Category: Financial Services Law

FinCEN Issues Final Rule on the Corporate Transparency Act Requiring Businesses to Report Beneficial Ownership Information

On September 30, 2022, the U.S. Financial Crimes Enforcement Network (“FinCEN”) published its final rule implementing Section 6403 of the Corporate Transparency Act (“CTA”). The final rule, which will take effect on January 1, 2024, will require “tens of millions” of companies doing business in the U.S. to report certain information about their beneficial owners. The reporting companies created or registered before January 1, 2024, will have until January 1, 2025, to file their initial beneficial ownership reports with FinCEN. Reporting companies created or registered on or after January 1, 2024, will be required to file initial beneficial ownership reports within 30 days of formation.

The CTA was passed by Congress on January 1, 2021, as part of the Anti-Money Laundering Act of 2020 in the National Defense Authorization Act for Fiscal Year 2021. After publishing a Notice of Proposed Rulemaking and receiving public comments, FinCEN adopted the proposed rule largely as proposed, with certain modifications intended to minimize unnecessary burdens on reporting companies.

What Entities are Reporting Companies? The final rule describes two types of reporting companies: domestic and foreign.

  • A domestic reporting company is any entity that is a corporation, a limited liability company, or other entity (such as limited liability partnerships, limited liability limited partnerships, business trusts, and most limited partnerships and business trusts) created by the filing of a document with a secretary of state or any similar office under the law of a state or American Indian tribe.

  • A foreign reporting company is any corporation, limited liability company, or other entity formed under the law of a foreign country and registered to do business in any state or tribal jurisdiction by the filing of a document with a secretary of state or any similar office under the law of a state or American Indian tribe.

What Entities are Exempt? The final rule exempts twenty-three separate categories of entities from the definition of the reporting company. Many of the exempted entities are already subject to federal or state regulations requiring disclosure of beneficial ownership information, such as banks, credit unions, depositary institutions, investment advisors, securities brokers and dealers, accounting firms, governmental entities, tax-exempt entities, and entities registered with the SEC under the Exchange Act of 1934. Additionally, the rules set forth an exemption for “large operating companies” that can demonstrate each of the following factors:

  • Employ more than 20 full-time employees in the U.S.

  • Have an operating presence at a physical office within the U.S.

  • Filed a federal income tax or information return in the U.S. for the previous year demonstrating more than $5 million in gross receipts or sales (excluding gross receipts or sales from sources outside the U.S.)

Finally, under the so-called “subsidiary exemption,” entities whose ownership interests are controlled or wholly owned by one or more exempt entities may also qualify for exemption. If a reporting company was formerly exempt but loses its exemption, it must file an updated report that announces the change and includes all the information required in a reporting company’s initial report.

Who are Beneficial Owners? The final rule requires reporting companies to report each individual who is a beneficial owner of such reporting company. A “beneficial owner” is any individual who, directly or indirectly, either exercises substantial control over the reporting company or owns or controls at least 25 percent of the ownership interests of the reporting company. An individual exercises “substantial control” if such individual:

  • Serves as a senior officer (except for corporate secretary or treasurer)

  • Has authority over the appointment or removal of any senior officer or a majority of the board of directors (or similar body)

  • Directs, determines, or has substantial influence over important decisions made by the reporting company

  • Has any other form of substantial control over the reporting company

Additionally, an individual may exercise substantial control over a reporting company, directly or indirectly, including as a trustee of a trust or similar arrangement, through:

  • Board representation

  • Ownership or control of a majority of the voting power or voting rights of the reporting company

  • Rights associated with any financing arrangement or interest in a company

  • Control over one or more intermediary entities that separately or collectively exercise substantial control over a reporting company

  • Arrangements or financial or business relationships, whether formal or informal, with other individuals or entities acting as nominees

  • Any other contract, arrangement, understanding, relationship, or otherwise

The final rule exempts five categories of individuals from the definition of beneficial owner: (i) minors, (ii) nominees, intermediaries, custodians, and agents, (iii) certain employees who are not senior officers, (iv) heirs with a future interest in the company, and (v) certain creditors.

Who are Company Applicants? In addition to the beneficial owner information, the final rule requires reporting companies created or registered on or after January 1, 2024, to report identifying information about each “company applicant.” A “company applicant” is:

  • Any individual who directly files the document to create a domestic reporting company or register a foreign reporting company with a secretary of state or similar office in the U.S.

  • Any individual who is primarily responsible for directing or controlling such filing if more than one individual is involved in the filing

The final rule provides further clarification as to certain individuals who, by virtue of their formation roles, fall under the definition of “company applicants.” For example:

  • If an attorney oversees the preparation and filing of incorporation documents and a paralegal files them, the reporting company would report both the attorney and paralegal as company applicants.

  • If an individual prepares and self-files documents to create the individual’s own reporting company, the reporting company would report the individual as the only company applicant.

The final rule removes the requirements that i) entities created before the effective date report company applicant information and ii) reporting companies update their company applicant information (except to correct inaccuracies), each of which were set forth in the proposed rules.

When are Initial Reports Due? When an initial report must be filed depends on the status of the reporting company as of January 1, 2024:

  • If Created or Registered on or after January 1, 2024 – It must file a report within 30 calendar days from the earlier of: i) the date on which the company receives actual notice that its creation or registration has become effective, or ii) the date a secretary of state or similar office first provides public notice, such as through a publicly accessible registry, that the company has been created or registered.

  • If Created or Registered Prior to January 1, 2024 – It must file a report not later than January 1, 2025.

What Information Must be Reported? An initial report must include the following information with respect to the reporting company:

  • The full legal name of the reporting company

  • Any trade name or “doing business as” name of the reporting company

  • The street address of the principal place of business of the reporting company (if outside the U.S., the street address of the primary location in the U.S. where it conducts business)

  • The state, tribal, or foreign jurisdiction of formation of the reporting company (a foreign reporting company must also report the state or tribal jurisdiction where it first registers)

  • The IRS Taxpayer Identification Number (“TIN”) of the reporting company (including the EIN of the reporting company, or if a foreign reporting company without a TIN, a tax identification number issued by a foreign jurisdiction and the name of such jurisdiction)

For each company applicant (of a reporting company registered or created on or after January 1, 2024) and each beneficial owner of a reporting company, the following information must be reported:

  • The full legal name of the individual

  • The date of birth of the individual

  • The current business street address (for a company applicant who forms or registers an entity in the course of such company applicant’s business) or residential street address (for all other individuals including beneficial owners)

  • A unique identifying number from, and image of, an acceptable identification document (e.g., a passport)

If a reporting company is directly or indirectly owned by one or more exempt entities and an individual is a beneficial owner of the reporting company exclusively by virtue of such individual’s ownership interest in the exempt entity, the reporting company’s report may list the name of the exempt entity in lieu of the beneficial ownership information set forth above.

When do Companies have to Report Changes? If there is any change with respect to required information previously submitted to FinCEN concerning a reporting company or its beneficial owners, including any change with respect to who is a beneficial owner or information reported for any particular beneficial owner, the reporting company is required to file an updated report within 30 calendar days of when the change occurred.

What are the Penalties for Violations? The final rule provides for a fine of up to $10,000.00 and/or imprisonment of up to two years for any person who willfully: (i) provides or attempts to provide false or fraudulent beneficial ownership information, or (ii) fails to report complete or updated beneficial ownership information to FinCEN. The penalties may also extend to individuals causing a reporting company’s failure to report or update information and senior officials of a reporting company at the time such failure occurs.

What is Coming Next from FinCEN? FinCEN is expected to publish the forms and instructions to be used for reporting beneficial ownership information well in advance of the effective date. FinCEN will further establish a secure nonpublic database for storage of the beneficial ownership information. Finally, FinCEN will issue rules on who may access the information (a limited group of governmental authorities and financial institutions), under what circumstances, and how the parties would generally be required to handle and safeguard the information.

