Tag: Securities and Exchange Commission

The SEC Speaks–And Fails to Defend Mandatory Climate Disclosures

During the opening remarks of the two-day SEC Speaks Conference, Chairman Gensler failed to express any statement of support in connection with the SEC’s recently promulgated rule on mandatory climate disclosures. (Instead, his speech focused on a number of other topics, including clearinghouse rules and proposed regulations.) In contrast, Republican SEC Commissioner Uyeda devoted the entirety of his speech to offering critiques of the SEC’s newly enacted mandatory climate disclosure rule.

While most of Commissioner Uyeda’s criticisms had been previously voiced on other occasions, certain legal arguments achieved greater prominence in these remarks. In particular, Commissioner Uyeda emphasized the concept of materiality, noting that “[t]he significant changes in the final rule reflect a recognition that no disclosure rule that veers from materiality is likely to survive a court challenge,” and opining that “changes to selected portions of the rule text intended to mitigate legal risk do not necessarily convert a climate change activism rule to a material risk disclosure rule.” There was also a focus on procedural concerns, including a potential violation of the Administrative Procedure Act due to “the failure to repropose the rule” since “the changes were so significant,” and that “the fail[ure] to consider [the] rule’s economic consequences [renders] the adoption of the rule arbitrary and capricious.” Finally, Commissioner Uyeda compared the climate disclosure rule to the previously enacted conflict minerals rule (which was mandated by Congress), stating that “public companies and investors are stuck with a mandatory disclosure rule that deviates from financial materiality but fails to resolve the social purpose for which it was adopted.” Each of these arguments should be expected to feature in the upcoming litigation in the Eighth Circuit concerning the legality of the SEC’s climate disclosure rule.

Still, the failure by Chairman Gensler and his fellow Democratic Commissioners to offer a robust public defense of the climate disclosure rule may simply reflect a shifting of priorities now that the rule has been enacted. Notably, just a few days ago–on March 22, 2024–Chairman Gensler forcefully defended the SEC’s climate disclosure rule at a conference hosted by Columbia Law School, where his entire speech advocated the concept of mandatory disclosures and stated that the SEC’s climate disclosure rule “enhance[d] the consistency, comparability, and reliability of [climate-related] disclosures.” Moreover, it is altogether possible that a speech on the second day of the conference might offer a rejoinder to the varied critiques of the climate disclosure rule.

Unlike the conflict minerals rule, which was mandated by Congress, the Commission has acted on its own volition to adopt a climate disclosure rule that seeks to exert societal pressure on companies to change their behavior. It is the Commission that determined to delve into matters beyond its jurisdiction and expertise. In my view, this action deviates from the Commission’s mission and contravenes established law.

https://www.sec.gov/news/speech/uyeda-remarks-sec-speaks-040224

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For more on the SEC, visit the NLR Securities & SEC section.

Recent Updates to State and Federal Climate Disclosure Laws

Last year, California became the first state to pass laws requiring companies to make disclosures about their greenhouse gas (“GHG”) emissions as well as the risks that climate change poses for their businesses and their plans for addressing those risks. These new laws now face funding and legal hurdles that are delaying their implementation.

While California’s new laws navigate these challenges, the U.S. Securities and Exchange Commission (“SEC”) adopted its own final climate disclosure rule on March 6. Formally entitled The Enhancement and Standardization of Climate-Related Disclosures for Investors (“SEC Rule”), it requires public companies to make disclosures about the climate-related risks that have materially impacted, or are reasonably likely to have a material impact on, a registrant’s business strategy, operations, or financial condition, and also to disclose their Scope 1 and Scope 2 GHG emissions. The SEC Rule is significantly scaled-back from what the SEC originally proposed in March 2022; most notably, it does not require disclosure of Scope 3 GHG emissions. It too faces legal challenges.

California’s New Laws[1]

On October 7, 2023, California Governor Gavin Newsom signed into law two sweeping climate disclosure bills, Senate Bill 253 (“SB 253”), the Climate Corporate Data Accountability Act, and Senate Bill 261 (“SB 261”), the Climate-Related Risk Act.

Under SB 253, companies that do business in California and have more than $1 billion in annual revenue will be required to disclose emissions data to the California Air Resources Board (“CARB”) each year, starting in 2026. The new law will affect more than 5,400 companies. Under the new law, CARB can levy fines of up to $500,000 per year for violations thereunder. The new reporting requirements apply to both public and private companies, unlike the SEC Rule, which applies only to certain public companies.

Under SB 261, companies with more than $500 million in annual revenue will be required to disclose on a biennial basis how climate change impacts their business, including reporting certain climate-related financial risks and their plans for addressing those risks. These disclosures also begin in 2026 and will affect roughly 10,000 companies.

Funding Hurdles

Funding is necessary for CARB to develop and implement regulations for both climate disclosure laws, as well as to review, administer, and enforce the new laws. To implement SB 253, CARB estimated that it required $9 million in the 2024-25 fiscal year and $2 million in the 2025-26 fiscal year. For SB 261, CARB estimated that it needed an aggregate of $13.7 million over the 2024-25 and 2025-26 fiscal years to identify covered entities, establish regulations, and develop a verification program.

