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

The House Subcommittee on Capital Markets, Securities, and Investments held a hearing which reviewed two pieces of legislation that have been introduced:

  • H.R. 2128, the “Due Process Restoration Act of 2017,” introduced by Representative Warren Davidson (R-OH), would amend the Securities and Exchange Act of 1934 to permit private persons to compel the Securities and Exchange Commission to seek legal or equitable remedies in a civil action instead of an administrative proceeding. The bill also provides that in any administrative proceeding a legal or equitable remedy may be imposed on the person against whom the proceeding was brought only on a showing by the SEC of clear and convincing evidence that the person has violated the relevant provision of law.”
  • H.R. 5037, the “Securities Fraud Act of 2018,” introduced by Representative Tom MacArthur (R-NJ), to provide for exclusive Federal jurisdiction over civil securities fraud actions. State securities commissions would retain jurisdiction over:
    • civil enforcement actions with respect to fraud or deceit, or unlawful conduct in connection with securities or securities transactions other than in connection with NYSE and Nasdaq listed securities or transactions of an NYSE or Nasdaq listed security (and senior securities with respect thereto); and
    • criminal enforcement actions with respect to fraud or deceit, or unlawful conduct in connection with a listed security or transactions of a NYSE or Nasdaq listed security(and senior securities with respect thereto) provided such State criminal enforcement actions shall comply in all respects with the legal requirements for securities fraud under Federal law.

SEC Commissioner Robert J. Jackson Jr. recently gave his views on stock buybacks.  Much of the speech focused on Rule 10b-18 which is used by public companies when conducting stock buybacks.  Rule 10b-18 provides a safe harbor from securities-fraud liability if the pricing and timing of buyback-related repurchases meet certain conditions.

Among other things, Commissioner Jackson described a study undertaken by his staff:

So we dove into the data, studying 385 buybacks over the last fifteen months.[20] We matched those buybacks by hand to information on executive stock sales available in SEC filings. First, we found that a buyback announcement leads to a big jump in stock price: in the 30 days after the announcements we studied, firms enjoy abnormal returns of more than 2.5%. That’s unsurprising: when a public company in the United States announces that it thinks the stock is cheap, investors bid up its price.

What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day. So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell.

And, in the process, executives take a lot of cash off the table. On average, in the days before a buyback announcement, executives trade in relatively small amounts—less than $100,000 worth. But during the eight days following a buyback announcement, executives on average sell more than $500,000 worth of stock each day—a fivefold increase. Thus, executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement . . .

Commissioner Jackson noted the trading was not necessarily illegal. However, Commissioner Jackson expressed his view that the safe harbor provided by Rule 10b-18 should not subsidize this sort of trading by executives.  According to the Commissioner,  SEC rules should encourage executives to keep their skin in the game for the long term. Thus, Commissioner Jackson believes Rule 10b-18 should be revised so that the safe harbor is not available to a public company that allows executives to sell stock during a buyback.

Commissioner Jackson also stated his view that corporate boards and their counsel should pay closer attention to the implications of a buyback for the link between pay and performance. In particular, the company’s compensation committee should be required to carefully review the degree to which the buyback will be used as a chance for executives to turn long-term performance incentives into cash. If executives will use the buyback to cash out, the committee should be required to approve that decision and disclose to investors the reasons why it is in the company’s long-term interests, according to Commissioner Jackson.

Minnesota Governor Mark Dayton has signed into law revisions to several Minnesota business organization statutes including the Minnesota Business Corporation Act, the Minnesota Revised Uniform Limited Liability Company Act, the Uniform Limited Partnership Act 2001, the Uniform Partnership Act (1994) and the Minnesota Nonprofit Corporation Act.

Minnesota Business Corporation Act

Amendments to the Minnesota Business Corporation Act (the “MBCA”) become effective August 1, 2018, and contain several provisions that modernize corporate governance processes and streamline certain types of transactions.

