Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The United States House of Representatives passed the bipartisan JOBS and Investor Confidence Act of 2018, which is often referred to as JOBS Act 3.0. The bill is comprised of 32 individual pieces of legislation that have passed the Financial Services Committee or the House this Congress with broad bipartisan support.  You can find a description of the individual pieces of legislation here.

The House legislation was passed as House Amendment to S. 488 (previously known as the Encouraging Employee Ownership Act), under suspension of the rules. The bill passed by a vote of vote of 406-4.

Senate Majority Leader Mitch McConnell has reportedly committed to bring the bill up for a vote.

Some of the highlights of the legislation follow.

The Promoting Transparent Standards for Corporate Insiders Act requires, among other things, the SEC to carry out a study of whether Rule 10b5–1 should be amended to limit the ability of issuers and insiders to adopt a certain 10b5-1 plans only during issuer-adopted trading windows and limit the ability of issuers and insiders to adopt multiple, overlapping trading plans. In addition, after the completion of the study, the SEC is required to revise Rule 10b5–1 consistent with the results of the study.

The Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017 amends the Securities and Exchange Act to provide a broad exemption from registration as a broker dealer for certain investment bankers selling privately held companies.

The Fair Investment Opportunities for Professional Experts Act changes the definition of accredited investor to include any natural person who is currently licensed or registered as a broker or investment adviser by the SEC or FINRA or any other natural person the SEC determines, by regulation, to have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA.

The Modernizing Disclosures for Investors Act requires the SEC to provide a report to Congress with a cost-benefit analysis of EGCs’ use of SEC Form 10-Q, including the costs and benefits to investors and other market participants of the current requirements for reporting on Form 10-Q, as well as the expected impact of the use of alternative formats of quarterly reporting for EGCs. The bill also directs the SEC to report to Congress with recommendations for decreasing costs, increasing transparency, and increasing efficiency of quarterly financial reporting by EGCs.

The SEC charged a hedge fund sponsor that manages private funds and separately managed accounts focused on global distressed, special situations, and opportunistic investing with failure to timely file a Schedule 13D. The hedge fund had previously reported its holding on Schedule 13G.

The hedge fund had a senior managing director and portfolio manager that became a candidate for a board seat on a public company and began acting as a de facto board member. On October 28, 2014, the portfolio manager and a financial analyst emailed a list of recommended changes to the public company’s lead outside director and Chief Executive Officer. The e-mail noted “operations are a mess” and that “[i]nvestors don’t have unlimited patience.”

On November 6, 2014, the public company, at the suggestion of the portfolio manager, formed a special sub-committee of the top three officers and the independent directors. Thereafter, the special sub-committee held regular discussions with management of the public company, including the consideration of proposals for cost cutting, capital allocation, oil well development, and changes to the tone at the top. The portfolio manager participated in these discussions even though he was not yet appointed to the public company board.

On December 15, 2014, the public company board voted in favor of appointing the portfolio manager and a second candidate to join the company’s board. Later that same day, the public company filed a Form 8-K announcing the new appointments to its board. On December 22, 2014, approximately 45 days after the SEC asserts it had incurred a filing obligation, the hedge fund sponsor filed a Schedule 13D, disclosing that its portfolio manager was appointed to the public company board of directors on December 15, 2014.

The parties involved did not admit or deny the SEC’s findings.

This statement from Congresswoman Maxine Waters (D-CA), Ranking Member of the House Committee on Financial Services, confirms the House continues to work on JOBS Act 3.0. The press release notes six Democratic bills were being considered by the House Committee. Congresswoman Waters stated “Mr. Chairman, these Democratic measures that I have outlined are a step in the right direction as you continue your effort to move forward a package of capital markets bills known as the JOBS Act 3.0. For the JOBS Act 3.0 to truly facilitate capital formation, promote a stronger economy and create jobs, it is important that we work together to include common-sense bipartisan legislation.”

The statement notes Congresswoman Waters is “sponsoring the Promoting Transparent Standards for Corporate Insiders Act, which would limit the ability of corporate insiders to trade on non-public information. For years, we have heard stories about executives abusing their power by using loopholes in the securities laws to personally gain from confidential information. This bill would require the SEC to study whether to amend antifraud provisions that are used to combat illegal insider trading, report to Congress and write rules consistent with the results of the study.”