Governor Newsom’s $291.5 billion budget proposal for the 2024-25 fiscal year did not allocate any funding for the implementation of the new laws. The sponsors of the two laws, SB 253’s Senator Scott Wiener and SB 261’s Senator Henry Stern, immediately released a statement sharply critical of this aspect of the Governor’s budget proposal.[2] With limited exceptions, the budget proposal defers all new discretionary spending decisions to the spring, pending input from the legislature, with a final spending plan expected in July of 2024.

The budget process in California can be a lengthy negotiation. The Governor proposes a budget, but then must work with the Legislature to develop the final budget. In this regard, it is important to note that Senator Wiener was appointed to chair the Senate Budget Committee earlier this year. Thus, it’s possible that funding will be provided to implement the laws, though CARB already faced an aggressive set of deadlines for developing the regulations.

Legal Challenges

Some companies, including tech giants like Apple and Salesforce, want the new rules implemented quickly. Large businesses may have an interest in implementing the legislation expeditiously for the benefit of operational certainty and because they have the resources to absorb costs that their smaller competitors cannot. Other companies view the new rules as needlessly burdensome and are committed to halting the legislation in its tracks.

In January, the U.S. Chamber of Commerce joined the American Farm Bureau Federation, California Chamber of Commerce, Central Valley Business Federation, Los Angeles County Business Federation and Western Growers Association in filing a lawsuit[3]in federal district court challenging the climate disclosure laws under the theory that they violate the First Amendment of the U.S. Constitution and are preempted by federal law.

According to the complaint, the climate disclosure requirements violate the First Amendment of the U.S. Constitution by “forc[ing] thousands of companies to engage in controversial speech that they do not wish to make, untethered to any commercial purpose or transaction…for the explicit purpose of placing political and economic pressure on companies to “encourage” them to conform their behavior to the political wishes of the State.” The plaintiffs argue that, in the event that the State seeks to compel a business to speak noncommercially on controversial political matters, such action shall be presumed by a reviewing court to be unconstitutional unless the government proves that it is narrowly tailored to serve a compelling state interest. The plaintiffs also allege that the new climate disclosure laws are not narrowly tailored to further any legitimate interest of the state, let alone a compelling one.

The lawsuit also contends that the federal Clean Air Act preempts California’s ability to regulate GHG emissions beyond its jurisdictional borders. According to the plaintiffs, the new laws seek to regulate out-of-state emissions “through a novel program of speech regulation.” The complaint further argues that, because the new disclosure requirements operate as de facto regulations of GHG emissions nationwide, they “run headlong” into the Dormant Commerce Clause and broader principles of federalism. The plaintiffs ask the court to enjoin California from implementing or enforcing the new rules, thereby making them null and void.

A more serious preemption challenge may be that the California climate disclosure laws are preempted by the SEC Rule. The issue was addressed during the March 6 SEC hearing (discussed below), and it’s been reported that SEC General Counsel Megan Barbero answered that “nothing” in the Rule “expressly preempts any state law.” However, she added that the issue could arise as a question of “implied preemption,” which “would be determined by a court in a future judicial proceeding.” The question would be whether the SEC has “occupied the field” to such an extent that it preempts state rules in the space. Those would be questions of fact largely turning on how the climate laws are being applied and enforced, and thus any such challenge is likely to await CARB’s implementation of the laws.

The SEC Rule

On March 6, 2024, the SEC adopted the final SEC Rule which will require public companies to include certain climate-related disclosures in registration statements and annual reports. The final SEC Rule requires registrants to disclose material climate-related risks, activities undertaken to mitigate or adapt to such risks, information regarding the board of directors’ oversight of climate-related risks and management of material climate-related risks, and information about climate-related targets or goals that are material to the company’s business, operations, or financial condition.

To add transparency to investors’ assessments of certain climate-related risks, the SEC Rule also requires disclosure of material Scope 1 and Scope 2 GHG emissions, the filing of an attestation report in connection thereof, and disclosure of impacts that severe weather events and other climate-related conditions have on financial statements, including costs and losses. The final SEC Rule includes a phased-in compliance period for all registrants, with compliance dates ranging from fiscal year 2025-26 to 2031-32, depending on the registrant’s filer status and the content of the disclosure. In general, the SEC Rule requires less than the California climate disclosure laws, as Senator Wiener observed[4].

Key Takeaways

  • Implementation and/or enforcement of SB 253 and SB 261 is delayed for the time being due to a lack of funding, and thus the roll-out of the regulatory regime for the two laws appears likely to slip, such that the laws’ 2026 compliance deadlines may also slip.
  • The lawsuit challenging SB 253 and SB 261 adds some uncertainty to the process of ensuring compliance with climate disclosure requirements, and may cause further delay.
  • The delayed implementation of the new laws affords companies additional time to develop a compliance strategy. Due to the lessened scope of the SEC Rule, companies that are prepared to comply with the California laws are likely to be prepared to comply with the SEC Rule. And implementation of the SEC Rule may be delayed by legal challenges as well, thereby creating more time for companies to develop a compliance strategy.

FOOTNOTES

[1] A prior article describing these laws in more detail is here.