Written Actions by Email

In a change that has the potential to simplify corporate record keeping with regard to board and shareholder resolutions that are approved via written actions rather than live votes, Section 302A.011, Subd. 36 now specifies that a written action includes a record “consented to by authenticated electronic communication” by the persons required to approve the action under the corporation’s governing documents. The MBCA already included the concept of “authenticated electronic communication,” which means an electronic communication received by a corporation or an officer of a corporation that “sets forth information from which the corporation can reasonably conclude that the communication was sent by the purported sender.”  The change to the definition of “written action” builds on the existing concept and makes clear that a written action could be circulated to board members or shareholders via email and the board members or shareholders could validly consent to the action merely by replying to the email.  This would obviate the need to circulate a written document that must be printed, manually signed, and faxed or delivered in .PDF format back to the corporation.

Exclusive Forum Bylaws

Minnesota is following the approach reflected in Section 115 of the Delaware General Corporation Law (DGCL) with respect to exclusive forum bylaws which seek to control the forum in which internal corporate claims may be litigated by shareholders. New Section 302A.191 of the MBCA expressly allows the articles or bylaws of a Minnesota corporation to require that all “internal corporate claims” be brought exclusively in Minnesota courts and disallows any provision of the articles or bylaws of a Minnesota corporation that prevents a party from initiating litigation over an internal corporate claim before the Minnesota courts, thus ensuring that a Minnesota corporation cannot designate the courts of another jurisdiction as the exclusive arbiters of an internal corporate claim.  “Internal corporate claims” are defined to include fiduciary duty claims, all derivative claims, and any claim arising under the MBCA or the corporation’s articles or bylaws.

Pre-Authorization for Share Issuance

New subsection (b) of Section 302A.401 provides boards with greater flexibility in approving the issuance of shares. The new language specifically allows a board to pre-authorize the issuance of shares in one or more transactions or at the direction of a person who need not be a director.  The pre-authorizing board resolution must specify the maximum number of shares that can be issued, the time period during which the shares can be issued, and the minimum consideration that must be received in connection with the issuance of the shares.  Corporations may find this useful for delegating grants of equity awards to senior employees, and public companies may find the provision attractive for implementing at-the-market equity offerings.

Fast Track for Two-Step Mergers

Acquisitions of public companies sometimes utilize a structure known as a two-step merger that combines a tender offer with a subsequent merger. At the first step of such transactions, the acquirer launches a tender offer to acquire shares of the public corporation.  Generally speaking, the tender offer will not result in acquisition of 100% of the target’s shares by the acquirer, so in the second step the acquirer proposes a merger.  If the tender offer at the first step resulted in the acquirer holding more than 50% of the issued and outstanding shares of the target, then shareholder approval of the merger at the second step is assured.  Nevertheless, prior to the amendments to the MBCA, Minnesota law provided that if the tender offer resulted in the acquirer holding more than 50% but less than 90% of the target’s issued and outstanding shares, the target would still be required to hold a shareholder meeting for consideration and voting upon the merger.  This meant that a corporation could be forced to incur the significant costs and expenses associated with preparing proxy materials, providing notice to shareholders, and holding a meeting, even though the result of the vote was a foregone conclusion.  The meaningless second step in such transactions also adds significant delay to transactions.

A new subdivision 4 to Section 302A.613 provides that the second-step merger of a publicly held corporation can be completed without a vote of the shareholders if the first-step tender offer results in the acquirer holding enough shares to approve the merger, provided that several fairly straight-forward requirements are satisfied. The elimination of the second step in certain transactions also impacts the MBCA’s dissenters’ rights provisions.  A corporation seeking to utilize the streamlined procedure under Section 302A.613, Subd. 4 may, at its option, send a dissenters’ rights notice to shareholders in connection with the tender offer (even though a tender offer normally would not trigger dissenters’ rights).  If a corporation elects to send the notice in connection with the tender offer, then shareholders seeking to preserve dissenters’ rights with regard to the subsequent merger must provide notice of their intent to seek payment of fair value for their shares before the consummation of the tender offer.