What Should Reporting Companies be Doing Now? Existing companies should begin evaluating whether they are a “reporting company” and if so, determining who are their beneficial owners. Such reporting companies, including any other reporting companies that may be created or registered before the effective date, will have until January 1, 2025, to file an initial report. As noted, reporting companies created or registered on or after the effective date will have 30 calendar days after the date of creation or registration to file an initial report.

Article By Thomas G. Appleman, Arthur L. Griem, and Vera S. Hansen of Miller Canfield

For more financial legal news, click here to visit the National Law Review.

© 2022 Miller, Canfield, Paddock and Stone PLC

CFPB Plans to Increase Regulation over “Buy Now, Pay Later” Lenders

The Consumer Financial Protect Bureau (CFPB) issued a release on September 15, 2022, announcing its intent to issue additional interpretive guidance or rules to ensure “Buy Now, Pay Later” (BNPL) lenders comply with the same or similar regulations already established for credit cards following a study on the industry.

In its press release, the CFPB Director Rohit Chopra noted the rapidly growing use of “Buy Now, Pay Later is a rapidly growing type of loan that serves as a close substitute for credit cards.” While credit cards include interest charges, BNPL loans do not, making them more attractive to consumers. Instead, these loans allow consumers to purchase a product and repay the purchase price through several installment payments. As a result, BNPL loans have become prominent over the past several years, particularly during the COVID-19 pandemic. These previously niche loans, typically used for apparel and beauty purchases, are now used in almost all consumer-facing industries.

The CFPB noted several highlights of BNPL loans found through the study, which include:

  • Increased loan approval rates year over year;
  • Increased occurrences of late fee charges;
  • Increased product returns by consumers; and
  • Shrinking profit margins by BNPL lenders.

As a result of the study, the CFPB outlined the following concerns with the BNPL industry, mainly because the marketing of these loans leads consumers to believe the loans are a “zero-risk credit option.”

  • Limited Consumer Protections: While BNPL loans are used as an alternative to credit cards, they lack the standard credit disclosures, dispute resolution rights, etc., that similar consumer credit transactions often require.
  • Data Harvesting: Lower profit margins associated with BNPL loans have pushed the industry to monetize consumer data, potentially impacting consumer privacy.
  • Debt Accumulation: According to the CFPB, BNPL loans encourage consumers to purchase more products and borrow more, resulting in consumers becoming overleveraged. While the CFPB notes that the lenders in this space do not furnish credit data to credit reporting companies, the CFPB is concerned about this industry extending credit to consumers who may not be able to repay the debt.

Takeaways

The CFPB has yet again reinforced its commitment to regulate lenders that extend consumer credit. The CFPB’s decision to either enforce existing consumer laws (i.e., the Truth in Lending Act disclosures already required for credit cards and other consumer loans) or create new rules on the growing BNPL industry is not unexpected. However, the CFPB’s release shows a renewed focus on protecting consumers’ privacy rights and ensuring that consumers can afford to repay their credit lines before offers of credit are extended, and demonstrates once more that the Bureau will seek to regulate emerging forms of consumer credit.

Article By David T. Long Jr. and Andrew J. Narod of Bradley Arant Boult Cummings LLP

For more financial institutions and banking legal news, click here to visit the National Law Review.

© 2022 Bradley Arant Boult Cummings LLP

Accounting Cases Involving SPACs

The Accounting Class Action Filings and Settlements—2021 Review and Analysis report features a spotlight section on accounting-related SPAC cases.

Special purpose acquisition companies (SPACs) have become an increasingly popular way for private companies to become publicly traded. The process typically proceeds through four phases:

  1. The SPAC initial public offering (IPO), when the SPAC becomes public as a shell company;
  2.  the search for a merger target, which typically involves a definitive time period (e.g., two years);
  3. the merger closing, during which time the SPAC sponsor and target company announce the merger, file a proxy statement, and solicit shareholder approval; and
  4. the period when the equity of the combined company becomes publicly traded, often referred to as the “De-SPAC” period.

Commentators have cited various reasons for the popularity of SPACs, including the perception of market participants that a private company may have more certainty as to pricing and control over the deal terms through a SPAC as compared to a traditional IPO.1 During 2021, there were 613 SPAC IPOs—nearly twice the number of traditional IPOs—and the $144.5 billion of capital raised was record-setting.2

SPAC filings that include accounting allegations tripled in 2021 as compared to the prior year.

SEC Statements Regarding Financial Accounting and Reporting

The increased popularity of SPACs has led to certain concerns from regulators. For example, the U.S. Securities and Exchange Commission (SEC) issued an investor bulletin on SPACs highlighting that the increased number of SPACs seeking to acquire an operating business may result in fewer attractive initial acquisitions.3 As of December 31, 2021, 575 SPACs were still searching for a merger target.4

The SEC has also highlighted concerns related to financial accounting and reporting issues that SPACs may face. For example, the SEC’s Acting Chief Accountant, Paul Munter, issued a statement on March 31, 2021, that raised questions about whether private company targets have the people and processes in place and the time that is needed to successfully transition to public company reporting requirements. Mr. Munter highlighted examples of complex financial accounting and reporting issues, including accounting for complex financial instruments and the need to comply with public company requirements for reporting on internal controls.5

Shortly after his March 31 statement, Mr. Munter and John Coates, the Acting Director of the SEC’s Division of Corporation Finance, issued a statement on April 12, 2021, that addressed accounting and reporting considerations for warrants issued by SPACs.6 The statement resulted in almost 500 SPACs restating their accounting for warrants by June 22, nearly all of which identified a material weakness in internal controls.7

Recent Trends in SPACs Involving Accounting Issues

During 2019 and 2020, only a handful of federal securities class actions involving SPACs were filed, but in 2021, federal filings involving SPACs became the dominant filing trend.8 Consistent with that overall trend, SPAC filings that include accounting allegations tripled in 2021 as compared to the prior year.

There are several trends in SPAC cases involving accounting issues over the past three years:

  • Approximately one in three initial complaints involving SPACs from 2019 through 2021 included accounting issues.
  • Three law firms—The Rosen Law Firm, Glancy Prongay & Murray LLP, and Pomerantz LLP—were associated with almost 80% of accounting case filings involving SPACs from 2019 through 2021.
  • Short-seller reports were commonly cited in cases involving SPACs. However, those reports were cited over one and a half times more often in accounting cases as compared with non-accounting cases filed during 2019 through 2021.
  • The median filing lag after a De-SPAC transaction was much greater in 2019–2020 (450 days) than it was in 2021 (106 days) for accounting case filings from 2019 through 2021 involving SPACs.
  • Inappropriate revenue recognition and weaknesses in internal controls were the most common allegations in SPAC accounting cases, followed by allegedly omitted disclosures of related-party transactions.

Because filings of SPAC cases have largely occurred very recently, based on our research only one of these cases had reached settlement as of the end of 2021, and this case included accounting allegations. As more of these cases progress, SPAC cases may play a role in future accounting case settlement trends.

1     “What You Need to Know About SPACs – Updated Investor Bulletin,” U.S. Securities and Exchange Commission, May 25, 2021, https://www.sec.gov/oiea/investor-alerts-and-bulletins/what-you-need-know-about-spacs-investor-bulletin.

2     Jay R. Ritter, “Initial Public Offerings: Updated Statistics,” Warrington College of Business, University of Florida, p. 48, https://site.warrington.ufl.edu/ritter/files/IPO-Statistics.pdf, accessed April 8, 2022.

3   “What You Need to Know About SPACs – Updated Investor Bulletin,” U.S. Securities and Exchange Commission, May 25, 2021, https://www.sec.gov/oiea/investor-alerts-and-bulletins/what-you-need-know-about-spacs-investor-bulletin.