[2] See Senators Wiener & Stern Respond to Governor Pausing Funding To Implement Landmark Climate Laws | Senator Scott Wiener (ca.gov)

[3] Chamber of Commerce of the United States of America, et al. v. Cal. Air Resources Board, et al. (Cal. Central Dist., Western Div.) (Case No. 2:24-cv-00801).

[4] See Senator Wiener Responds to Watered Down SEC Climate Rule: “California’s Climate Leadership is More Critical than Ever” | Senator Scott Wiener).

Copyright © 2024, Sheppard Mullin Richter & Hampton LLP.
For more on Climate Laws, visit the NLR Environmental, Energy & Resources section.

SEC’s Slimmed Down Climate-Related Disclosures Finally Adopted

On March 6, 2024, the Securities and Exchange Commission (the “SEC”) adopted regulations[1] that will require public companies to file mandatory climate-related disclosures with the SEC beginning in 2026. First proposed in March 2022, the climate-related disclosure rules were finalized after consideration of over 24,000 comment letters and active lobbying of the SEC by business and public interest groups alike. These new rules are aimed at eliciting more consistent, comparable, and reliable information for investors to make informed decisions related to climate-related risks on current and potential investments.

The new rules require a registrant to disclose material climate-related risks and activities to mitigate or adapt to those risks; information about the registrant’s oversight of climate-related risks and management of those risks; and information on any climate-related targets or goals that are material to the registrant’s business, results of operations, or financial condition. In addition, these new rules require disclosure of Scope 1 and/or Scope 2 greenhouse gas (“GHG”) emissions with attestation by certain registrants when emissions are material; and disclosure of the financial effects of extreme weather events.

Unlike the initial proposal, the EU Climate Sustainability Reporting Directive (“CSRD”) and the California Climate Data Accountability Act, the new rules do not require disclosure of Scope 3 GHG emissions. The new rules require reporting based upon financial materiality, not the double-materiality (impact and financial) standard utilized by the EU under the CSRD. Whether registrants will ultimately be required to comply with the new rules depend upon the outcome of anticipated challenges, such as the challenge to the SEC’s authority to promulgate the rule filed in the Eleventh Circuit on March 6th by a coalition of ten states.

Highlights of the New Rule

In the adopting release, the SEC notes that companies are increasingly disclosing climate-related risks, whether in their SEC filings or via company websites, sustainability reports, or elsewhere; however, the content and location of such disclosures have been varied and inconsistent.[2] The new rules not only specify the content of required climate-related disclosures but also the presentation of such disclosures.

The new rules amend the SEC rules under the Securities Act of 1933 (“Securities Act”) and Securities Exchange Act of 1934 (“Exchange Act”), creating a new subpart 1500 of Regulation S-K and Article 14 of Regulation S-X. As a result, registrants, companies that are registered under the Exchange Act, will need to:

  • File climate-related disclosures with the SEC in their registration statements and Exchange Act annual reports;
  • Provide the required climate-related disclosures in either a separately captioned section of the registration statement or annual report, within another appropriate section of the filing, or the disclosures may be included by reference from another SEC filing so long as the disclosure meets the electronic tagging requirements; and
  • Electronically tag climate-related disclosures in Inline XBRL.

The rules require a registrant to disclose:

  • Climate-related risks that have had or are reasonably likely to have a material impact on the registrant’s business strategy, results of operations, or financial condition;
  • The actual and potential material impacts of any identified climate-related risks on the registrant’s strategy, business model, and outlook;
  • Specified disclosures regarding a registrant’s activities, if any, to mitigate or adapt to a material climate-related risk including the use, if any, of transition plans, scenario analysis, or internal carbon prices;
  • Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the registrant’s material climate-related risks;
  • Any processes the registrant has for identifying, assessing, and managing material climate-related risks and, if the registrant is managing those risks, whether and how any such processes are integrated into the registrant’s overall risk management system or processes;
  • Information about a registrant’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal or actions taken to make progress toward meeting such target or goal;
  • For large accelerated filers (“LAFs”) and accelerated filers (“AFs”) that are not otherwise exempted, information about material Scope 1 emissions and/or Scope 2 emissions;
  • For those required to disclose Scope 1 and/or Scope 2 emissions, an assurance report at the limited assurance level, which, for an LAF, following an additional transition period, will be at the reasonable assurance level;
  • The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;
  • The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (“RECs”) if used as a material component of a registrant’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements; and
  • If the estimates and assumptions a registrant uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements.

Highlights of what did not get adopted

In its adopting release, the SEC described various modifications it made to its March 2022 proposed rules. The SEC explained that it made many of these changes in response to various comment letters it received. Some of the proposed rules that did not get adopted are:[3]

