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….

 

Delaware Tightens Rules on SPACs

SPACs have been criticized extensively for favoring the promoters and their cronies while the merged operating company does not reward the investors.  Most SPACs are formed and will continue to be formed in Delaware.  The Chancery Court early this month agreed to allow a shareholder suit to proceed against the founders of a SPAC in a manner suggesting how Delaware courts will view claims leveled at SPAC directors (see In re: MultiPlan Corp Stockholders Litigation, #2021-0300).

There are technical elements to this case which defy terse analysis,  but basically the claim is that the promoters did not give full disclosure of details to the SPAC investors, who then did not ask for their investment to be refunded (as they were at the time legally entitled to request), but stayed invested and became thus shareholders of target company that the SPAC acquired; in this fashion the acquired company became publicly held.  Stockholders claim that they were not given all the facts when they decided to stay with the merged company, and sued the directors (and the promoter who got a .$300M promote on the merger) for the money they lost when the new company shares fell in value by reason of facts known to the directors at time of deal.

Disclosure in SPAC acquisitions historically has not been complete as to the insider deals, and promoters have sometimes named the same people over and over as directors, who made profit without risk and voted in favor of the acquisition.  Perhaps the thrust of this case is that the level of SPAC disclosure of deal terms will be stepped up in order to protect promoters and directors; the mere receipt of profit is not itself wrongful if it is disclosed in fullness, so as to permit investors to say “no” and get their money back pre-merger if they so elect.

A separate issue is the SEC regulatory view: if SPAC acquisition disclosure were made as robust as is required in a regular IPO as to insider benefits, presumably application of such a standard would insulate profiting directors and promoters from liability even if those SPAC investors ultimately lose money by staying in the deal.

Forgive me, finally, if you know this but I just love the nomenclature here: the transaction by which a SPAC acquires a target and makes the target a publicly held entity is called a “de-SPAC.”  I guess the plaintiffs in the above case would choose different wording.

Warby Parker and Harry’s Founder Interview

I just got off a Zoom webinar where Jeffrey Raider, a founder of both Warby Parker and Harry’s (the shaving company), spoke about his approach to innovation and the growth of his two multi-billion-dollar companies. Notable take-aways follow:

Each company was built digitally but is viewed as branded companies and thus product finds its way into brick-and-mortar.  The reason is simple: that is where a large part of the market resides.  The companies started on-line but the management view is “customer first” and not “digital first.”

Each company was founded based upon perceived need in the market-place.  If you want to start a company, “ask what upsets you” in the consumer experience.  Examples: glasses too expensive due to various mark-ups taken in various steps delivering product; razor blades were far too expensive; waiting for a taxi was aggravating (reference presumably to birth of Uber et al).  (Per the interviewer, Harvard Professor Jeffrey Rayport, founders should fall in love with the problem, not the solution.)

Harry’s was built in some measure by deep involvement with customers to find out what they wanted.  Digital engagement was successful and, for example, when customers were asked for reactions, one email was opened by 50% of recipients and responded to by 10%.

Warby’s was conceived  by Wharton students while still in school.  Not an unusual story, but interesting nonetheless.

Btw, kudos to C Level Community, a company affiliated with the Neptune Advisory Company, for organizing programs with leading corporate presidents and founders; the program with Raider was one of them.

PE, Hedge Fund Fees in SEC Gunsights

I have written here, and in my recent article (Fall 2021 issue in Massachusetts InHouse) about the activist agenda of the Democratic-controlled SEC under Chair Gary Gensler.  Yesterday, Gensler furthered that agenda by announcing that the SEC will address transparency in fees paid to sponsors of PE and hedge funds.

The SEC cannot attack substance, in the sense that the amount of fees taken by the sponsor-operators of these funds is a matter of freedom of contract.  But every dollar going to these folks is indeed a dollar less going to the investors.  The SEC is of the view that funds are not making sufficiently clear what the sponsors are in fact taking off the table– a matter of disclosure.