You can find a description of eight bills advanced by the House Committee here, which includes the Promoting Transparent Standards for Corporate Insiders Act.

This Washington Examiner article notes JOBS Act 3.0 faces an uphill battle during an election year. However, Jeb Hensarling, the conservative chairman of the House Financial Services Committee, reportedly secured a commitment from Senate Majority Leader Mitch McConnell for a vote on a legislative package. That deal was struck in order to facilitate the passage of the recent Dodd-Frank reform legislation.

 

The SEC has targeted disclosure of executive perquisites in another settled enforcement action.  According to the SEC, the issuer did not follow the Commission’s standard regarding disclosure of perquisites, which provides that:

  • An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.
  • Otherwise an item is a perquisite or personal benefit if it confers a direct or indirect benefit that has a personal aspect without regard to whether it may be provided for some business reason or for the convenience of the company, unless it is generally available on a nondiscriminatory basis to all employees.

Instead, the SEC stated the issuer incorrectly applied a standard whereby a business purpose related to the executive’s job was sufficient to determine that a benefit would not be a perquisite that required disclosure.  As a result, the issuer did not disclose personal use of corporate aircraft and other expenses.

The SEC alleged the issuer did not adequately train employees in key roles, including those tasked with drafting the CD&A section of the proxy statement and compiling the executive compensation tables, to ensure that the proper standard was applied for perquisites disclosure.  The SEC also alleged the issuer had inadequate processes and procedures to ensure proper reporting of perquisites. The issuer’s personnel compiled the executive compensation table from a variety of sources without ensuring that the amounts reported were consistent with the Commission’s perquisite disclosure rules.

The issuer agreed to pay a civil money penalty in the amount of $1,750,000.  Among other things, the issuer agreed to retain at its own expense an independent consultant, not unacceptable to the staff of the Commission, for a period of one year, to conduct a review of the issuer’s policies, procedures, controls, and training relating to the evaluation of whether payments and other expense reimbursements should be disclosed as perquisites under the securities laws, including the Commission’s rules and standards.

The issuer did not admit or deny the SEC’s findings.

The SEC entered into an agreed settlement with a private equity group for receiving accelerated fees without the consent of all necessary parties prior to the commitment of capital. The SEC alleged the private equity group typically entered into agreements with portfolio companies, pursuant to which it received periodic fees in exchange for performing consulting and advisory services for the portfolio companies. Upon the initial public offering or sale of the portfolio companies, certain of the private equity group’s agreements with the portfolio companies terminated automatically, and the private equity group received an accelerated, lump sum payment of the fees that would have been payable to it for providing services for the remaining term of the agreement. Between 2013 and 2015, the private equity group received accelerated fees upon the early termination of portfolio company agreements in five instances, one upon the sale of a portfolio company and four upon initial public offerings of portfolio companies.

According to the SEC, the private equity group disclosed in the funds’ governing documents that it may enter into consulting agreements with portfolio companies and receive consulting fees from portfolio companies, a majority percentage of which would be shared with the funds’ limited partners in the form of management fee credits, while the private equity group kept the remainder of the fees. Additionally, as to one fund, the private equity group entered into binding side letter agreements that contained a provision stating “[f]or the avoidance of doubt” that the private equity group may receive fees upon the sale or IPO of portfolio companies, which the private equity group also credited against management fees. The private equity group provided notice of the side letter provision to more than three quarters, but not all, of the fund’s limited partners. The private equity group also disclosed, in semi-annual financial reports provided to all limited partners, the amount of periodic and accelerated fees and the shared and retained portions, and portfolio companies disclosed the accelerated fees in Commission filings in connection with their IPOs or, in the case of one company, sale.

Nevertheless, and despite the robust disclosure, the SEC said the private equity group did not adequately disclose to the funds, their advisory committees, or all the funds’ limited partners, prior to their commitment of capital, that the private equity group may receive accelerated fees upon the early termination of portfolio company agreements.  Among other things, the SEC found that by engaging in a practice of negotiating and receiving accelerated fees from portfolio companies without adequately disclosing this practice to all of the funds’ limited partners prior to their commitment of capital, certain statements by the private equity fund to the funds’ limited partners were made misleading, and thus the private equity group negligently violated Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

The private equity group did not admit or deny the SEC’s findings.