4   SPACs still searching for a target are those that have completed their IPO but not yet announced a De-SPAC transaction target. See SPAC Insider.

5  Paul Munter, Acting Chief Accountant, “Financial Reporting and Auditing Considerations of Companies Merging with SPACs,” U.S. Securities and Exchange Commission, March 31, 2021, https://www.sec.gov/news/public-statement/munter-spac-20200331.

6  John Coates, Acting Director, Division of Corporation Finance, and Paul Munter, Acting Chief Accountant, “Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (‘SPACs’),” U.S. Securities and Exchange Commission, April 12, 2021, https://www.sec.gov/news/public-statement/accounting-reporting-warrants-issued-spacs.

7   See Will SPAC Restatement Wave Trigger Shareholder Litigation?, Cornerstone Research (2021), for further discussion.

8   See Securities Class Action Filings—2021 Year in Review, Cornerstone Research (2022), for further discussion.

Article By Elaine M. Harwood, Laura E. Simmons, Frank T. Mascari, and Sally Bai of Cornerstone Research

For more SEC and securities legal news, click here to visit the National Law Review.

Copyright ©2022 Cornerstone Research

Large Corporate Bankruptcy Filings Continue to Decrease through First Half of 2022

Most industry groups saw bankruptcy filings decline from mid-2020 pandemic highs.

New York—Following the spike in large corporate bankruptcy filings triggered by the COVID-19 pandemic, filings in 2021 and the first half of 2022 fell to levels below historical averages, according to a Cornerstone Research report released today.

The report, Trends in Large Corporate Bankruptcy and Financial Distress—Midyear 2022 Update, examines trends in Chapter 7 and Chapter 11 bankruptcy filings by companies with assets of $100 million or higher. It finds that 70 large companies filed for bankruptcy in 2021, down significantly from 155 in 2020 and below the annual average of 78 filings since 2005. In the first half of 2022, only 20 large companies filed for bankruptcy, compared to midyear totals of 43 in 1H 2021 and 89 in 1H 2020. The 20 bankruptcies in 1H 2022 were the lowest midyear total since the second half of 2014.

“U.S. government stimulus programs, low borrowing rates, and high debt forbearance helped disrupt predictions of continued growth in the number of bankruptcy filings,” said Nick Yavorsky, a report coauthor and Cornerstone Research principal. “Looking ahead, however, there are some concerns that increased corporate debt levels, rising interest rates and inflation, and a potential global recession may contribute to an increase in bankruptcy filings.”

In 2021, there were 20 “mega bankruptcies”—bankruptcy filings among companies with over $1 billion in reported assets—a substantial decline from the 60 mega bankruptcy filings in 2020. The first half of 2022 saw four Chapter 11 mega bankruptcy filings, compared to nine in the first half of 2021 and at a pace significantly lower than the annual average of 22 filings in 2005–2021.

Most industry groups saw bankruptcy filings decrease in 2021 and the first half of 2022, including those industries with the highest number of filings following the pandemic’s onset: Mining, Oil, and Gas; Retail Trade; Manufacturing; and Services.

Read the full report here.

Article By Allie Schwartz, Joseph B. “J.B.” Doyle, Nicholas D. Yavorsky, and Diego Vega San Martin of Cornerstone Research

For more bankruptcy legal news, click here to visit the National Law Review.

Copyright ©2022 Cornerstone Research

Practical and Legal Considerations for Extending Cash Runway in a Changing Economy

The funding environment for emerging companies has fundamentally shifted in 2022 for both venture capital and IPOs, particularly after a banner year in 2021. Whether these headwinds suggest significant economic changes or a return to previous valuation levels, companies need to be realistic about adapting their business processes to ensure they have sufficient cash runway to succeed through the next 2-3 years.

This article provides a comprehensive set of tactics that can be used to extend cash runway, both on the revenue/funding and cost side. It also addresses areas of liability for companies and their directors that can emerge as companies change business behaviors during periods of reduced liquidity.

Ways to Improve and Extend Cash Runway

Understanding Your Cash Runway

Cash runway refers to the number of months a company can continue operations before it runs out of money. The runway can be extended by increasing revenue or raising capital, but in a down economy, people have less disposable income and corporations are more conservative with their funds. Therefore companies should instead focus on cutting operating costs to ensure their cash can sustain over longer periods.

As a starting point, companies can evaluate their business models to determine expected cash runway based on factors such as how valuations are currently being determined, total cash available, burn rate, and revenue projections. This will help guide the actions to pursue by answering questions such as:

  1. Is the company currently profitable?
  2. Will the company be profitable with expected revenue growth even if no more outside funding is brought in?
  3. Is there enough cash runway to demonstrate results sufficient to raise the next round at an appropriate valuation?

Even if companies expect to have sufficient cash runway to make it through a potential economic downturn, tactics such as reducing or minimizing growth in headcount, advertising spend, etc. can be implemented as part of a holistic strategy to stay lean while focusing on the fundamentals of business model/product-market fit.

Examining Alternative Sources of Financing

Even though traditional venture capital and IPO financing options have become more difficult to achieve with desired valuations, companies still have various other options to increase funding and extend runway. Our colleagues provided an excellent analysis of many of these options, which are highlighted in the discussion below.

Expanding Your Investor Base to Fund Cash Flow Needs

The goal is to survive now, excel later; and companies should be open to lower valuations in the short term. This can create flexibility to circle back with investors who may have been open to an earlier round but not at the specific terms at that time. Of course, to have a more productive discussion, it will be helpful to explain to these investors how the business model has been adapted for the current environment in order to demonstrate that the new valuation is tied to clear milestones and future success.

Strategic investors and other corporate investors can also be helpful, acting as untapped resources or collaborators to help drive forward milestone achievements. Companies should understand how their business model fits with the investor’s customer base, and use the relationship to improve their overall position with investors and customers to increase both funding and revenue to extend runway.1

If the next step for a company is to IPO, consider crossover or other hybrid investors, understanding that much of the cash deployment in 2022 is slowing down.

Exploring Venture Debt

If a company has previously received venture funding, venture debt can be a useful tool to bridge forward to future funding or milestones. Venture debt is essentially a loan designed for early stage, high growth startups who have already secured venture financing. It is effective for targeting growth over profitability, and should be used in a deliberate manner to achieve specific goals. The typical 3-5 year timeline for venture debt can fit well with the goal of extending cash runway beyond a currently expected downturn.

Receivables/Revenue-Based Financing and Cash Up Front on Multi-Year Contracts

Where companies have revenue streams from customers — especially consistent, recurring revenue — this can be used in various ways to increase short-term funds, such as through receivables financing or cash up front on long-term contracts. However, companies should take such actions with the understanding that future investors may perceive the business model differently when the recurring revenue is being used for these purposes rather than typical investment in growth.

Receivable/revenue-based financing allows for borrowing against the asset value represented by revenue streams and takes multiple forms, including invoice discounting and factoring. When evaluating these options, companies should make sure that the terms of the deal make sense with runway extension goals and consider how consistent current revenue streams are expected to be over the deal term. In addition, companies should be aware of how customers may perceive the idea of their invoices being used for financing and be prepared for any negative consequences from such perceptions.

Revenue-based financing is a relatively new financing model, so companies should be more proactive in structuring deals. These financings can be particularly useful for Software-as-a-Service (SaaS) and other recurring revenue companies because they can “securitize the revenue being generated by a company and then lend capital against that theoretical security.”2

Cash up front on multi-year contracts improves the company’s cash position, and can help expand the base where customers have sufficient capital to deliver up front with more favorable pricing. As a practical matter, these arrangements may result in more resources devoted to servicing customers and reduce the stability represented by recurring revenue, and so should be implemented in a manner that remains aligned with overall goal of improving product-market fit over the course of the extended runway.

