors.  The SEC proposals would add the management of the target company to the group liable for the inaccurate public disclosure, which presumably would force the target company to be more candid about the value and operations of the target entity being acquired by the SPAC.

Further, certain statutory provisions written into Federal Law in 1995 protect issuers of securities from liability if their projections are honestly generated even if proven wrong. This is particularly important in SPAC offerings, where projections of future performance, seldom placed in traditional IPO prospectuses, typically are included in the public disclosures.  The SEC proposal makes this statutory protection unavailable to SPAC deals, putting great pressure on keeping projections more shall we say “modest.”

There are other technical proposals having to do with who is an underwriter of securities (that status can create liability in a bad deal) and, for edification of the truly curious, a discussion of how to keep a SPAC out of classification as an Investment Company (to save space, let me just say that being an Investment Company creates huge regulatory issues).

Again, I am constrained to note, the sole surviving Republican SEC Commissioner voted “nay,” claiming that adoption of these proposals was a death knell for SPACS.  Although not likely, surely these regulatory changes may well take the sizzle out of SPACs — although one might think that the market reaction to existing SPACs would have had that result already, that is if any retail investors were paying attention.

Your Stock Broker Is Not Your Fiduciary

Massachusetts Secretary of State Galvin, who supervises the State Securities Division that in turn oversees investment markets and professionals, long has been diligent in pushing the limits of his power to protect the retail investor.  In March of 2020, his office promulgated a rule holding stock brokers who make recommendations to customers to a “fiduciary” standard, which is the highest legal obligation that one can hold.

Along comes Robinhood Financial, the no-charge brokerage platform about as controversial as a brokerage can be.  Think the run-up of GameStock shares.  Robinhood brought suit against the Secretary of State, claiming that a brokerage does not have an almost absolute liability, in recommending a stock, at least as far as a duty to investigate the stock in detail and apply a high standard of taking actions with the constant intent to protect the investor.  This is the kind of duty that your investment advisor owes you– not to be always right, but to take very great pains to try to be right.

There is no doubt a continuum of duties here, and the line may be hard to find, but it matters what the legal standard says.  And, Robinhood just won its case, as the Suffolk Superior Court held that it was not within the power of the Secretary of State to require that brokers be held to the same standard applied to investment advisors.

Beyond our scope is a discussion of Federal regulation which has grappled with defining these standards; the Massachusetts case turned on the fact that Massachusetts common law (court decisions) never had held that brokers were fiduciaries and that Galvin had no authority to set a different rule.  Galvin was given thirty days to appeal.

Massachsuetts always has been rigorous in overseeing the securities industry.  I recall decades ago an upstart company was doing an IPO, I was a user of its product and wanted to invest, and Massachusetts wouldn’t allow Mass brokers to handle the stock.  I had to call my father in New York to buy me a hundred shares.  Pretty embarrassing as I was already practicing law at the time.  Of course I was and am glad I persevered; turns out that Apple was in fact a pretty good investment…..

SEC’s New Climate Reporting

The SEC announced last week proposed new climate disclosure requirements for public companies which are sweeping to the point of panicking management and disclosure professionals.  No doubt during the public comment period there will be many calls to cut back the regulations.  Why the furor?  Everyone knows climate is a big deal and can cause economic havoc and companies public and private to adjusting strategy because they clearly must.

Much of the required disclosure is obvious: what is the company policy to control emissions that might impact the environment.  There is also a requirement to discuss how a company is handling severe weather– perhaps not about energy policy but is anyone out there ignoring weather issues these days?

Well, there is a requirement to report on so-called “Scope 2” factors– how the company is dealing with emissions by suppliers of electricity, steam, heat and cooling.  And “Scope 3” disclosures seek  an overall report of a company’s environmental footprint based on emissions of suppliers and customers.  Since Scope 3 does appear outside the control of a company, at least as to customers, it feels like a stretch at best, and social engineering through the disclosure laws at the worst.

And the one still-surviving Republican SEC member raised these very points, questioning also the accuracy and relevance of such data: the data “are, in large part, highly unreliable.”

Whether this is just disguised global warming denial or not, nonetheless it surely is hard to picture how a company can measure actions of, or cause  impact  upon, its customers, and even measure  the degree to which effective pressure can be put on suppliers.  Maybe Germany can pressure its supplier Russia these days, but how that thinking translates to the economic marketplace is a bit more opaque.

I almost did not do this post; I delayed it.  I am all for a robust energy policy and better environment and fewer forest fires and tornados.  And there has been so much written in the general and business press about these proposed regulations that I wondered if the world really needed to hear my view on the subject. Indeed, corporate advisors and major accounting firms are tripping over themselves to offer Zoom meetings about what this means in the real world.

But I do think it is useful to ask the question in terms of how our government should operate, even if one endorses a liberal agenda and favors the control of emissions as a matter of government policy.  The question is, why is the SEC on point on this?  Seems to me the legislature, advised by government agencies in the sciences, ought to be the source of laws saying what you must do.  Why is this issue being approached by telling companies what they must to disclose, and this coming from an agency that is neither elected by voters nor informed by a deep dive in the science?  Is it simply that the administration can control the SEC but cannot get social policy passed by the Senate?

I am sure the SEC gathered a lot of data and that its heart is in the right place, but still– just makes me nervous that the SEC seems to be the cutting edge on climate control.

Ukraine, SEC and Cyber

Those tuning into the numerous webinars offered by investment advisors and other organizations, and those reading the serious press, have been made aware of the fear of Russian cyber attacks in the context of the Ukrainian invasion.  Those following US business have long been aware of the risk and cost of cyber attacks and ransomware on both vital infrastructure and the operation of all manner of business enterprises.