Domestications

Domestication is generally the process of changing the status of an entity so that it is governed by the organizational laws of another state without changing the form of the entity. For example, a Delaware corporation transitioning to become governed by the MBCA rather than by the Delaware General Corporation Law would be a domestication, as would the reverse transition.  This is in contrast to “conversions” which refer to a change in the form of the entity itself rather than a change in the selection of the entity’s governing law (i.e., a change from a limited liability company to a corporation).  Historically, domestications and conversions under the MBCA have been handled under a single set of statutory provisions set forth in Section 302A. 682 et seq.  New section 302A.682 Subd. 3 incorporates into the statute the long-term understanding of the Minnesota bar that the foregoing statutes permit domestications as well as conversions.

Minnesota Revised Uniform Limited Liability Company Act

Amendments to the Minnesota Revised Uniform Limited Liability Company Act (the “LLC Act”) include a new streamlined parent-subsidiary merger process and a change to clarify the reinstatement provisions applicable to administratively‑dissolved LLCs.

Mergers of Wholly Owned Subsidiaries

The statutory revisions add provisions which simplify the merger of a wholly owned limited liability company subsidiary into a parent Minnesota limited liability company, or such parent’s merger of two wholly owned subsidiaries into one of the wholly owned subsidiaries. The merger need only be authorized by a resolution that includes the elements of a specified plan of merger that is approved in the manner required to decide a matter in the ordinary course of business of the parent.  For example, in a manager-managed LLC, unless the Operating Agreement provides otherwise, the consent of the members is required for actions outside of the ordinary course of business; the revisions to the LLC Act allow a parent-subsidiary merger to proceed with only the manager’s approval.  Due to the variety of governance structures permitted under the LLC Act and the many ways these structures can be modified in operating agreements, the new Section 322C.1016 seeks to preserve flexibility by making the distinction between ordinary course of business and non-ordinary course of business matters, rather than referring to specific constituencies.

If the parent organization is not a Minnesota limited liability company, under Section 322C.1016 the parent organization can merge a wholly owned subsidiary into itself, or merge two wholly owned subsidiaries into one of the wholly owned subsidiaries, if authorized by the parent’s governing statute and upon adoption of a plan of merger that includes specified elements. A “wholly owned subsidiary” is defined to be a limited liability company in which all of the rights to distributions and management rights are owned directly or indirectly by a parent organization.  This change is effective on August 1, 2018.

Reinstatement

Section 322C.0706 provides that if an LLC “is administratively terminated” it may be reinstated through a simple statutory process. The present-tense language left some doubt as to the fate of LLCs that were formed under Chapter 322B, the now largely repealed prior LLC statute in Minnesota which had been administratively terminated before becoming subject to the LLC Act.  A revision to Section 322C.0706 clarifies that the reinstatement process applies equally to LLCs that were administratively terminated under Chapter 322B rather than under the LLC Act.  This change is effective retroactive to January 1, 2018, which is the date upon which the LLC Act became applicable to LLCs formed under Chapter 322B that had not already opted-in to the new statute.

Uniform Limited Partnership Act 2001

Effective January 1, 2019, changes to the Uniform Limited Partnership Act 2001 (the “ULPA”) implement the concept of domestication and provide updates to the conversion provisions to coincide with the principles reflected in the domestication and conversion provisions in the LLC Act.

Domestication

The ULPA in its current form does not make a distinction between changes in an entity’s form and changes in the selection of governing law, dealing with both in a single section. The changes to the ULPA follow the statutory scheme set forth in the LLC Act, as opposed to the MBCA.  Accordingly, the revisions to the ULPA separate the domestication process from the conversion process and permit a Minnesota limited partnership to domesticate to another jurisdiction as a limited partnership and a foreign limited partnership to domesticate to Minnesota as a limited partnership.  The new statutory provisions provide for the conditions to domestication and the manner of approval and required filings to effect a domestication of a limited partnership.