Shared Earning Agreements

A shared earning agreement is an agreement between investors and founders that entitles investors to future earnings of the company, and often allow investors to capture a share of founders’ earnings. These may be well suited for relatively early stage companies that plan to focus on profitability rather than growth, due to the nature of prioritizing growth in the latter.

Government Loans, Grants, and Tax Credits

U.S. Small Business Administration (SBA) loans and grants can be helpful, particularly in the short term. SBA loans generally have favorable financing terms, and together with grants can help companies direct resources to specific business goals including capital expenditures that may be needed to reach the next milestone. Similarly, tax credits, including R&D tax credits, should be considered whenever applicable as an easy way to offset the costs.

Customer Payments

Customers can be a lifeline for companies during an economic downturn, with the prioritization of current customers one way companies can maintain control over their cash flow. Regular checks of Accounts Receivable will ensure that customers are making their payments promptly according to their contracts. While this can be time-consuming and repetitive, automating Accounts Receivable can streamline tasks such as approving invoices and receiving payments from customers to create a quicker process. Maintenance of Accounts Receivable provides a consistent flow of cash, which in turn extends runway.

To increase immediate cash flow companies should consider requiring longer contracts to be paid in full upon delivery, allowing the company to collect cash up front and add certainty to revenue over time. This may be hard to come by as customers are also affected by the economic downturn, but incentivizing payments by offering discounts can offset reluctance. Customers are often concerned with locking in a company’s services or product and saving on cost, with discounts serving as an easy solution. While they can create a steady cash flow, it may not be sustainable for longer cash runways. Despite their attractive value, companies should use care when offering discounts for early payments. Discounts result in lower payments than initially agreed upon, so companies should consider how long of a runway they require and whether the discounted price can sustain a runway of such length.

Vendor Payments

One area where companies can strategize and cut costs is vendor payments. By delaying payments to vendors, companies can temporarily preserve cash balance and extend cash runway. Companies must review their vendor agreements to evaluate the potential practical and legal ramifications of this strategy. If the vendor agreements contain incentives for early payments or penalties for late payments, then such strategy should not be employed. Rather, companies can try to negotiate with vendors for an updated, extended repayment schedule that permits the company to hold on to their cash for longer. Alternatively, companies can negotiate with vendors for delayed payments without penalty. Often vendors would prefer to compromise rather than lose out on customers, especially in a down economy.

Lastly, companies can seek out vendors who are willing to accept products and services as the form of payment as opposed to cash. Because the calculation for cash runway only takes into account actual cash that companies have on hand, products and services they provide do not factor into the calculation. As such, companies can exchange products and services for the products and services that their vendors provide, thereby reserving their cash and extending their cash runway.

Bank Covenants

In exercising the various strategies above, it is important to be mindful of your existing bank covenants if your company has a lending facility in place. There are often covenants restricting the amount of debt a borrower can carry, requiring the maintenance of a certain level of cash flow, and cross default provisions automatically defaulting a borrower if it defaults under separate agreements with third parties. Understanding your bank covenants and default provisions will help you to stay out of default with your lender and avoid an early call on your loan and resulting drain on you cash position.

Employee Considerations

As discussed extensively in our first article Employment Dos and Don’ts When Implementing Workforce Reductions, the possibility of an economic downturn not only will have an impact on your customer base, but your workforce as well. Employees desire stability, and the below options can help keep your employees engaged.

Providing Equity as a Substitute for Additional Compensation.

Employees might come to expect cash bonuses and pay raises throughout their tenure with an employer; in a more difficult economic period this may further strain a business’s cash flow. One alternative to such cash-based payments is the granting of equity, such as options or restricted stock. This type of compensation affords employees the prospect of long-term appreciation in value and promotes talent retention, while preserving capital in the immediate term. Further, to the employee holding equity is to have “skin in the game” – the employee now has an ownership stake in the company and their work takes on increasing importance to the success of the company.

To be sure, the company’s management and principal owners should consider how much control they are ceding to these new minority equity holders. The company must also ensure such equity issuances comply with securities laws – including by structuring the offering to fit within an exemption from registration of the offering. Additionally, if a downturn in the company’s business results in a drop in the value of the equity being offered, the company should consider conducting a new 409A valuation. Doing so may set a lower exercise price for existing options, thus reducing the eventual cost to employees to exercise their options and furnishing additional, material compensation to employees without further burdening cash flow.

Transitioning Select Employees to Part-Time.

Paying the salaries of employees can be a major burden on a business’s cash flow, and yet one should be wary of resorting to laying off employees to conserve cash flow in a downturn. On the other hand, if a business were to miss a payroll its officers and directors could face personal liability for unpaid wages. One means of reducing a business’s wage commitments while retaining (and paying) existing employees is to transition certain employees to part-time status. In addition to producing immediate cash flow benefits, this strategy enables a business to retain key talent and avoid the cost of replacing the employees in the future. However, this transition to part-time employees comes with important considerations.

Part-time employees are often eligible for overtime pay and must receive the higher of the federal or state minimum hourly wage. And if transitioned employees are subject to restrictive covenants, such as a non-competition agreement, they might argue their change in status should release them from such restrictions. Particularly since the COVID-19 pandemic, courts have shown reluctance to enforce non-competes in the context of similar changes in work status when the provision is unreasonable or enforcement is against the public interest.

Director Liability in Insolvency

Insolvency and Duties to Creditors

There may be circumstances where insolvency is the only plausible result. A corporation has fiduciary duties to stockholders when solvent, but when a corporation becomes insolvent it additionally owes such duties to creditors. When insolvent, a corporation’s fiduciary duties do not shift from stockholders to creditors, but expand to encompass all of the corporation’s residual claimants, which include creditors. Courts define “insolvency” as the point at which a corporation is unable to pay its debts as they become due in the ordinary course of business, but the “zone of insolvency” occurs some time before then. There is no clear line delineating when a solvent company enters the zone of insolvency, but fiduciaries should assume they are in this zone if (1) the corporation’s liabilities exceed its assets, (2) the corporation is unable to pay its debts as they become due, or (3) the corporation faces an unreasonable risk of insolvency.

Multiple courts have held that upon reaching the “zone of insolvency,” a corporation has fiduciary duties to creditors. However, in 2007 the Delaware Supreme Court held that there is no change in fiduciary duties for a corporation upon transitioning from “solvent” to the “zone of insolvency.” Under this precedent, creditors do not have standing to pursue derivative breach of fiduciary duty claims against the corporation until it is actually insolvent. Once the corporation is insolvent, however, creditors can bring claims such as for fraudulent transfers of assets and for failure to pursue valid claims, including those against a corporation’s own directors and officers. To be sure, the Delaware Court of Chancery clarified that a corporation’s directors cannot be held liable for “continuing to operate [an] insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors,” along with other caveats to the general fiduciary duty rule. Still, in light of the ambiguity in case law on the subject, a corporation ought to proceed carefully and understand its potential duties when approaching and reaching insolvency.

1 Diamond, Brandee and Lehot, Louis, Is it Time to Consider Alternative Financing Strategies?, Foley & Lardner LLP (July 18, 2022)

2 Rush, Thomas, Revenue-based financing: The next step for private equity and early-stage investment, TechCrunch (January 6, 2021)

Article By Natasha Allen, David W. Kantaros, Nikhil T. Pradhan, and Graham P. MacEwan of Foley & Lardner LLP

For more financial institutions and banking legal news, click here to visit the National Law Review.

© 2022 Foley & Lardner LLP

SEC Proposes to Clear-Up Clearing Agencies’ Governance to Mitigate Directors’ Potential Conflicts of Interest

Clearing agencies registered with the Securities and Exchange Commission (SEC) will have to make governance changes to their boards of directors under a new rule proposed by the SEC on August 8, 2022.