  • The SEC eliminated the proposed requirement to provide Scope 3 emissions disclosure.
  • The adopted rules in many instances now qualify the requirements to provide certain climate-related disclosures based on materiality.
  • The SEC eliminated the proposed requirement for all registrants to disclose Scope 1 and Scope 2 emissions in favor of requiring such disclosure only by large accelerated filers and accelerated filers on a phased in basis and only when those emissions are material and with the option to provide the disclosure on a delayed basis.
  • The SEC also exempted emerging growth companies and smaller reporting companies from the Scope 1 and Scope 2 disclosure requirement.
  • The SEC modified the proposed assurance requirement covering Scope 1 and Scope 2 emissions for accelerated filers and large accelerated filers by extending the reasonable assurance phase in period for LAFs and requiring only limited assurance for AFs.
  • The SEC eliminated the proposed requirements for registrants to disclose their GHG emissions in terms of intensity.[4]
  • The SEC removed the requirement to disclose the impact of severe weather events and other natural conditions and transition activities on each line item of a registrant’s financial statements. The SEC now requires disclosure of financial statement effects on capitalized costs, expenditures, charges, and losses incurred as a result of severe weather events and other natural conditions in the notes to the financial statements.
  • The adopted rules are less prescriptive than certain of those that were proposed. For example, the former now exclude in Item 1502(a) of Regulation S-K negative climate-related impacts on a registrant’s value chain from the definition of climate-related risks required to be disclosed. Similarly, this definition no longer includes acute or chronic risks to the operations of companies with which a registrant does business. Also, Item 1501(a) as adopted omits the originally proposed requirement for registrants to disclose (a) the identity of board members responsible for climate-risk oversight, (b) any board expertise in climate-related risks, (c) the frequency of board briefings on such risks, and (d) the details on the board’s establishment of climate-related targets or goals. Along the same lines, Item 1503 as adopted requires disclosure of only those processes for the identification, assessment, and management of material climate-related risks as opposed to a broader universe of climate-related risks. The rule as adopted does not require disclosure of how the registrant (a) determines the significance of climate-related risks compared to other risks, (b) considers regulatory policies, such as GHG limits, when identifying climate-related risks, (c) considers changes to customers’ or counterparties’ preferences, technology, or market prices in assessing transition risk, and (d) determines the materiality of climate-related risks. In the same vein, the adopted rules, unlike the proposed rules, do not require disclosure of how the registrant determines how to mitigate any high priority risks. Nor do the new rules retain the proposed requirement for a registrant to disclose how any board or management committee responsible for assessing and managing climate-related risks interacts with the registrant’s board or management committee governing risks more generally.
  • The SEC eliminated the proposal to require a private company that is a party to a business combination transaction, as defined by Securities Act Rule 165(f), registered on Form S-4 or Form F-4, to provide the subpart 1500 and Article 14 disclosures.

Timing of Implementation

The new rules will become effective 60 days after publication in the Federal Register. Compliance with the rules will not be required until much later, however.

Consistent with its earlier proposal, and in response to comments that the SEC received concerning the timing of implementing the proposed rule, the new rules contain delayed and staggered compliance dates that vary according to the registrant’s filing status and the type of disclosure.

The below table from the SEC’s new release summarizes the phased-in implementation dates.[5]

FILING STATUS

Large Accelerated Filers (“LAFs”)—a group whom the SEC believed most likely to be already collecting and disclosing climate-related information—will be the first registrants required to comply with the rule. The earliest that an LAF would be required to comply with the climate-disclosure rules would be upon filing its Form 10-K for the fiscal year ended December 31, 2025, which would be due no later than March 2026.[6]

Accelerated Filers (“AFs”) are not required to comply with the new rules for yet another year after LAFs. Climate-related disclosures for AFs must be included upon filing a Form 10-K for the fiscal year ended December 31, 2026, due no later than March 2027. Smaller Reporting Companies (“SRCs”), Emerging Growth Companies (“EGCs”), and Non-Accelerated Filers (“NAFs”) have yet another year to meet the first compliance deadline for climate-related disclosures. These types of filers need not include their climate-related disclosures until filing their Form 10-Ks for the fiscal year ended December 31, 2027, which, again, would be due no later than March 2028.

TYPES OF DISCLOSURES

The new rules also phase in the requirements to include certain disclosures over time. The requirements to provide quantitative and qualitative disclosures concerning material expenditures and material impacts to financial estimates or assumptions under Items 1502(d)(2), 1502(e)(2), and 1504(c)(2) are not applicable until the fiscal year immediately following the fiscal year in which the registrant’s initial compliance is required. LAFs, for example, are not required to report these qualitative and quantitative disclosures until filing a Form 10-K for the fiscal year ended December 31, 2026, due in March 2027. That should be one year after an LAF files its first Form 10-K with climate-related disclosures. The SEC adopted this phased-in approach to respond to commentators’ concerns regarding the availability (or current lack thereof) of policies, processes, controls, and system solutions necessary to support these types of disclosures.

Likewise, the new rules provide for a further phased-in compliance date for those registrants required to report their Scope 1 and Scope 2 GHG emissions and an even later date for those filers to obtain limited or reasonable assurance for those emissions disclosures. An LAF, for example, is not required to disclose its Scope 1 and Scope 2 emissions until filing its Form 10-K for the fiscal year ended December 31, 2026, due in March 2027. And those disclosures would not be required to be subject to the limited-assurance or reasonable-assurance requirements until filing the Form 10-K for the year ended December 31, 2029 or December 31, 2033, respectively.

In accordance with the table above, AFs, SRCs, EGCs, and NAFs have even more time to meet these additional disclosure requirements, if they are required to meet them at all.