Conversion

The revisions to the ULPA provide for conversions of entities to a different form, whether domestic or foreign, to and from a Minnesota limited partnership. The current version of the ULPA also provides for this process, but the revisions reflect the splitting out of the domestication process.  For example, conversions are not permitted to or from a limited partnership or a foreign limited partnership because that process is now covered by the domestication provisions of the ULPA.  In addition, the revisions to the language of the conversion statutes, to be consistent with the format utilized in the LLC Act (compare, for example, 322C.1007 with the revised 321.1101), incorporate restrictions that prohibit conversions involving nonprofit corporations, organizations owning assets irrevocably dedicated to a charitable purpose and public benefit corporations.

Uniform Partnership Act (1994)

Amendments to the Uniform Partnership Act (1994) (the “UPA”) implement domestication and conversion mechanisms similar to those present in the as-amended ULPA. Previously the UPA only permitted conversions of a partnership to a limited partnership and a limited partnership to a partnership.  Domestications and other changes in corporate form were not permitted.  The revisions to the UPA permit domestication of partnerships in a manner similar to the ULPA’s revisions.  .  Rather than being limited to conversions from a partnership to a limited partnership and vice versa, the revisions to the UPA will permit conversions from a partnership to other foreign and domestic organizational forms, such as corporations and LLCs.  However, as with the conversion provisions in the as-amended ULPA, conversions involving non-profit corporations, organizations owning assets irrevocably dedicated to charitable purposes and public benefit corporations are restricted.  The domestication and conversion amendments to the UPA are effective January 1, 2019.

Minnesota Nonprofit Corporation Act

The changes to the Minnesota Nonprofit Corporation Act clarify provisions related to mergers of subsidiaries, noting that 317A.621 is applicable only to mergers of wholly owned LLCs and are substantially similar to the related changes to the LLC Act. Amendments to the Minnesota Nonprofit Corporation Act become effective August 1, 2018.

The SEC announced settlements with 13 registered private fund investment advisers who repeatedly failed to provide required information that the agency uses to monitor risk. In SEC parlance, private funds are generally hedge funds and private equity funds that are required to register with the SEC. While I do not want to question the efforts of the enforcement staff, this looks like it is likely that a robo-cop generated a list of targets based on other filings the targets made with the SEC.

According to the SEC’s orders, the advisers failed to file annual reports on Form PF informing the agency about the private funds they advise, including the amount of assets under management, fund strategy, performance, and use of borrowed money and derivatives. Private fund advisers managing $150 million or more of assets have been required to make annual filings on Form PF since 2012.  The orders found that the 13 advisers were delinquent in their filings over multi-year periods.

The SEC uses Form PF data to monitor industry trends, inform rulemaking, identify compliance risks, and target examinations and enforcement investigations. The SEC publishes quarterly reports with aggregated information and statistics derived from Form PF data to inform the public about the private fund industry.  It also provides Form PF data to the Financial Stability Oversight Council to help it evaluate systemic risks posed by hedge funds and other private funds.

The SEC’s orders find that the advisers violated the reporting requirements of the Investment Advisers Act of 1940. Without admitting or denying the findings, the advisers agreed to be censured, to cease and desist, and to each pay a $75,000 civil penalty.  During the course of the SEC’s investigation, the advisers also remediated their failures by making the necessary filings.

It is likely there will be more enforcement actions in this area. The investigation may have turned up more private funds that did not file a Form PF but have additional compliance deficiencies or other private funds that have not remediated their failure like the settling group.

The Economic Growth, Regulatory Relief, and Consumer Protection Act (S. 2155), which is primarily aimed at easing regulations on community banks, also contains provisions designed to facilitate capital formation. President Trump signed the bill into law on May 24, 2018.