The SEC proposed the new rule1 to mitigate the conflicts of interests inherent in clearing agency relationships. The rule follows episodes of market volatility in 2021 that included large fluctuations surrounding COVID-19 and the meme stock craze.

The new rule would amend Section 17Ad-25 of the Securities Exchange Act of 1934 (Exchange Act) to require additional management and governance requirements for clearing agencies that register with the SEC. The proposed rules provide specific new governance requirements on clearing board composition, independent directors, nominating committees and risk management committees. The rule also requires the board to oversee relationships with critical service providers and includes a board obligation to consider various stakeholder views and inputs.

Rationale

The SEC’s rationale for proposing Rule 17Ad-25, titled Clearing Agency Governance and Conflicts of Interest, is to reduce the risk that conflicts of interest inherent in various clearing agency relationships substantially harm the security-based swaps or larger financial market. The SEC is proposing this rule to mitigate conflicts of interest, promote the fair representation of owners and participants in the governance of a clearing agency, identify responsibilities of the board, and increase transparency into clearing agency governance.

The SEC noted that those episodes of increased market volatility revealed certain vulnerabilities in the US securities market and the essential role clearing agencies play in managing the risk if securities transactions fail to clear.

The SEC observed three potential sets of conflicts of interest that the proposed rule attempts to address.

  1. The proposed rule addresses the different perspectives the various stakeholders involved in clearing agencies might have. In particular, a clearing agency owner’s potential interest in protecting the equity and continued operation of the clearing agency diverges from a participant’s potential interest in avoiding the allocation of losses from another defaulting participant. For instance, in the event of a loss, clearing agency participants might prefer to limit access to clearing, while owners may choose to expand the scope of products offered to collect fees.

  2. Larger clearing agency participants’ priorities may diverge significantly from the interests of smaller clearing agency participants. In particular, when a small number of dominant participants exercise control over a registered clearing agency concerning services provided by that clearing agency, those participants might promote margin requirements that are not commensurate with the risks they take, thereby indirectly limiting competition and increasing profit margins for themselves. In other words, a registered clearing agency dominated by a small number of large participants might make decisions designed to provide them with a competitive advantage.

  3. Certain participants may exert undue influence to limit access to the clearing agency based on their own interests, and thus could limit the benefits of the clearing agency to indirect participants.

Rule Requirements

The proposed rule would impose these seven requirements:

  1. define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of directors on the board be independent, unless a majority of the voting rights distributed to shareholders of record are directly or indirectly held by participants of the registered clearing agency, in which case at least 34 percent of the board must be independent directors;

  2. establish requirements for a nominating committee, including with respect to the composition of the nominating committee, fitness standards for serving on the board, and documenting the process for evaluating board nominees;

  3. establish requirements for the function, composition, and reconstitution of the risk management committee;

  4. require policies and procedures that identify, mitigate or eliminate, and document the identification and mitigation or elimination of conflicts of interest;

  5. require policies and procedures that obligate directors to report potential conflicts promptly;

  6. require policies and procedures for the board to oversee relationships with service providers for critical services; and

  7. require policies and procedures to solicit, consider, and document the registered clearing agency’s consideration of the views of its participants and other relevant stakeholders regarding its governance and operations.

The proposing release will be published on SEC.gov and in the Federal Register. The public comment period will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.

FOOTNOTES

1 https://www.sec.gov/rules/proposed/2022/34-95431.pdf

Article By Susan Light of Katten. Jacob C. Setton, an associate in the Financial Markets and Funds practice and candidate for admission to the New York State bar, also contributed to this advisory.

For more SEC and securities legal news, click here to visit the National Law Review.

©2022 Katten Muchin Rosenman LLP

Federal Reserve Doubles Down on Oversight of Crypto Activities for Banks

The Federal Reserve Board (the “FRB”) issued Supervision and Regulation Letter 22-6 (“SR 22-6”), providing guidance for FRB-supervised banking organizations (referred to collectively herein as “FRB banks”) seeking to engage in activities related to cryptocurrency and other digital assets.  The letter states that prior to engaging in crypto-asset-related activities, such FRB banks must ensure that their activities are “legally permissible” and determine whether any regulatory filings are required.  SR 22-6 further states that FRB banks should notify the FRB prior to engaging in crypto-asset-related activities.  Any FRB bank that is already engaged in crypto-asset-related activities should notify the FRB promptly regarding the engagement in such activities, if it has not already done so.  The FRB also encourages state member banks to contact state regulators before engaging in any crypto-asset-related activity.

These requirements send a clear message to FRB banks and in fact to all banks that their crypto-asset related activities are considered to be risky and not to be entered into lightly.

Indeed, the FRB noted that crypto-asset-related activities may pose risks related to safety and soundness, consumer protection, and financial stability, and thus a FRB bank should have in place adequate systems, risk management, and controls to conduct such activities in a safe and sound manner and consistent with all applicable laws.

SR 22-6 is similar to guidance previously issued by the OCC and FDIC; in all cases, the agencies require banks to notify regulators before engaging in any kind of digital asset activity, including custody activities. The three agencies also released a joint statement last November in which they pledged to provide greater guidance on the issue in 2022.  Further, in an August 17, 2022 speech, FRB Governor Bowman stated that the FRB staff is working to articulate supervisory expectations for banks on a variety of digital asset-related activities, including:

  • custody of crypto-assets
  • facilitation of customer purchases and sales of crypto-assets
  • loans collateralized by crypto-assets, and
  • issuance and distribution of stablecoins by banking organizations

Interestingly, SR 22-6 comes a few days after a group of Democratic senators sent a letter to the OCC requesting that the OCC withdraw its interpretive letters permitting national banks to engage in cryptocurrency activities and a day after Senator Toomey sent a letter to the FDIC questioning whether it is deterring banks from offering cryptocurrency services.

Although past guidance already required banks to notify regulators of crypto activity, this guidance likely could discourage additional banks from entering into crypto-related activities in the future or from adding additional crypto services. In the end, it could have the unfortunate effect of making it more difficult for cryptocurrency companies to obtain banking services.

Article By Grant F. Butler, Jeremy M. McLaughlin, Anthony R.G. Nolan, and Judith E. Rinearson of K&L Gates

For more finance and banking legal news, click here to visit the National Law Review.

Copyright 2022 K & L Gates

UK Prohibits Certain Investment in Russia

From 19 July 2022,1 it is a violation of UK financial sanctions for any person who knows or has reasonable cause to suspect that they are carrying out, directly or indirectly, certain investment activity in Russia. These prohibitions follow the UK Government’s 6 April 2022 announcement of its intention to introduce an outright ban on all new outward investment in Russia.

The prohibitions are subject to exceptions and do not impact acts undertaken to satisfy obligations under a contract concluded before 19 July 2022, or an ancillary contract necessary for the satisfaction of that contract, subject to notifying Her Majesty’s Treasury at least five working days before the day on which any related act is carried out. There is also the option to apply for a specific Treasury licence, such as to enable humanitarian assistance activity or if connected with the provision of medical goods or services.

Furthermore, General Licence INT/2022/2002560 has been granted, taking effect from 19 July 2022 and expiring on 26 July 2022, allowing a seven-day wind-down period in respect of the prohibited activities.

What Is Prohibited?

The Regulations prohibit:

  • Directly or indirectly establishing any joint venture with a person connected with Russia;
  • Opening representative offices or establishing branches or subsidiaries in Russia;
  • Directly or indirectly acquiring any ownership interest in Russian land and persons connected with Russia for the purpose of making funds or economic resources available directly or indirectly to, or for the benefit of, persons connected with Russia;
  • Directly or indirectly acquiring any ownership interest in or control over a relevant entity or persons (other than an individual) with a place of business in Russia for the purpose of making funds or economic resources available, directly or indirectly, to, or for the benefit of, persons connected with Russia; and
  • The provision of investment services directly related to all the activities summarised above.