As we noted here, the SEC has issued final rules regarding the mandatory use of Inline XBRL and revising the definition of smaller reporting companies, or SRCs.

Inline XBRL

The new Inline XBRL rules include conforming amendments to the cover pages for certain periodic reports, including Forms 10-K and 10-Q. The change to the cover pages eliminates reference to compliance with the website posting requirement. While there is a generous phase in period for required use of Inline XBRL, the rules are technically effective 30 days from publication in the Federal Register.  Therefore, these  changes to the cover page are potentially applicable to second quarter Form 10-Qs for calendar year issuers.

The referenced forms have been revised as follows:

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Smaller Reporting Companies

The new rules include conforming amendments to the cover pages for registration statements (Forms S-1, S-3, S-4, S-8, S-11, Form 10) and periodic reports (Forms 10-K and 10-Q). The new SRC rules now specify a larger threshold for SRC status but the definition of “accelerated filer” remains unchanged.  The change to the cover page of the referenced form reflects this change.  The rules are effective 60 days from publication in the Federal Register.

The referenced forms have been revised as follows:

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company”, and “emerging growth company” in Rule 12b 2 of the Exchange Act.:

Large accelerated filer  []        Accelerated filer []

Non accelerated filer [] (Do not check if a

smaller reporting company)

Smaller reporting company []

Emerging growth company []

The SEC has long recognized that smaller issuers should be subject to somewhat less stringent disclosure standards than larger companies. The SEC has referred to this as “scaled disclosure” and has embodied the idea in a series of rules for smaller reporting companies, or SRCs.  The SEC has adopted final rules to expand the availability of scaled disclosure requirements for a company qualifying as an SRC by allowing companies with a public float of less than $250 million to qualify as an SRC, as compared to the $75 million threshold under the prior definition.  In addition, companies that do not have a public float are now permitted to provide scaled disclosures if annual revenues are less than $100 million, as compared to the prior threshold of less than $50 million in annual revenues.

The adopting release for the change to the SRC definition discusses other important topics as well. For instance, the Commission did not raise the accelerated filer public float threshold or otherwise modify the Section 404(b) requirements (which include mandatory auditor attestation of internal controls) for registrants with a public float between $75 million and $250 million in this release, choosing instead to defer such potential relief to future rulemaking.  So public companies with a float of $75 million to less than $250 million can take advantage of scaled disclosures, but since accelerated filer status does not change, the deadline for filing reports stays constant.  In addition, unless an issuer is an emerging growth company it will need to continue to provide auditor attestation of internal controls.

While not required under the new rules, issuers planning to avail themselves of the newly-available thresholds for SRCs should consider providing advance notice to the investing public that future filings will include scaled disclosures commensurate with requirements applicable to SRCs under Regulation S-K. This could be done in the upcoming second quarter 10-Q.

The SEC also adopted final rules mandating issuers use Inline XBRL. Inline XBRL embeds most of the XBRL data in the text of the SEC filing rather than an exhibit to the SEC filing.  The SEC believes this makes the XBRL data more useful and easier to prepare, thereby reducing errors.  While portions of the rule will be effective shortly, mandatory use of Inline XBRL is subject to an extended transition period.  The Inline XBRL requirements for financial statement information will apply to all operating company filers, including SRCs, emerging growth companies and foreign private issuers.

SEC Reduces Thresholds for Smaller Reporting Company Definition

The Securities and Exchange Commission voted to approve modifications to the SRC definition under Rule 12b-2 of the Exchange Act increasing the population of companies that may provide scaled disclosure in public filings pursuant to the requirements for SRCs under Regulation S-K. The Commissioners were unanimous in their approval of the technical changes to the SRC definition despite debating the significance of the changes and their impact on compliance costs and capital formation.

SRC Thresholds

The final rules enable a company with public float of less than $250 million to provide scaled disclosures as an SRC, as compared to the $75 million threshold under the prior definition. In addition, companies that do not have a public float are now permitted to provide scaled disclosures if annual revenues are less than $100 million, as compared to the prior threshold of less than $50 million in annual revenues.