Section 508 of the bill directs the SEC to revise Regulation A+ to permit public companies to use Regulation A+ to offer securities. Regulation A+ offers a streamlined procedure to offer securities as compared to the more burdensome use of SEC Form S-1. The bill also directs the SEC to revise its rules so that a currently public company can satisfy the Regulation A+’s ongoing reporting requirements for Tier 2 offerings by filing of reports such as 10-Ks and 10-Qs required under Section 13 of the Exchange Act.

Rule 701 provides an exemption for non-public companies to grant equity awards to employees. Section 507 of the bill directs the SEC to increase Rule 701’s threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation adjusted every five years.

Section 501 of the bill provides for additional preemption of state blue sky securities laws. Securities will now be considered “covered securities” under Section 18(b)(1) of the Securities Act, and thus not subject to blue sky regulation, if the security is listed on a national securities exchange that is a member of the National Market System.  The test for having substantially similar listing standards to NYSE or Nasdaq is removed.

The SEC has issued a series of frequently asked questions, which in SEC speak are referred to as Compliance and Disclosures Interpretations (or C&DIs for short), on proxy statements and proxy solicitations.  In general the C&DIs replace previously issued telephone interpretations, but the lead in notes where substantive changes have been made.  For those who have not reviewed the age-old telephone interpretations manual recently, some of the more interesting C&DIs address Item 10 of Schedule 14A which sets forth disclosure requirements when compensation plans are submitted for shareholder approval.

According to the C&DIs:

  • Any action on a compensation plan that must be submitted for security holder approval requires all of the disclosure called for under Item 10 of Schedule 14A. If the action proposed is only an amendment to an existing plan (e.g., adding shares available under an option plan, or adding a new class of participants), the Item 10 disclosure still must include a complete description of any material features of the plan (Item 10(a)(1)), including the material differences from the existing plan (Instruction 2).
  • Item 10(a)(2)(i) disclosure regarding benefits or amounts that will be received by or allocated to each of the named executive officers and certain groups will only be called for if the plan being acted upon is: (i) a plan with set benefits or amounts (e.g., director option plans); or (ii) one under which some grants or awards have been made by the board or compensation committee subject to security holder approval (e.g., action is to add shares available under an existing option plan because there are not enough shares remaining under the plan to honor exercises of all outstanding options).
  • A registrant is required to disclose the New Plan Benefits Table called for under Item 10(a)(2) of Schedule 14A should list in the table all of the individuals and groups for which award and benefit information is required, even if the amount to be reported is “0”. Alternatively, the registrant can choose to identify any individual or group for which the award and benefit information to be reported is “0” through narrative disclosure that accompanies the New Plan Benefits Table.
  • A registrant cannot include other information, such as that called for by Item 10(b) of Schedule 14A, in the New Plan Benefits Table mandated by Item 10(a)(2) of Schedule 14A.
  • For option plans, no “dollar value” information should be given in the New Plan Benefits Table (i.e., no Black-Scholes or other valuation). The number of shares underlying the options should be provided in the “Number of Units” column.
  • Item 10(a)(2)(iii) of Schedule 14A does not require disclosure of actual awards made under an existing plan for the prior fiscal year. The language of Item 10(a)(2)(iii) stating “if the plan had been in effect” contemplates plans that were not in effect for the prior fiscal year. Accordingly, Item 10(a)(2)(iii) disclosure of actual awards under an existing plan for the last fiscal year is not required. Disclosure under this item would be required when action is being taken on an existing plan only where the existing plan is being amended to alter a formula or other objective criteria to be applied to determine benefits.
  • Item 10(a)(2)(i) or 10(a)(2)(iii) of Schedule 14A does not require a “pro forma” presentation of the benefits or amounts that would have been received under a plan where such awards or benefits are discretionary. Such discretionary awards or benefits would not be considered to be determinable for purposes of these two item requirements.
  • The disclosure requirement in Item 10(a)(2)(iii) of Schedule 14A applies only to plans that have objective criteria for determining the compensation payable under the plan so that the registrant can take the criteria and, assuming the variables of the last year, determine what would have been paid under the plan had it been in place then. An example would be a bonus or long-term incentive plan with award opportunities based upon a fixed percentage of salary and actual payment earned based upon corporate performance against fixed measures (such as percentage growth in earnings over previous years).
  • The “market value of the securities underlying the options, warrants, or rights as of the latest practicable date” for purposes of Item 10(b)(2)(i)(D) of Schedule 14A may be presented as either: (i) market price per share or (ii) aggregate market value of the total number of shares underlying all options (granted or available for grant) under the plan.
  • Item 10(b)(2)(ii) of Schedule 14A, requires the registrant to state separately the amount of options received or to be received. The requirement covers only options under the plan upon which action is being taken. For example, it would be inapplicable if a new plan was being considered because there would be no grants under that new plan to report. No disclosure is required if a new plan is being considered, even if the registrant has other plans under which there have been or will be options granted, and even if a previous or existing plan appears identical to the new plan in all but name.
  • The disclosure under Item 10(b)(2)(ii) of Schedule 14A does not need to appear in a table.
  • Item 10(b)(2)(ii) of Schedule 14A does not apply only to options received during the last year. It applies to all options received at any time (not just last year) and options to be received (if determinable) by the specified persons and groups. The information called for under this item requirement should be given for each individual and group (including those for which the amount of options received or to be received is “0”).