Definitions

A “person connected with Russia” means:

  • any individual or group of individuals who are ordinarily resident or located in Russia, or an entity which is incorporated or constituted under Russian law or domiciled in Russia;2

and is not:

  • A Schedule 2 Entity, as detailed in the Regulations;3 or
  • An entity domiciled outside of Russia or a branch, or subsidiary, of such a non-Russian entity.4

A “branch”5 means, in relation to a person other than an individual, a place of business which forms a legally dependent part of that person and which carries out all or some of the transactions inherent in the business of that person.

A “relevant entity”6 means a person, other than an individual, which has a place of busines located in Russia, but is not a person connected with Russia.

A person directly or indirectly “acquiring any ownership interest in or control over a person or entity”7 means:

  • Acquiring any share in the person or entity;
  • Acquiring any voting rights in the person or entity;
  • Acquiring any right to appoint or remove a majority of the board of directors of the person or entity; or
  • Acquiring any means of ensuring that the affairs of the person or entity are conducted in accordance with the wishes of the person.

Exceptions

The exceptions8 introduced enables a person to deal directly or indirectly with:

  • A transferable security otherwise prohibited by Regulation 16;
  • A relevant security issued by a person connected with Russia; or
  • A relevant security issued by a relevant entity.

Full definitions of the terms above are included within Regulation 60ZZA.

From 19 July 2022,1 it is a violation of UK financial sanctions for any person who knows or has reasonable cause to suspect that they are carrying out, directly or indirectly, certain investment activity in Russia. These prohibitions follow the UK Government’s 6 April 2022 announcement of its intention to introduce an outright ban on all new outward investment in Russia.

The prohibitions are subject to exceptions and do not impact acts undertaken to satisfy obligations under a contract concluded before 19 July 2022, or an ancillary contract necessary for the satisfaction of that contract, subject to notifying Her Majesty’s Treasury at least five working days before the day on which any related act is carried out. There is also the option to apply for a specific Treasury licence, such as to enable humanitarian assistance activity or if connected with the provision of medical goods or services.

Furthermore, General Licence INT/2022/2002560 has been granted, taking effect from 19 July 2022 and expiring on 26 July 2022, allowing a seven-day wind-down period in respect of the prohibited activities.

What Is Prohibited?

The Regulations prohibit:

  • Directly or indirectly establishing any joint venture with a person connected with Russia;
  • Opening representative offices or establishing branches or subsidiaries in Russia;
  • Directly or indirectly acquiring any ownership interest in Russian land and persons connected with Russia for the purpose of making funds or economic resources available directly or indirectly to, or for the benefit of, persons connected with Russia;
  • Directly or indirectly acquiring any ownership interest in or control over a relevant entity or persons (other than an individual) with a place of business in Russia for the purpose of making funds or economic resources available, directly or indirectly, to, or for the benefit of, persons connected with Russia; and
  • The provision of investment services directly related to all the activities summarised above.

Definitions

A “person connected with Russia” means:

  • any individual or group of individuals who are ordinarily resident or located in Russia, or an entity which is incorporated or constituted under Russian law or domiciled in Russia;2

and is not:

  • A Schedule 2 Entity, as detailed in the Regulations;3 or
  • An entity domiciled outside of Russia or a branch, or subsidiary, of such a non-Russian entity.4

A “branch”5 means, in relation to a person other than an individual, a place of business which forms a legally dependent part of that person and which carries out all or some of the transactions inherent in the business of that person.

A “relevant entity”6 means a person, other than an individual, which has a place of busines located in Russia, but is not a person connected with Russia.

A person directly or indirectly “acquiring any ownership interest in or control over a person or entity”7 means:

  • Acquiring any share in the person or entity;
  • Acquiring any voting rights in the person or entity;
  • Acquiring any right to appoint or remove a majority of the board of directors of the person or entity; or
  • Acquiring any means of ensuring that the affairs of the person or entity are conducted in accordance with the wishes of the person.

Exceptions

The exceptions8 introduced enables a person to deal directly or indirectly with:

  • A transferable security otherwise prohibited by Regulation 16;
  • A relevant security issued by a person connected with Russia; or
  • A relevant security issued by a relevant entity.

Full definitions of the terms above are included within Regulation 60ZZA.

FOOTNOTES

1 Regulation 18B introduced via The Russia (Sanctions) (EU Exit) (Amendment) (No. 12) Regulations 2022 [2022 No. 801], in force as of 19 July 2022.

2 Regulation 19A(2), The Russia (Sanctions) (EU Exit) Regulations 2019 [2019 No. 855] – as amended.

3 See pp. 123-124.

4 Regulation 16(4D), Ibid.

5 Regulation 18B(8), The Russia (Sanctions) (EU Exit) (Amendment) (No. 12) Regulations 2022 [2022 No. 801].

6 Regulation 18B(8), Ibid.

7 Regulation 18B(8), Ibid.

8 Regulation 60ZZA, Ibid.

Article By Annabel Thomas, Jo Rickards, Gavin Costelloe, Bethany Histed, Kara M. Bombach, and Erik de Bie of Greenberg Traurig, LLP

For more global law legal news, click here to visit the National Law Review.

©2022 Greenberg Traurig, LLP. All rights reserved.

What Public Comments on the SEC’s Proposed Climate-Related Rules Reveal—and the Impact They May Have on the Proposed Rules

On March 21, 2022, the Securities and Exchange Commission (“SEC”) published for comment its much-anticipated proposed rules on climate disclosures, entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors.”[1]  The SEC invited public comments on these rules, and the response was overwhelming—nearly 15,000 comments were published on the SEC’s website over the course of three months, from individuals and organizations representing all aspects of modern American society.  Few, if any, of the SEC’s rule proposals have ever received such voluminous, significant, and diverse comments.  And the comments themselves range from brief statements to complex legal arguments either in support or in opposition, as well as detailed proposals for further changes to the proposed climate disclosures.  The comment period closed on June 17, 2022, and further action by the SEC to finalize the proposed rule is anticipated this fall.

This article provides a brief summary of the comments, and analyzes and summaries the key points the comments conveyed.

Statistical Analysis of Form and Individualized Submissions

Since the beginning of the public comment period, the SEC has received 14,645 comments on the proposed climate disclosure rules.[2]  To provide some context for how massive that figure is, the SEC has only received 144 comments on its proposed cybersecurity risk management rules, which were announced two weeks before the proposed climate disclosures and have also been the subject of extensive commentary in the press.  Yet despite the prominence of the SEC’s cybersecurity proposal, it has received fewer than 1% of the comments offered on the climate disclosure rule.

Of the 14,645 comments, approximately 12,304, or 84% of the total, are form letters.  This includes 10,589 comments that the SEC itself identified as form letters, and another 1,715 apparently individualized comments that were actually form letters.  However, even when removing these form letters from consideration, fully 2,341 individualized comment letters remain—a substantial number, and a significant percentage (16%) of the volume.[3]

The form letters are worth exploring in more detail.  Of the 12,304 comments, fully 10,861 (88%) broadly express support for the proposed climate disclosure rule, and only 1,443 (12%) are in opposition.  This disparity in the level of support for the two positions is best conveyed by the chart below.

Positions for and against the new SEC Disclosures

Notably, it has been possible to identify some, although not all, of the organizations that sponsored the form letter writing campaign.  In particular, form letters proposed by the Union of Concerned Scientists in support of the proposed climate disclosures were submitted 6886 times—more than 55% of the total volume of form letters.  Additionally, the form letters proposed by the Climate Action Campaign and the National Wildlife Federation in support of the SEC’s proposed disclosures were also quite voluminous among the submissions—1208 and 956 comment letters, respectively.  The most frequent form letters submitted in opposition to the proposed climate disclosure rules—e.g., those proposed by FreedomWorks (348 letters) and the Club for Growth (172 letters)—did not achieve nearly the same volume of submissions.