As under the prior rules, once a company exceeds either of the thresholds, it will not qualify as a smaller reporting company again until public float or revenues decrease below a lower threshold set at 80% of the initial threshold. Under the final rules, a company would re-qualify as an SRC only if its public float is less than $200 million or, if it has no public float, its annual revenues are less than $80 million.

The impact of the changes will be felt by a number of companies for which scaled disclosure will now be available. In her comments on the rulemaking, Commissioner Kara Stein cited data indicating that nearly a thousand public companies will become eligible to provide scaled disclosure as new SRCs upon adoption of the rules.

An issuer’s status as an SRC is determined on an annual basis. For issuers required to file public reports under section 13(a) or 15(d), the applicable public float is measured on the last day of the issuer’s most recently completed second fiscal quarter, while annual revenues are tested as of the most recently completed fiscal year for which audited financial statements are available. Issuers must reflect their determination of SRC status in quarterly reports for the first fiscal year of the next year and in subsequent filings. The final rules will become effective 60 days following their publication in the Federal Register. Practically speaking, this means that that for calendar year filers the new rules will be available for Forms 10-Q filed for the third quarter in 2018.

Issuers should also keep in mind that the new rules include conforming amendments to the cover pages for registration statements (Forms S-1, S-3, S-4, S-8, S-11, Form 10) and periodic reports (Forms 10-K and 10-Q) and will need to re-evaluate the appropriate boxes to check.

We would also advise any issuers planning to avail themselves of the newly-available thresholds for SRCs to consider providing advanced notice to the investing public that future filings will include scaled disclosures commensurate with requirements applicable to SRCs under Regulation S-K. This could be done in the upcoming second quarter 10-Q.

Rule 3-05 of Regulation S-X

The final rules also revise the financial statement requirements for business acquisitions under Regulation S-X. In its prior formulation, paragraph (b)(2)(iv) of Rule 3-05 of Regulation S-X allowed registrants to omit financial statements for the earliest of three fiscal years required if the net revenues of the business to be acquired are less than $50 million (following the revenue threshold under the SRC definition). The newly-adopted rules make corresponding changes to Rule 3-05 to permit the omission of the financial statements of acquired business falling under $100 million in annual revenues.

Accelerated and Large Accelerated Filer Definitions

The final rules also revise the “accelerated filer” or “large accelerated filer” definitions to remove provisions specifically excluding from the definitions issuers eligible to use rely on the scaled disclosure for their annual and quarterly reports. As a result, the final rules preserve the prior thresholds contained in the accelerated filer and large accelerated filer definitions but, as expected, do not include commensurate amendments to the public float thresholds for when a registrant would qualify as an accelerated filer or large accelerated filer in coordination with the increased SRC thresholds. As a result, companies with $75 million or more of public float that qualify as smaller reporting companies under the new rules will also be subject to the requirements that apply to accelerated filers, including the timing of the filing of periodic reports and the requirement that accelerated filers provide the auditor’s attestation of management’s assessment of internal controls over reporting required by Section 404(b) of the Sarbanes-Oxley Act of 2002.

Section 404(b)

As expected, the approved rules did not revise the accelerated filer definition to provide relief from the auditor attestation requirements under Section 404(b) in coordination with the changes to the SRC thresholds.  The staff was, however, left with a mandate from Chairman Jay Clayton to formulate recommendations for possible additional changes to the accelerated filer definition that, if adopted, would have the effect of reducing the number of registrants that qualify as accelerated filers (thereby reducing the number of issuers required to comply with auditor attestation requirements). Nonetheless, while the Commissioners were in agreement on the adoption of the SRC modifications, each of the Commissioners also indicated that any future rulemaking with respect to the more significant issues surrounding application of Section 404(b) would be a more contentious subject. In particular, both Commissioners Stein and Jackson cited significant reservations on removing this requirement for any number of issuers while Commissioners Piwowar (in his final open meeting) and Peirce expressed strong support for reducing the regulatory costs associated with auditor attestation.  Any future modifications to the applicability of Section 404(b) will surely be marked by heavy debate and as these comments made clear, achieving a clear consensus amongst the commissioners on the issue seems unlikely.