The United States District Court for the Southern District of New York recently issued an opinion granting a preliminary injunction with respect to alleged Section 5 violations by certain persons associated with ill-fated Regulation A+ issuer Longfin. More specifically, the preliminary injunction extends until the conclusion of the case an emergency order previously entered by the Court freezing more than $27 million in trading proceeds from allegedly illegal distributions and sales of restricted shares of Longfin.

The opinion reads like a law school exam question related to the application of the Rule 144 exemption, and as an alternative the Section 4(1) exemption, for the sales of restricted securities and control securities. One of the more interesting aspects of the opinion is whether at trial the defendants were likely to be found affiliates of Longfin.

Andy Altahawi.  Altahawi’s association with Longfin began when he signed a consulting agreement to assist Longfin to initiate a Regulation A+ Tier II Direct Public Offering, or DPO.  The determination of whether Altahawi could rely on Rule 144 for certain sales hinged on whether he was an affiliate.  The Court said this is a question of fact which depends on the totality of the circumstances including an appraisal of influence upon management and policies of a corporation.  The Court discussed Altahawi acting as secretary of Longfin, managing an unusual distribution of Longfin shares and his acquisition of a portion of those shares a short time later, his communications with the SEC, arranging to remove the restrictive legend on his shares, his domination of the public market for Longfin shares and other matters.  In the end the Court found that Altahawi was likely to be found an affiliate at trial solely because of his personal management of the entire DPO process and his control of the public float in Longfin shares.

Suresh Tammineedi.  The Court stated the record provided strong support Tammineedi would be found to be an affiliate of Longfin.  Tammineedi was a director of Stampede Capital Limited which owned well over 10% of Longfin’s shares and was Longfin’s largest shareholder.  Venkata Meenavalli founded both Longfin and Stampede Capital.  Meenavalli held 17.11% of Stampede Capital and Meenavalli and Tammineedi were “frequent business colleagues and close associates.”

Dorababu Penumarthi.  The Court stated the record provided strong support Penumarthi would also be found to be an affiliate of Longfin.  Penumarthi worked as a consultant for Longfin.  Penumarthi had publicly stated he was director of Longfin’s UK operations, although in opposition to the motion before the Court, Penumarthi claimed this statement was in error.  The Court noted Penumarthi grew up with Meenavalli and appears to have been a previous business partner of his.

It should be noted that the opinion was not a final decision on the merits and no court has found the defendants violated the law.