It should be noted that the SEC recognized that registrants may have difficulty in obtaining GHG emission metrics by the date their 10-K report would be due. As a result, the rule contains an accommodation for registrants required to disclose Scope 1 and Scope 2 emissions, allowing domestic registrants, for example, to file those disclosures in the Form 10-Q for the second fiscal quarter in the fiscal year immediately following the year to which the GHG emissions disclosure relates. This disclosure deadline is permanent and not for a transition period.

Liability for Non-Compliance

In the introduction to the adopting release, the SEC explains that requiring registrants to provide certain climate-related disclosures in their filings will, among other things, “subject them to enhanced liability that provides important investor protections by promoting the reliability of the disclosures.”[7] This enhanced liability stems from the treatment of the disclosures as “filed” rather than “furnished” for purposes of Exchange Action Section 18 and, if included or otherwise incorporated by reference into a Securities Act registration statement, Securities Act Section 11.[8] According to the SEC, “climate-related disclosures should be subject to the same liability as other important business or financial information” that registrants include in registration statements and periodic reports and, therefore, should be treated as filed disclosures.[9]

In an attempt to balance concerns about the complexities and evolving nature of climate data methodologies and increased litigation risk, the SEC, in the adopting release, emphasizes certain modifications made in the new rules including:

  • limiting the scope of the GHG emissions disclosure requirement;
  • revising several provisions regarding the impacts of climate-related risks on strategy, targets and goals, and financial statement effects so that registrants will be required to provide the disclosures only in certain circumstances, such as when material to the registrant; and
  • adopting a provision stating that disclosures (other than historic facts) provided pursuant to certain of the new subpart 1500 provisions of Regulation S-K constitute “forward-looking statements” for the purposes of the PSLRA safe harbors.[10]

Registrants are subject to liability under Securities Act Section 17(a), Exchange Act Section 10(b), and/or Rule 10b-5 for false or misleading material statements in the information disclosed pursuant to the new rules.[11]

Observations

Consistent with its recent trajectory, the SEC continues to be a kinder, gentler regulator on climate disclosure requirements. Although the new rules will apply broadly to publicly traded companies, their scope is less demanding than the requirements under recent similar laws enacted in California or the EU. Under the California Climate Corporate Data Accountability Act (the “CCDA”), companies with annual revenues in excess of $1 billion and “doing business in California”[12] will be required to publicly disclose Scope 1 and Scope 2 emissions beginning in 2026, and Scope 3 emissions beginning in 2027. And because the California law applies to all companies, not just those that are publicly traded, it is also more broadly applicable and will trigger assessments and compliance for companies that are not subject to the SEC’s rule. The CCDA is currently the subject of legal challenge that includes questions of whether the required disclosures violate the First Amendment right to free speech, as well as possible federal preemption. As a result, there is a chance that the CCDA may yet be diluted or found unconstitutional. But in light of the imminent timeline for compliance, many companies subject to the CCDA are already developing programs to facilitate and ensure timely compliance with the requirements.

Similarly, the EU has broader reporting obligations under the CSRD than the SEC’s new rules. Compliance with the CSRD is required for both public and private EU companies as well as for non-EU companies with certain net annual turnovers, certain values of assets, and a certain number of employees. Under the CSRD, companies must publish information across a wide spectrum of subjects, including emissions, energy use, diversity, labor rights, and governance. Initial reporting under the CSRD begins to phase-in in 2025.

A key takeaway here is that although the SEC rules may have taken a lighter approach to climate disclosures, many large companies are likely to be subject to more stringent requirements under either the CCDA or the EU CSRD. And as some companies begin to comply to provide this information and data, the market may drive demand and an expectation that other companies, not otherwise subject to these various reporting regimes, follow suit. While the SEC rules may be a slimmed down version of what could have been, it is likely that the trend toward transparency and disclosure will continue to be driven by other regulatory bodies and market forces alike.

[1] Securities and Exchange Commission, Final Rule The Enhancement and Standardization of Climate-Related Disclosures for Investors, 17 CFR 210, 229, 230, 232, 239, and 249, adopting release available at https://www.sec.gov/files/rules/final/2024/33-11275.pdf.

[2] Id. at 48.

[3] Id. at 31-33.

[4] Id. at 225.

[5] Id. at 589.

[6] The new rules’ compliance dates apply to annual reports and registration statements. But, in the case of registration statements, compliance is required beginning with any registration statement that is required to include financial information for the full fiscal year indicated in the table above.

[7] Id. at 13.

[8] Id. at 584. At a high level, Section 18 imposes liability for false and misleading statements with respect to any material fact in documents filed with the SEC under the Exchange Act and Section 11 imposes liability for material misstatements or omissions made in connection with registered offerings conducted under the Securities Act.

[9] Id.

[10] Id. at 803.

[11] Id.

[12] A term which is not defined in the law, but is likely intentionally very broad, and is expected to be interpreted in that way.

© 2024 Foley & Lardner LLP
For more on SEC Climate Disclosures, visit the NLR Environmental, Energy & Resources section.