SEC Requires Use of Inline XBRL

The SEC also adopted final rules to require the use of Inline XBRL. Currently, data in XBRL format is attached as an exhibit to SEC filings.  Inline XBRL allows filers to embed XBRL data directly into the body of the SEC filing, eliminating most of the need to tag a copy of the information in a separate XBRL exhibit.  Inline XBRL will still require exhibits to be used with and the exhibits will contain contextual information about the XBRL tags embedded in the filing.  Inline XBRL would be both human-readable and machine-readable for purposes of validation, aggregation and analysis.

Phase In

The rules will be effective 30 days after publication in the Federal Register. However, the rules apply the following phase in period for required use of Inline XBRL:

  • June 15, 2019–large accelerated filers that prepare their financial statements in accordance with U.S. GAAP;
  • June 15, 2020—accelerated filers that prepare their financial statements in accordance with U.S. GAAP; and
  • June 15, 2021—all other filers.

Domestic form filers will be required to comply beginning with their first Form 10-Q for a fiscal period ending on or after the applicable compliance date, as opposed to the first filing for a fiscal period ending on or after that date, to enable filers to gain experience with Inline XBRL through less complex filings.

Officer Certifications and Auditor Assurance

Inline XBRL does not change any requirements with respect to officer certification or auditor assurance. The changes relate only to the manner of submitting interactive data and not the data comprising the data files.  Currently, the financial statement information included in interactive data files is excluded from the officer certification requirements under Rules 13a-14(f) and 15d-14(f) of the Exchange Act.  Furthermore, auditors are not required to apply AS 2710 (Other Information in Documents Containing Audited Financial Statements), AS 4101 (Responsibilities Regarding Filings Under Federal Securities Statutes), or AS 4105 (Reviews of Interim Financial Information) to the interactive data files submitted with a company’s reports or registration statements.  However, the SEC has previously stated that XBRL is part of an issuer’s disclosure controls and procedures.  However, consistent with the existing XBRL requirements, issuers would not be prohibited from indicating in the financial statements (such as in a footnote) the degree (or lack thereof) of auditor involvement related to the financial statement information XBRL data.

Scope

The Inline XBRL requirements for financial statement information will apply to all operating company filers, including SRCs, emerging growth companies and foreign private issuers.

Elimination of Website Posting Requirements

Currently the rules require XBRL files be posted on the filer’s website, if any, on the earlier of the calendar day that the filer submitted or was required to submit the XBRL files. The new rules eliminate this requirement.  This requirement is not subject to the phase in period and will be effective 30 days after the rules are published in the Federal Register.

Changes to SEC Forms

The new rules include conforming amendments to the cover pages for certain periodic reports, including Forms 10-K and 10-Q. The change to the cover pages eliminates reference to compliance with the website posting requirement. Like the elimination of the website posting requirements, these form changes are not subject to the phase in period.

In Lucia v. Securities and Exchange Commission, the SEC brought an administrative action before one of its administrative law judges, or ALJ’s, against Raymond Lucia for allegedly using misleading slide presentations to deceive prospective investors using a retirement savings strategy called “Buckets of Money.”  The ALJ that adjudicated the case issued an initial decision finding Mr. Lucia violated the law and imposed sanctions.

Mr. Lucia then began the lengthy appellate process, appealing to the SEC and arguing the administrative proceeding was invalid because the ALJ had not been constitutionally appointed.  The argument goes something like this: The Appointments Clause of the U.S. Constitution requires that “inferior officers” be appointed by the President, department heads or courts of law. SEC administrative law judges, or ALJs, are not appointed by the SEC – they are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions and the Office of Personnel Management. If the ALJ is an inferior officer, the ALJ was not constitutionally appointed and the administrative proceeding is invalid.

The SEC rejected Mr. Lucia’s arguments, holding that ALJs are not officers of the United States but are instead mere employees – officials with lesser responsibilities who are not subject to the Appointments Clause.  The Court of Appeals for the D.C. Circuit held the same on a subsequent appeal.