The SEC’s recent proposed guidance for investment advisers has implications for private equity sponsors.  Perhaps the most important part of the guidance for private equity sponsors is that related to the duty of loyalty which addresses conflicts of interest.  By nature the sponsor’s relationship with investors is complex, and inherent in almost every structure is a perceived conflict of interest on behalf of the sponsor.  The SEC says these conflicts must be clearly explained, and if they can’t be clearly explained they must be eliminated in the view of the SEC.

According to the SEC, the duty of loyalty requires an investment adviser to put its client’s interests first.  Accordingly:

  • An investment adviser must not favor its own interests over those of a client or unfairly favor one client over another.
  • An adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.
  • An adviser must seek to avoid conflicts of interest with its clients, and, at a minimum, make full and fair disclosure of all material conflicts of interest that could affect the advisory relationship.
  • The disclosure should be sufficiently specific so that a client is able to decide whether to provide informed consent to the conflict of interest.

The proposed guidance notes disclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty and section 206 of the Advisers Act.   Any disclosure must be clear and detailed enough for a client to make a reasonably informed decision to consent to such conflicts and practices or reject them.  An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and business practices well enough to make an informed decision.  For example, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.

The SEC notes that a client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit. The SEC believes, however, that it would not be consistent with an adviser’s fiduciary duty to infer or accept client consent to a conflict where either:

  • the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or
  • the material facts concerning the conflict could not be fully and fairly disclosed.

The SEC notes that in some cases, conflicts may be of a nature and extent that it would be difficult to provide disclosure that adequately conveys the material facts or the nature, magnitude and potential effect of the conflict necessary to obtain informed consent and satisfy an adviser’s fiduciary duty. In other cases, disclosure may not be specific enough for clients to understand whether and how the conflict will affect the advice they receive. With some complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific, but also understandable, to the adviser’s clients. In all of these cases where full and fair disclosure and informed consent is insufficient, the SEC expects an adviser to eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.

 

In perhaps the SEC’s first major shot across the bow, Yahoo (now known as Altaba) has agreed to pay the SEC $35 million for failure to disclose a massive security breach to its investors. I’m guessing Equifax, Facebook and a few others are evaluating this result with interest.

According to the SEC’s order, within days of a December 2014 intrusion, Yahoo’s information security team learned that Russian hackers had stolen what the security team referred to internally as the company’s “crown jewels”: usernames, email addresses, phone numbers, birthdates, encrypted passwords, and security questions and answers for hundreds of millions of user accounts. Although information relating to the breach was reported to members of Yahoo’s senior management and legal department, Yahoo failed to properly investigate the circumstances of the breach and to adequately consider whether the breach needed to be disclosed to investors.  The fact of the breach was not disclosed to the investing public until more than two years later, when in 2016 Yahoo was in the process of closing the acquisition of its operating business by Verizon Communications, Inc.

The SEC’s order finds that when Yahoo filed several quarterly and annual reports during the two-year period following the breach, the company failed to disclose the breach or its potential business impact and legal implications. Instead, the company’s SEC filings stated that it faced only the risk of, and negative effects that might flow from, data breaches.  In addition, the SEC’s order found that Yahoo did not share information regarding the breach with its auditors or outside counsel in order to assess the company’s disclosure obligations in its public filings.

According to the SEC order, Yahoo’s senior management and legal teams did not share information regarding the breach with Yahoo’s auditors or outside counsel in order to assess the company’s disclosure obligations in its public filings. Yahoo did not maintain disclosure controls and procedures designed  to ensure that reports from Yahoo’s information security team raising actual incidents of the theft of user data, or the significant risk of theft of user data, were properly and timely assessed to determine how and where data breaches should be disclosed in Yahoo’s public filings, including, but not limited to, in its risk factor disclosures or MD&A.6

While I am sure the SEC expects the matter to cause concern amongst public companies, in an effort to calm nerves an SEC official noted “We do not second-guess good faith exercises of judgment about cyber-incident disclosure. But we have also cautioned that a company’s response to such an event could be so lacking that an enforcement action would be warranted.  This is clearly such a case.”