But the apparent overwhelming majority in favor of the proposed SEC climate disclosure rules, as conveyed by the form letters, is belied by the individualized submissions, which were far more closely divided.  Of the 2341 individualized comment letters submitted, approximately 53% (1238 comment letters) expressed support, about 43% (1015 comment letters) were opposed, and a handful—around 4% (88 comment letters)[4]—did not express a position.  The below chart demonstrates the levels of support expressed by the individualized submissions:

Individual submissions supporting, opposing, and neutral to the new SEC Disclosures

Besides the mere volume of submissions, however, the most noteworthy aspect of the individualized submissions are the substantive arguments—both factual and legal—that these comment letters articulate, whether in support or opposition to the proposed rules, as well as the identity of those making these submissions.

Arguments in Support of the Proposed SEC Climate Disclosure Rules

The organizations and individuals that chose to offer support for the SEC’s proposed climate disclosures represent a wide swathe of society.  Broadly speaking, these proposed climate disclosures attracted support from, among others: Democratic politicians, civil society organizations (such as environmental NGOs), individual corporations, professional services organizations, and academics. While the rationales offered by these different groups varied considerably, in part due to their varying perspectives (e.g., environmental NGOs were more concerned with the impact on the transition to a clean-energy environment, while corporations often focused on the consequences of particular aspects of the rules), the individualized comments in support of the proposed disclosures nonetheless shared some common features.

Specifically, there are a number of common arguments that are frequently featured among the 1239 individualized submissions in support of the SEC’s proposed climate disclosures.  Six arguments appear in over 10% of the submissions.  In order of prevalence, these are:

  1. Environmental Protection (347 submissions, 28%): that the proposed rules will help protect the environment
  2. Investor Choice (280 submissions, 23%): that the proposed rules will enable investors to make more informed choices
  3. Investor Protection (263 submissions, 21%): that the proposed rules will enable investors to protect themselves and their investments from climate-related risk
  4. Standardization of Climate Disclosures (259 submissions, 21%): that the proposed rules will enable the standardization of climate disclosures, making data comparable
  5. Increased Transparency (171 submissions, 14%): that the proposed rules will increase transparency and hold companies accountable for their emissions
  6. Alignment with International and Foreign Regulatory Frameworks (169 submissions, 14%): that the proposed rules will bring the United States into alignment with both international frameworks and other countries (e.g., the EU)

No other argument appeared in more than 6% of the individualized submissions in support of the SEC’s proposed climate disclosures.

Notably, the most common arguments in favor of the proposed climate disclosures share a common feature: these are all policy arguments, focusing on the benefits to investors and the broader economy from the adoption of the SEC’s proposed disclosures.  Only a single argument among the top ten most frequent arguments in support was a legal argument—namely that the proposed rules fall within the SEC’s statutory authority—and that argument appeared in only around 3% of the submissions (41 submissions).[5]  This focus on policy benefits among supporters of the SEC’s proposed climate disclosures is unsurprising, as these public policy rationales were a key factor in encouraging the Biden Administration to pursue this regulatory agenda.  However, the reluctance to engage with critics of the proposed climate disclosures on a legal basis may signal the difficulties that the SEC’s proposed climate disclosures may encounter in future court challenges.

Arguments in Opposition to the Proposed SEC Climate Disclosure Rules

Those entities and individuals that submitted individualized comment letters opposing the SEC’s proposed climate disclosures also represent a broad range of American society, albeit with a somewhat different focus.  Generally, individualized letters in opposition to the SEC’s proposed climate disclosures tended to be submitted by, among others: Republican politicians, individual corporations, trade industry groups, and NGOs. (Unsurprisingly, the fossil fuel industry and extractive industries were particularly well-represented among the commenters.)  These individualized submissions—frequently lengthy and extensively analyzing the SEC’s regulatory practices and authority—shared a number of common themes.

In particular, there are a number of common arguments that featured frequently among the 1014 individualized submissions to the SEC in opposition to these proposed climate disclosures.  Three (3) arguments appeared in more than ten (10) percent of these submissions:

  1. Ultra vires (322 submissions, 32% ): that the SEC lacks the ability to issue these disclosures as the proposed rule is beyond the scope of the SEC’s legal authority
  2. Compliance Costs (218 submissions, 21% ): that compliance with the proposed rule will impose unreasonable and extensive costs on businesses
  3. Climate Science Skepticism (123 submissions, 12%): that the science concerning climate change is unsettled and therefore the proposed rule is inappropriate

Although no other common argument appeared in more than 7% of the individualized letters in opposition, it should still be noted that there were a large number of letters that objected to the increased burdens placed on particular types of businesses, whether farmers (53 submissions, 5%), fossil fuel companies (49 submissions, 5%), or small businesses (36 submissions, 4%).

Overall, it is striking that around a third of the comments submitted in opposition stated that the SEC had acted beyond its authority (ultra vires) in proposing this new rule.  While this critique is hardly novel—it has been a frequent refrain of the Republican SEC Commissioners ever since this topic was first broached—the prevalence of this argument among the individualized comments suggests that both the public and sophisticated market actors perceive this issue as a key vulnerability in the SEC’s proposal, and that this legal argument will likely be emphasized in the inevitable legal challenge to this SEC rule.  And, based on recent decisions by the Supreme Court, it is altogether likely that this line of attack may find a sympathetic audience in the courts.

Potential Changes to the SEC Climate Disclosure Rules Resulting from Public Comments

Despite the differences between the advocates and opponents of the SEC’s proposed climate disclosures, both sides submitted proposals to the SEC to change or adjust the proposed rules.  Although there was often substantial disagreement about the content of these proposed changes, there were also significant areas of convergence.

Some of the changes to the SEC’s proposed climate disclosures frequently submitted by supporters of the rule included:

  1. ISSB: that the SEC should further align its proposal with the ISSB and help create a global standard (76 comments);
  2. Extended Phase-In Period: to extend the phase-in period for these new disclosure requirements (72 comments);
  3. Alignment with International and Foreign Standards: that the SEC should further align its proposal with international and foreign standards, such as the EU or TCFD (66 comments);
  4. Enhance Scope 3 GHG Emissions: to eliminate exemptions so that all companies must disclose Scope 3 GHG emissions (55 comments);
  5. Principles-Based Approach to Materiality: to adopt a principles-based approach to materiality rather than bright-line rules (53) comments;
  6. Remove Scope 3 GHG Emissions: to remove the requirement that Scope 3 GHG emissions be disclosed (36 comments);
  7. Furnish, Not File: that the disclosures be provided in a document that is “furnished” to the SEC, rather than filed (which impacts potential liability) (26 comments).

Although certain proposed changes by proponents of the SEC’s proposed climate disclosure rule are undeniably expected (e.g., removing exemptions for disclosure of Scope 3 GHG emissions), there are others that seem somewhat surprising on initial review (e.g., extending the phase-in period or removing Scope 3 GHG emissions entirely).  This can most easily be explained by the fact that supporters of the SEC’s proposed rule include corporations and other business interests, which will resist certain burdensome regulations even if generally offering support for the overall thrust of the proposal.  There are also academics and others who continue to express skepticism concerning the utility of disclosing Scope 3 emissions, or even whether it can be adequately measured.

It should be emphasized that these changes proffered by supporters of the SEC’s proposed rule, many of which are designed to render the proposed rule less onerous, may indicate that the support for the proposed rule—or at least the most stringent aspects of it—is relatively weak (or at least among the corporate interests nominally aligned with the SEC).