The Race to Report: DOJ Announces Pilot Whistleblower Program

In recent years, the Department of Justice (DOJ) has rolled out a significant and increasing number of carrots and sticks aimed at deterring and punishing white collar crime. Speaking at the American Bar Association White Collar Conference in San Francisco on March 7, Deputy Attorney General Lisa Monaco announced the latest: a pilot program to provide financial incentives for whistleblowers.

While the program is not yet fully developed, the premise is simple: if an individual helps DOJ discover significant corporate or financial misconduct, she could qualify to receive a portion of the resulting forfeiture, consistent with the following predicates:

  • The information must be truthful and not already known to the government.
  • The whistleblower must not have been involved in the criminal activity itself.
  • Payments are available only in cases where there is not an existing financial disclosure incentive.
  • Payments will be made only after all victims have been properly compensated.

Money Motivates 

Harkening back to the “Wanted” posters of the Old West, Monaco observed that law enforcement has long offered rewards to incentivize tipsters. Since the passage of Dodd Frank almost 15 years ago, the SEC and CFTC have relied on whistleblower programs that have been incredibly successful. In 2023, the SEC received more than 18,000 whistleblower tips (almost 50 percent more than the previous record set in FY2022), and awarded nearly $600 million — the highest annual total by dollar value in the program’s history. Over the course of 2022 and 2023, the CFTC received more than 3,000 whistleblower tips and paid nearly $350 million in awards — including a record-breaking $200 million award to a single whistleblower. Programs at IRS and FinCEN have been similarly fruitful, as are qui tam actions for fraud against the government. But, Monaco acknowledged, those programs are by their very nature limited. Accordingly, DOJ’s program will fill in the gaps and address the full range of corporate and financial misconduct that the Department prosecutes. And though only time will tell, it seems likely that this program will generate a similarly large number of tips.

The Attorney General already has authority to pay awards for “information or assistance leading to civil or criminal forfeitures,” but it has never used that power in any systematic way. Now, DOJ plans to leverage that authority to offer financial incentives to those who (1) disclose truthful and new information regarding misconduct (2) in which they were not involved (3) where there is no existing financial disclosure incentive and (4) after all victims have been compensated. The Department has begun a 90-day policy sprint to develop and implement the program, with a formal start date later this year. Acting Assistant Attorney General Nicole Argentieri explained that, because the statutory authority is tied to the department’s forfeiture program, the Department’s Money Laundering and Asset Recovery Section will play a leading role in designing the program’s nuts and bolts, in close coordination with US Attorneys, the FBI and other DOJ offices.

Monaco spoke directly to potential whistleblowers, saying that while the Department will accept information about violations of any federal law, it is especially interested in information regarding

  • Criminal abuses of the US financial system;
  • Foreign corruption cases outside the jurisdiction of the SEC, including FCPA violations by non-issuers and violations of the recently enacted Foreign Extortion Prevention Act; and
  • Domestic corruption cases, especially involving illegal corporate payments to government officials.

Like the SEC and CFTC whistleblower programs, DOJ’s program will allow whistleblower awards only in cases involving penalties above a certain monetary threshold, but that threshold has yet to be determined.

Prior to Monaco’s announcement, the United States Attorney’s Office for the Southern District of New York launched its own pilot “whistleblower” program, which became effective February 13, 2024. Both the Department-wide pilot and the SDNY policy require that the government have been previously unaware of the misconduct, but they are different in a critical way: the Department-wide policy under development will explicitly apply only to reports by individuals who did not participate in the misconduct, while SDNY’s program offers incentives to “individual participants in certain non-violent offenses.” Thus, it appears that SDNY’s program is actually more akin to a VSD program, while DOJ’s Department-wide pilot program will target a new audience of potential whistleblowers.

Companies with an international footprint should also pay attention to non-US prosecutors. The new Director of the UK Serious Fraud Office recently announced that he would like to set up a similar program, no doubt noticing the effectiveness of current US programs.

Corporate Considerations

Though directed at whistleblowers, the pilot program is equally about incentivizing companies to voluntarily self-disclose misconduct in a timely manner. Absent aggravating factors, a qualifying VSD will result in a much more favorable resolution, including possibly avoiding a guilty plea and receiving a reduced financial penalty. But because the benefits under both programs only go to those who provide DOJ with new information, every day that a company sits on knowledge about misconduct is another day that a whistleblower might beat them to reporting that misconduct, and reaping the reward for doing so.

“When everyone needs to be first in the door, no one wants to be second,” Monaco said. “With these announcements, our message to whistleblowers is clear: the Department of Justice wants to hear from you. And to those considering a voluntary self-disclosure, our message is equally clear: knock on our door before we knock on yours.”

By providing a cash reward for whistleblowing to DOJ, this program may present challenges for companies’ efforts to operate and maintain and effective compliance program. Such rewards may encourage employees to report misconduct to DOJ instead of via internal channels, such as a compliance hotline, which can lead to compliance issues going undiagnosed or untreated — such as in circumstances where the DOJ is the only entity to receive the report but does not take any further action. Companies must therefore ensure that internal compliance and whistleblower systems are clear, easy to use, and effective — actually addressing the employee’s concerns and, to the extent possible, following up with the whistleblower to make sure they understand the company’s response.