The stated SEC drivers are to increase competition which will lower fees, and thus assist the investor cadre, which is appealingly described  as consisting of pension funds, school endowments, retiring people and those paying for college.  I  suppose that wealthy, non-retired, childless trading professionals also will be allowed to benefit from whatever investor benefits will be derived from this effort…..  🙂

Nor do I suggest that the bottom line goals of the SEC are misguided and, in this context, it is a bit difficult to understand Republican member resistance, which is actually framed in what seems a thin disguise of complaining that comment periods on new regulations are being expedited to shrink public comment periods from customary 60 days to 45 days or less; readers of public comments on pending SEC regulations, accessible to the public at SEC.gov., know that people with a real interest are prompt to post support or objections.  Surely lawyers for fund sponsors and managers are not going to miss an earlier comment deadline.

Supply Chain Impacts You Never Knew

With thanks to National Association of Corporate Directors–New England for this week’s  fabulous panel discussion with senior executives of General Motors, Boston Scientific and Dunkin’, here are some take-aways beyond an understanding that product disruption is being generated by various supply chain problems of both suppliers and intermediary freight services:

  1. Inflation may well be here to stay.  Increased prices driven by scarcity and increased delivery cost will not be surrendered by shippers or vendors later on; all this gets passed on to purchasers.
  2. Changes in the labor market due to COVID are permanent. The price of labor will remain high.  When we off-load all the stuff on the water, there will be a flood of more goods to be processed, sold etc.  This will make worse the labor shortage.  Furthermore, US birth rate is not sufficient to fuel future growth; we need to address the supply chain of labor.  Issue: immigration policy.
  3. Inflation in cost and thus price is no big deal to vendors because everyone is suffering, everyone will raise prices so market share will not be lost by charging more.
  4. “Just in time” buying has made markets efficient but that left no flexibility.  No excess production or delivery options.  Today purchasing models are different, inventories growing (“just in case”). We will return to just in time delivery in the supply chain BUT will likely be changes: perhaps a bit more inventory on hand, getting more suppliers of each item for flexibility, sourcing suppliers closer to home (“on-shoring”; less Asian reliance), design of components to be more easily duplicated/produced.  Counterpoint: inventory build-up is fundamentally inflationary as it increases price , and thus is heavy on management’s mind– at 10% increase in inventory at GM, vs “just in time,” cuts profit margins by the cost of money for $10 Billion of inventory maintained.  (“Supply chain is 70% of our {G&M] P&L.”)
  5. Everyone is focused on labor not just in terms of cost but also in terms of quality of performance; with wages increasing and mobility easier and with new models of working, everyone is working to ensure that key employees do not leave– ESG, DEI and pay factors related to managing supply chain issues now and adapting to changes in the future.  Question for board comp committees: do you reward the team or do you pick out your key players and build a comp plan based on specific performance of specific persons with specific measurable tasks?
  6. Chinese government COVID policy impacts supply chain and drives on-shoring because zero COVID tolerance=plants entirely shut down if any COVID=less supply being produced by definition.
  7. Some industries have shelf-life issues.  Dunkin’ supply chain and distribution chain deals with food-stuffs that spoil.  Boston Scientific deals with biologics.  Think about each business: some cannot tolerate much deterioration in “just in time.”
  8. Specific interesting issues: to cut costs of delivering  product, some companies will produce them nearer to markets.  In this regard, interestingly, GM has a shelf-life problem like Dunkin’ as its products have a shelf-life also by model year.  Boston Scientific is major world-wide supplier of certain products that have life-saving aspects, and they are attempting to recast supply and distribution chains because people can die if not done well.
  9.  Inventory levels will stay high for 2-3 years. Return to “normal” will be slow due to lack of flexibility in current systems.
  10. Everyone needs chips. Cars of course.  Boston Scientific of course.  Every business as they are working on AI solutions to supply chain issues which need devices which contain chips, etc.
  11. One corporate director on the panel noted that every business needs chips even when you do not think so; her companies make robotic cleaning devices all over the world; Tupperware makes kitchen gadgets.