Along the way, things got weird. In a man-bites-dog twist of fate, the Solicitor General, arguing on behalf of the United States, abandoned its position and switched sides before the Supreme Court heard the case, effectively supporting much of Mr. Lucia’s position. In response to the defection by the Trump Administration, the SEC ratified the appointment of the current (not former) ALJs and directed the ALJs to review their actions in all open administrative proceedings to determine whether to ratify those actions.  The ALJs were directed to reconsider the record, and allow parties to submit new evidence when ratifying their prior actions.

The Supreme Court held the ALJs were not validly appointed.  Much of the opinion rests on Freytag v. Commissioner, a case that found special trial judges, or STJs, of the Tax Court were not validly appointed.  Among other things, the Court’s opinion noted the SEC’s ALJs, like the Tax Court’s STJs, hold a continuing office established by law. The SEC’s ALJs exercise the same “significant discretion” when carrying out the same “important functions” as STJs do. The ALJs and STJs both take testimony, conduct trials, rule on the admissibility of evidence and have the power to enforce discovery orders.  To protect Mr. Lucia’s constitutional rights, the Supreme Court held that a different ALJ must hear Mr. Lucia’s case on remand.

So the question at hand is what happens to all of the prior cases and cases in process adjudicated by the ALJs? John Jenkins at TheCorporateCounsel.net (with appropriate disclaimers) notes the following passage in the Courts opinion: “This Court has held that “One who makes a timely challenge to the constitutional validity of the appointment of an officer who adjudicates his case” is entitled to relief. Ryder v. United States. Lucia made just such a timely challenge: He contested the validity of Judge Elliot’s appointment before the Commission, and continued pressing that claim in the Court of Appeals and this Court.”  Does that infer those who did not make a timely challenge are out of luck in overturning an ALJs findings?

Also disclaiming an inability to predict what will happen, I took a high level, non-exhaustive look at the case law.  Ryder involved an enlisted member of the Coast Guard, who was convicted by a court-martial of drug offenses, and the Coast Guard Court of Military Review affirmed. After rehearing and on appeal the Court of Military Appeals agreed with petitioner that the appointment of civilian judges to the Coast Guard Court of Military Review violated the Appointments Clause.  The case was then appealed to the Supreme Court.

In Ryder the Supreme Court discussed the de facto officer doctrine, which confers validity upon acts performed under the color of official title even though it is later discovered that the legality of the actor’s appointment or election to office is deficient.  The Supreme Court found the de facto officer doctrine inapplicable on the facts presented.  After examining the difference in function and authority between the Coast Guard Court of Military Review, and the Court of Military Appeals, the Supreme Court said “we therefore hold that the Court of Military Appeals erred in according de facto validity to the actions of the civilian judges of the Coast Guard Court of Military Review. Petitioner is entitled to a hearing before a properly appointed panel of that court.” It is not necessarily clear that a timely challenge is a condition precedent to finding the de facto officer doctrine is inapplicable.  The passage referred to in Lucia may have been a convenient way to skirt the issue because it fit the facts in that case.

Nguyen v. United States is another Supreme Court cases decided after Ryder.  In that case, petitioners were tried, convicted, and sentenced on federal narcotics charges in the District Court of Guam, a territorial court with subject matter jurisdiction over both federal-law and local-law causes. The Ninth Circuit panel convened to hear their appeals included two judges from that court, both of whom were life-tenured Article III judges, and the Chief Judge of the District Court for the Northern Mariana Islands, an Article IV territorial-court judge appointed by the President and confirmed by the Senate for a 10-year term. Neither petitioner objected to the panel’s composition before the cases were submitted for decision, and neither sought rehearing to challenge the panel’s authority to decide their appeals after it affirmed their convictions. However, each filed a certiorari petition claiming that the judgment is invalid because a non-Article III judge participated on the panel.

From the emanations and penumbra of Nguyen we learn actions are de facto only with respect to a technical violation, significant defects mean the action of the defectively appointed officer are invalid and that inaction to raise an argument on the part of a defendant cannot create authority in an invalidly appointed officer. In limiting its review to a statute conferring jurisdiction and not constitutional questions, the Supreme Court noted  “we have found a judge’s actions to be valid de facto when there is a “merely technical” defect of statutory authority.” In discussing the impermissible panel designation, the Supreme Court noted it was akin to “the difference between an action which could have been taken, if properly pursued, and one which could never have been taken at all.”  The Supreme Court also noted that ignoring the violation of the designation would incorrectly suggest that some action (or inaction) on petitioners’ part could create authority on the part of the panel.