Yahoo/Altaba did not admit or deny the findings in the SEC order.

 

The SEC has proposed two rules and an interpretation to address retail investor confusion about the relationships that they have with investment professionals and the harm that may result from that confusion. Confusion has resulted from differing standards applied to broker-dealers and investment advisers.

As a result of the proposed rules, the SEC will consider strengthening the standard of conduct that broker-dealers owe to their customers. The proposed rules also reaffirm and, in some cases, clarify, the standard of conduct that investment advisers owe to their clients. The SEC believes the proposed rules also provide additional transparency and clarity for investors through enhanced disclosure designed to help them understand who they are dealing with, and why that matters.  According to the SEC, the rulemaking package seeks to enhance investor protections while preserving retail customer access to transaction-based brokerage accounts and a broad range of investment products.

When adopting the proposed rules, SEC Chair Jay Clayton discussed the so called “fiduciary rule” adopted by the Department of Labor which was cast into doubt following a ruling by the Fifth Circuit of the Court of Appeals. According to Chair Clayton, the DOL action and other developments drove significant change in the market for investment advice. A number of broker-dealers limited the products or services they provide to customers, particularly those customers with fewer assets. More specifically with respect to those services, some broker dealers shifted customers from full-service brokerage, which includes investment advice, to discount brokerage, which does not. Other firms that are dually registered as both broker-dealers and investment advisers, as well as broker dealers that have an affiliated investment advisers, shifted customers into advisory accounts, where, depending on the customer’s investment strategy, they may pay more in fees for advice and services. Chair Clayton believes this reduction in transaction-based service offerings has, and will continue to have, negative impacts on certain types of retail investors — for example, for buy-and-hold investors that transact infrequently, a brokerage account may be a more appropriate and potentially less expensive account option.

A short summary of the proposed rules and interpretation follows.

Regulation Best Interest

Under the proposed rules, a broker-dealer making a recommendation to a retail customer would have a duty to act in the best interest of the retail customer at the time the recommendation is made, without putting the financial or other interest of the broker-dealer ahead of the retail customer.

A broker-dealer would discharge this duty by complying with each of three specific obligations:

  • Disclosure obligation: disclose to the retail customer the key facts about the relationship, including material conflicts of interest.
  • Care obligation: exercise reasonable diligence, care, skill, and prudence, to (i) understand the product; (ii) have a reasonable basis to believe that the product is in the retail customer’s best interest; and (iii) have a reasonable basis to believe that a series of transactions is in the retail customer’s best interest.
  • Conflict of interest obligation: establish, maintain and enforce policies and procedures reasonably designed to identify and then at a minimum to disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives; other material conflicts of interest must be at least disclosed.

Investment Adviser Interpretation

An investment adviser owes a fiduciary duty to its clients — a duty that the Supreme Court found exists within the Advisers Act. The proposed interpretation reaffirms, and in some cases clarifies, certain aspects of the fiduciary duty that an investment adviser owes to its clients.

Form CRS – Relationship Summary

Investment advisers and broker-dealers, and their respective associated persons, would be required to provide retail investors a relationship summary. This standardized, short-form (4 page maximum) proposed disclosure would highlight key differences in the principal types of services offered, the legal standards of conduct that apply to each, the fees a customer might pay, and certain conflicts of interest that may exist.

Investment advisers and broker-dealers, and the financial professionals who work for them, would be required to be direct and clear about their registration status in communications with investors and prospective investors. Certain broker-dealers, and their associated persons, would be restricted from using, as part of their name or title, the terms “adviser” and “advisor” — which are so similar to “investment adviser” that their use may mislead retail customers into believing their firm or professional is a registered investment adviser.