If an employee does elect to provide information to DOJ, companies must ensure that they do not take any action that could be construed as interfering with the disclosure. Companies already face potential regulatory sanctions for restricting employees from reporting misconduct to the SEC. Though it is too early to know, it seems likely that DOJ will adopt a similar position, and a company’s interference with a whistleblower’s communications potentially could be deemed obstruction of justice.

© 2024 Bracewell LLP
For more on Whistleblowers, visit the NLR Criminal Law / Business Crimes section.

SEC Issues Long-Awaited Climate Risk Disclosure Rule

INTRODUCTION

On Wednesday, 6 March 2024, the Securities and Exchange Commission (SEC) approved its highly anticipated final rules on “The Enhancement and Standardization of Climate-Related Disclosures for Investors” by a vote of 3-2, with Republican Commissioners Hester Peirce and Mark Uyeda dissenting. Accompanying the final rules was a press release and fact sheet detailing the provisions of the rulemaking. The final rules will go into effect 60 days after publication in the Federal Register and will include a phased-in compliance period for all registrants.

This is likely to be one of the most consequential rulemakings of Chairman Gary Gensler’s tenure given the prioritization of addressing climate change as a key pillar for the Biden administration. However, given the significant controversy associated with this rulemaking effort, the final rules are likely to face legal challenges and congressional oversight in the coming months. As such, it remains unclear at this point whether the final rules will survive the forthcoming scrutiny.

WHAT IS IN THE RULE?

According to the SEC’s fact sheet:

  • “The final rules would require a registrant to disclose, among other things: material climate-related risks; activities to mitigate or adapt to such risks; information about the registrant’s board of directors’ oversight of climate-related risks and management’s role in managing material climate-related risks; and information on any climate-related targets or goals that are material to the registrant’s business, results of operations, or financial condition.
  • Further, to facilitate investors’ assessment of certain climate-related risks, the final rules would require disclosure of Scope 1 and/or Scope 2 greenhouse gas (GHG) emissions on a phased-in basis by certain larger registrants when those emissions are material; the filing of an attestation report covering the required disclosure of such registrants’ Scope 1 and/or Scope 2 emissions, also on a phased-in basis; and disclosure of the financial statement effects of severe weather events and other natural conditions including, for example, costs and losses.
  • The final rules would include a phased-in compliance period for all registrants, with the compliance date dependent on the registrant’s filer status and the content of the disclosure.”

NEXT STEPS

The final rules are likely to face significant opposition, including legal challenges and congressional oversight. It is expected that there will be various lawsuits brought against the final rules, which are likely to receive support from several industry groups, or potentially GOP-led state attorneys general who have been active in litigating against environmental, social and governance (ESG) policies and regulations. It is also possible that the final rules could face criticism from some climate advocates that the SEC did not go far enough in its disclosure requirements.

Further, it is expected that the House Financial Services Committee (HFSC) will conduct oversight hearings, as well as introduce a resolution under the Congressional Review Act (CRA), to attempt to block the regulations from taking effect. HFSC Chairman Patrick McHenry (R-NC) indicated that the Oversight and Investigations Subcommittee will hold a field hearing on March 18 and the full Committee will convene a hearing on April 10 to discuss the potential implications of the rules. If a CRA resolution were to pass the House and garner sufficient support from moderate Democrats in the Senate to pass, it would likely be vetoed by President Biden.

Ultimately, the SEC climate risk disclosure rules are unlikely to significantly change the trajectory of corporate disclosures made by multinational companies based in the U.S., most of whom have already been making sustainability disclosures in accordance with the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures. The ongoing problem for investors is that such disclosures are not standardized and therefore are not comparable. Consequently, many of these large issuers may continue to enhance their sustainability disclosures in accordance with standards issued by the International Sustainability Standards Board and the Global Reporting Initiative as an investor relations imperative notwithstanding the SEC’s timetable for implementation of these final rules.

A more detailed analysis of the SEC rules is forthcoming from our Corporate and Asset Management and Investment Funds practices in the coming days.

Copyright 2024 K & L Gates
For more news on the SEC’s Climate Disclosure Rule, visit the NLR Environmental, Energy & Resources section.

Regulatory Update and Recent SEC Actions 2024

REGULATORY UPDATES

RECENT SEC LEADERSHIP CHANGES

Stephanie Allen Named as SEC’s Director of Media Relations and Speechwriting

The Securities and Exchange Commission (the “SEC”) announced the appointment of Stephanie Allen as director of media relations and speechwriting, effective Oct. 1, 2023. Allen served as director of speechwriting and senior adviser to the chair since March 2023, and replaces Aisha Johnson, who recently departed the agency.

Allen will serve as the primary spokesperson for the SEC and for Chair Gensler and will lead media relations for the Office of Public Affairs. Allen was previously the executive director of the Ludwig Institute for Shared Economic Prosperity. Before that, she was the director of strategic communications and marketing at Promontory Financial Group, an IBM company. After working for two senators earlier in her career, she served as Chair Gensler’s speechwriter at the Commodity Futures Trading Commission.

SEC Names Kate E. Zoladz as Regional Director of Los Angeles Office

The SEC named, on November 29, 2023, Kate Zoladz as regional director of the SEC’s Los Angeles Office. Zoladz joined the SEC in 2010 as a staff attorney in the Los Angeles office and later joined the Division of Enforcement’s Asset Management Unit in 2017. Zoladz recently served as acting co-director since June 2023 and the associate regional director for enforcement since October 2019.