What then is the effect of the subsequent SEC ratification of ALJ appointments?  Probably not much.  First, the ratification only related to the current ALJs and unfinished business before the ALJs.  This is a small subset of the decisions rendered by the unconstitutionally appointed ALJs. But the ratification is suspect in and of itself.  In CFPB v Gordon et al, the Ninth Circuit found that Richard Cordray, Director of the CFPB, properly ratified his prior bureau actions upon being properly appointed and therefore the court did not examine the de facto officer doctrine. Gordon is likely inapplicable because in Lucia the Supreme Court directed a different ALJ to proceed over any subsequent adjudication.  The SEC ratified the apointmens of its ALJs and directed them to reexamine their own proceedings which does not fit in the confines of the remedy accorded in Lucia.

It’s important to keep the issue in context.  The SEC loves to tell us that the lion’s share of the work done by the (unconstitutionally appointed) ALJs does not relate to contested adjudications such as Mr. Lucia and his “Buckets of Money” strategy.  Rather the administrative court’s business largely relates to approval of agreed settlements, delisting issuers that do not file their Exchange Act reports and the like.  As such those contesting prior ALJ decisions will likely not result in a wave of securities law recidivists having their records erased and going free.  Dealing with the issue may well be burdensome for the SEC but the storm clouds were brewing for years and it did nothing.

Those choosing to challenge prior ALJ adjudications under Lucia that did not previously raise the issue have an uphill battle.  However, case law reviewed above offers a few glimmers of hope.

 

Many public companies became subject to the new revenue recognition rules when they filed their first quarter Form 10-Qs in 2018. It appears the SEC may not have wasted any time in beginning to issue comments. The following was noted in a comment letter that became publicly available:

We note your disclosure which states you adopted ASC 606 in the first quarter of 2018 and the adoption did not result in significant changes to the timing or nature of your revenue recognition. We also note that the disclosure of the disaggregation of revenue from contracts with customer in Note 4.  Please tell us your considerations of the other disclosures set forth in ASC 606-10-50 (e.g. explanations of your performance obligations, transaction price allocated to remaining performance obligations, transition, etc.).  We remind you of the guidance in Rule 10-01(a)(5) of Regulation S-X, which would elicit both annual and interim periods financial statement disclosures prescribed by new accounting principles and practice in each quarterly report in the year of adoption.

As public companies get ready to prepare for their second quarter Form 10-Qs, we believe it would be beneficial to review the above comment and make all required disclosures.

William Hinman, Director, SEC Division of Corporation Finance, gave his personal views on when tokens and coins, which he referred to as digital assets, are securities and when they are not.

Mr. Hinman framed the question as follows: A digital asset that was originally offered in a securities offering likely cannot be later sold in a manner that does not constitute an offering of a security where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise. On the other side of the ledger, Mr. Hinman noted a digital asset likely could be sold (a “qualified yes” in his words) where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.

While he elaborated in great detail on the foregoing themes, he noted that whether a digital asset is a security will always depend on the particular facts and circumstances. However, he offered the following non-exhaustive list as being illustrative of key considerations to determine if a digital asset is a security:

  • Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  • Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  • Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  • Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  • Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  • Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Mr. Hinman noted that while the foregoing factors are important in analyzing the role of any third party, there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security. It depends on the economic substance of the transaction. Mr. Hinman offered the following non-exhaustive list as being illustrative of key considerations to determine if a digital asset is not a security, noting that he does not believe each and every one of these factors needs to be present to establish a case that a digital asset is not being offered as a security:

  • Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
  • Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
  • Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
  • Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
  • Is the asset marketed and distributed to potential users or the general public?
  • Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
  • Is the application fully functioning or in early stages of development?

It should be noted Mr. Hinman’s remarks express his views and do not necessarily reflect those of the SEC, the SEC Commissioners or other members of the SEC staff. The SEC disclaims responsibility for any private publication or statement of any SEC employee or Commissioner.