The most frequent changes suggested by opponents of the rule included:

  1. Remove Scope 3 GHG Emissions: to remove the requirement that Scope 3 GHG emissions be disclosed (69 comments);
  2. Principles-Based Approach to Materiality: to adopt a principles-based approach to materiality rather than bright-line rules (35 comments);
  3. Extended Phase-In Period: to extend the phase-in period for these new disclosure requirements (25 comments);
  4. Furnish, Not File: that the disclosures be provided in a document that is “furnished” to the SEC, rather than filed (which impacts potential liability) (18 comments).

These proposed changes (and others) advanced by opponents of the SEC’s proposed rule are generally designed to make the rules less stringent and also to reduce costs and potential legal liability.

As can be seen by comparing the above lists, there are certain areas where suggested changes to the proposed rule converged.  In particular, there are issues where both opponents of the SEC’s proposed rule and some of its supporters would try to render it less intrusive or impactful, particularly with respect to the elimination of the requirement to report Scope 3 GHG emissions and to extend the phase-in period further.  (Although, as noted, this apparent convergence between opponents and supporters of the SEC’s proposed rule may be due to divergent interests among the supporters of the SEC’s proposed rule with respect to its implementation.)

But, regardless of the specific content of the particular proposed changes, what is undoubtedly significant is that these proposed changes have highlighted the aspects of the SEC’s proposed climate disclosure rule that are likely most sensitive to regulated corporations.  Such an insight reveals not only the areas where active lobbying is most likely to take place, but also previews probable priorities for corporate compliance departments.  In effect, focusing on the aspects of the proposed rule where changes were proposed is a means to identify the key issues from the perspective of the regulated entities and the public at large.

Conclusion

The level of engagement with the SEC’s proposed climate disclosures, as demonstrated by the number and detail of the public comments offered, is extraordinary. This degree of attention indicates the significant impact that is expect to result from the ultimate promulgation of these rules (or a revised version thereof).

Of course, the key question here is what changes, if any, are likely to be made to the SEC’s proposed rule based upon the public comments submitted to the SEC.  In this context, it is noteworthy that a handful of key issues have been identified by both proponents and opponents of the proposed disclosures as especially ripe for potential revision.  As noted above, these include, among others, the length of the phase-in period and the disclosure of Scope 3 GHG emissions.  If any changes are to be made to the SEC’s proposed climate disclosure rule, it is likely that such changes will be related to these issues.

However, given the relative lack of forward momentum with respect to other aspects of the Biden Administration’s climate agenda, there may well be political pressure not to weaken or otherwise rollback the SEC’s proposed rule, as this is one of the few areas where significant—and publicly-recognized—progress has been made with regulations designed to address the issue of climate change.  Further, the Biden Administration’s SEC has certainly recognized the inevitability of a legal challenge to these proposed climate disclosures, and, since no degree of alteration would suffice to preempt such a lawsuit, the SEC may conclude that it is better to seek to implement all aspects of the proposed regulation for the political benefit that can be achieved in the short term, since the substantive aspects of the proposed disclosure may not ultimately survive judicial scrutiny.  The SEC may also prefer to send a strong signal to the market by maintaining its original proposed rule.  Recognizing these pressures, it seems unlikely that the public comments submitted to the SEC will have a significant impact on the final rule promulgated in the coming months—and improbable that the SEC will make the proposed disclosures less robust.

FOO​TNOTES

[1] These proposed rules are discussed more fully in our prior publication:  https://www.mintz.com/insights-center/viewpoints/2451/2022-03-30-brief-summary-secs-proposed-climate-related-rules

[2] Although the total number of comments, when including both form letters and individualized letters, is 14,739, there are 94 comment letters on the SEC website that are duplicates, and have thus been removed from the calculation.

[3] For comparison, the proposed SEC rule on disclosing compensation ratios drew about 300,000 form letters and around 1500 individualized comment letters.  In this case, the individualized comment letters represented only about 0.5% of the total volume.  https://www.sec.gov/comments/s7-07-13/s70713.shtml

[4] The eighty-eight comment letters that did not adopt an express position on the proposed climate disclosure rules instead conveyed a number of different points, including proposing narrow changes to the proposed rule without taking a stance on the rule as a whole, or offering further context for the SEC’s actions (e.g., comparing the SEC to other regulators, whether domestic or international).  This category also includes a number of early comments that simply requested that the SEC extend the deadline for submitting comments.

[5] There are public comments in support of the proposed rule that focus on the legal issues.  In particular, the submission of Prof. John Coates of Harvard Law School, a former SEC official, is devoted exclusively to defending the legal authority of the SEC to issue the proposed climate disclosure rule. https://www.sec.gov/comments/s7-10-22/s71022-20130026-296547.pdf

Article By Jacob H. Hupart, Megan N. Gates, William F. Weld, Douglas P. Baumstein, Jennifer B. Rubin, and Courtney O. Taylor of Mintz. Luke Haubenstock also contributed to this article.

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A Fool in Idaho; SEC Sues Idahoans for Insider Trading Scheme

In July 1993 two brothers, David and Tom Gardner, and a friend, Erik Rydholm, founded a private investment advisory firm in Alexandria, Virginia. They named that firm Motley Fool after the court jester in “As You Like It,” a play written by William Shakespeare (it is believed in 1599). The Motley Fool, or Touchstone as he is known in the play, was the only character who could speak the truth to Duke Frederick without having his head cut off. Similarly, Motley Fool, the advisory firm, sought to give investors accurate advice, even if it flew in the face of received wisdom. For example, in advance of April Fool’s Day 1994, Motley Fool issued a series of online messages promoting a non-existent sewage-disposal company. The April Fool’s Day prank was intended to teach investors a lesson about penny stock companies. The messages gained widespread attention including an article in The Wall Street Journal.

Over time Motley Fool grew into a worldwide subscription stock recommendation service. It now releases new recommendations every Thursday, and subscribers receive them through computer interfaces provided by Motley Fool. The terms of service in a Motley Fool subscription agreement (in the words of the May 3, 2022 Complaint brought by the U.S. Securities and Exchange Commission [“SEC”] in the Federal Court for the Southern District of New York) “expressly prohibit unauthorized access to its systems.”  David Lee Stone of Nampa, Idaho (southwest of Boise), is a 36-year-old computer design and repair person with a degree in computer science.  Since June 2021, he and his wife have lived periodically in Romania, a fact cited in the Complaint, suggesting, perhaps, some involvement with Romania-based computer hackers. In any event, Stone is alleged in the Complaint to have used deceptive means beginning in November 2020 to obtain pre-release access to upcoming Motley Fool stock picks. Using that information, Stone and a co-defendant made aggressive investments, typically in options, which generated more than $12 million in gains. Stone, his codefendant, and his family and friends all benefited financially from knowing in advance the Motley Fool picks.

The SEC seeks injunctions against Stone and his co-defendant, as well as disgorgement with interest and civil penalties, for violating the antifraud provisions of federal law. The Commission also seeks disgorgement with interest from the family and friends. In addition, the U.S. Attorney for the Southern District of New York has filed criminal charges against Stone.

This case is in many ways reminiscent of the 1985 federal prosecution by the U.S. Attorney for the Southern District of New York (who happened to be Rudolph Giuliani at the time) of R. Foster Winans. Winans was, from 1982 to 1984, the co-author of “Heard on the Street,” a column in The Wall Street Journal. Winans leaked advance word of what would be in his column to a stockbroker who then invested with the benefit of that information, sharing some of the profits with Winans. Winans argued that his actions were unethical, but not criminal. He was found guilty of insider trading and wire fraud and was sentenced to 18 months in prison. He appealed his conviction all the way to the U.S. Supreme Court, which upheld the lower court rulings.

Attempting to profit on market sensitive information can be both a civil and a criminal offense. The SEC Enforcement Division and the relevant U.S. Attorney are prepared to introduce a perpetrator to those consequences.

Article By Peter D. Hutcheon of Norris McLaughlin P.A.

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