It is thus both unsurprising and timely that on March 9 the SEC proposed robust amendment to its mandatory disclosure scheme for public companies relative to cyber risk.  Highlights of the numerous suggested regulatory changes follow; all are subject to a two month period of public comment.

The SEC has proposed: current reporting about material cyber incidents including those previously reported; disclosure of company policy and procedure to uncover and manage cyber risk; specific focus on the board’s oversight, and disclosure of board cyber expertise if any, and the role of management in cyber risk.

The request to disclose board cyber expertise carries with it the implicit suggestion that well-run companies might do well to have a “cyber” member.  It would appear, however, that a board which has sharp focus on cyber nonetheless could rely upon management, supported by third party consultants and technical support, to do a good job on this area of technical vulnerability.  The fact that something has great risk speaks to focus on it and clear identification for the risk committee, and not the necessity to place a person on the board.  Cyber (however vital and important) is not a strategic area, but rather an operational area.  We do not have board members who are expert on manufacturing assembly lines or IT configuration, and to the extent the SEC is suggesting there needs to be a cyber board seat we might see kick-back in the public comments.

SEC Ratchets Up Shareholder Rights, Disclosures

Last week the SEC advised a meeting of institutional investors that by April it will issue for public comment rules to facilitate submission by shareholders of proposals to be considered at annual meetings, and promised to strengthen disclosure requirements about human capital and climate.

There is lack of clarity, and often legal squabbling, over whether shareholders are entitled to include ESG-related provisions on the stockholders’ agenda.  The Democratic majority on the Commission is reported by Law360, a legal industry source, as having “moved toward policies considered friendlier to shareholder advocates.”

Separately, in continued efforts to roll back Trump-era regulation protecting businesses from both SEC oversight and other criticism, the Commission also promised to scale back regulations limiting activities of proxy firms (firms that advise stockholders as to objectionable management activity or policy).

Both climate change, and the increasingly difficult task of finding human capital management approaches that mitigate the effects of workforce costs and mobility, make these subjects prime landing grounds for shareholder activist proxy focus so these SEC developments are not so startling in current context.

SEC To Shrink Investor Access to Private Offerings?

To use the most efficient exemption from SEC registration in the sale of company shares, Regulation D, purchasers generally must meet the definition of “accredited investor.” In the waning days of the Trump-Republican SEC, the definition of “accredited investor” was widened to allow more people to participate in the private placement of securities for non-public companies, including start-ups. Today, with the Democratic majority of commissioners in control, the focus has swung back toward what is characterized as investor protection (as opposed to investor access).

Last week the SEC announced it would propose for comment, in April, amendments to shrink back those eligible for “accredited investor” status.  The threshold of wealth to so qualify ($200K of annual earnings, $300K for couples) has been static for forty years, and now will be adjusted prospectively for inflation.  At the start, only 2% of American qualified for this status; today, 13% do.

It is unclear whether the 2020 liberalization of the people eligible for this status, beyond earnings, would be amended; that new cohort included sophisticated persons, holders of brokerage licenses and “knowledgeable employees” of private funds.  Or whether the net worth alternative test will be adjusted.

Other possible approaches: establishing higher or lower economic thresholds for different parts of the country (higher in wealthier city areas), amending the Rule (701) that allows small firms to  compensate workers with equity which is not registered, and limiting the number of repeat unregistered offerings.

The policies of the SEC always have reflected the differing sensibilities of the party in power, but it is hard to believe that the financial markets are much benefited by a rapid back-and-forth pattern of regulation.

SEC: To Regulate “Unregistered” Unicorns?

Unicorns are huge companies, often with many shareholders, whose securities are not registered with the SEC.  They have been privately financed by sophisticated investors, have never done an IPO, and do not have over 2000 shareholders (which would require them to registered under the Securities Exchange Act of 1934 and provide periodic reporting.)

We are told there are 986 of these Billion dollar plus entities so their total unregulated market value is well in excess of a trillion dollars.

Nothing annoys the current Democratic SEC more than anything unregulated– unless it is something that is large and unregulated.

The current SEC agenda includes a study of how shareholders “of record” are counted for the purposes of falling into the mandatory reporting category of 2000.  (The number was upped in 2012 from 500 to reduce regulation and fuel private financing of larger enterprises.) At present, the following investors count as “1” in such calculation: VC and other funds; a brokerage’s street-name holdings.  Each of these could have dozens, indeed hundreds of ultimate “stockholders” but they are not “of record” so the count is only one for each.  The SEC current agenda seems to be considering requiring the disclosure and counting of underlying  investors in each category, no doubt greatly increasing the number of shareholders — likely in some cases over 2000.

Can the SEC change the method of counting?  Current legal commentary seems to think that they can, as there is no law fixing a method.  Perhaps the reference to stockholders “of record” is deemed within the power of the SEC to interpret (although one could imagine a challenge to that power if the SEC takes action).

What will the effect be if such a change is promulgated?  Large companies now private will become public, their shares freely tradeable, their information knowable in detail (and subject to lawyer scrutiny for misrepresentation suits).  Will this threat cause future would-be unicorns to in fact register up front?  Will such action slow down capital formation by subjecting large investment needs to SEC delays and investor reticence (do some people invest because they think they have an inside track on a private deal?)? Will management, which may not want to be public for whatever benign or non-benign purpose,  limit the nature and number of early investors, thus shutting off the wider investment community from the investment opportunity (not an SEC goal, presumably)?  Will present unicorns do reverse stock splits or redemptions to reduce the number of investors to below 2000?

Trite but true: you had best stay tuned….