Daniel Gregus, Director of the Chicago Regional Office, to Depart the SEC

The SEC announced on December 7, 2023, that Daniel R. Gregus, director of the Chicago Regional Office, would leave the agency at the end of December after more than 30 years of service. Vanessa Horton and Kathryn Pyszka are now the acting co-directors. Horton has been an associate regional director of the Investment Adviser/Investment Company (IA/IC) examination program in the Chicago Regional Office since 2020. She joined the SEC’s Chicago office in 2004 as an accountant and was later an exam manager and an assistant regional director in the Chicago IA/IC examination program. Pyszka has served as an associate regional director for enforcement in the Chicago office since 2017. She began her SEC service in 1997 as a staff attorney and later served in the positions of branch chief, senior trial counsel, and as an assistant director in the Chicago office and the Enforcement Division’s Market Abuse Unit.

SEC Risk Alerts

SEC Announces 2024 Exam Priorities

The SEC’s Division of Examinations (the “Division”) issued its report (the “Report”) on October 16, 2023, regarding exam priorities for the upcoming year concerning investment advisers, broker-dealers, self-regulatory organization, and other market participants.

According to the Report, examination priorities continue to focus on whether investment advisers are adhering to their duty of care and duty of loyalty obligations. Areas of continued focus include:

  • Investment advice provided to clients (with an emphasis on advice to older clients and those saving for retirement) with regard to products, investment strategies, and account types:
    • Complex products, such as derivatives and leveraged exchange-traded funds (“ETFs”);
    • High-cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (“REITs”); and
    • Unconventional strategies, including those that purport to address rising interest rates.
  • Processes for determining that investment advice is provided in clients’ best interest, including:
    • Making initial and ongoing suitability determinations;
    • Seeking best execution;
    • Evaluating costs and risks; and
    • Identifying and addressing conflicts of interest.

Per the Report, assessments will look at the factors that advisers consider in light of the clients’ investment profiles, including investment goals and account characteristics. Examinations will review how advisers address conflicts of interest, including: (i) mitigating or eliminating the conflicts of interest, when appropriate, and (ii) allocating investments to accounts where investors have more than one account (e.g., allocating between accounts that are adviser fee-based, brokerage commission-based, and wrap fee, as well as between taxable and non-taxable accounts).

Additionally, examinations will focus on the economic incentives and conflicts of interest associated with advisers that are dually registered as broker-dealers, use affiliated firms to perform client services, and have financial professionals servicing both brokerage customers and advisory clients to identify, among other things: (i) investment advice to purchase or hold onto certain types of investments (e.g., mutual fund share classes) or invest through certain types of accounts when lower cost options are available; and (ii) investment advice regarding proprietary products and affiliated service providers that result in additional or higher fees to investors. Exams will include review of disclosures made to investors and whether they include all material facts relating to conflicts of interest associated with the investment advice sufficient to allow a client to provide informed consent to the conflict.

Specific areas of focus will include:

  • Marketing Rule and whether advisers, including advisers to private funds, have:
    • Adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and the rules thereunder including reforms to the Marketing Rule;
    • Appropriately disclosed their marketing-related information on Form ADV;
    • Maintained substantiation of their processes and other required books and records; and
    • Disseminated advertisements that include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements.
  • Compensation arrangements:
    • Fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others;
    • Alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and
    • Fee breakpoint calculation processes, particularly when fee billing systems are not automated.
  • Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets, such as commercial real-estate or private placements.
  • Disclosure review for the accuracy and completeness of regulatory filings, including Form CRS, with a particular focus on inadequate or misleading disclosures and registration eligibility.
  • Policies and procedures with respect to:
    • Selecting and using third-party and affiliated service providers;
    • Overseeing branch offices when advisers operate from numerous or geographically dispersed offices; and
    • Obtaining informed consent from clients when advisers implement material changes to their advisory agreements.
Investment Advisers to Private Funds

According to the Report, examinations will prioritize specific topics, such as:

  • Portfolio management risks in connection with exposure to recent market volatility and higher interest rates and effects on funds experiencing poor performance, significant withdrawals, and valuation issues for private funds with more leverage and illiquid assets.
  • Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
  • Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
  • Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
  • Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
  • Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor, and the distribution of private fund audited financial statements.
  • Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.
Registered Investment Companies (including Mutual Funds and ETFs)

Per the Report, exam focus may include the following assessments:

  • Compliance programs and fund governance practices—review boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers;
  • Disclosures to investors and accuracy of reporting to the SEC;
  • Valuation practices, particularly for those addressing fair valuation practices (e.g., implementing board oversight duties, setting recordkeeping and reporting requirements, and overseeing valuation designees), and, as applicable, the effectiveness of registered investment companies’ derivatives risk management and liquidity risk management programs;
  • Fees and expenses and whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and implemented any associated fee waivers and reimbursements. Areas of particular focus include:
    • Charging different advisory fees to different share classes of the same fund;
    • Identical strategies offered by the same sponsor through different distribution channels but that charge differing fee structures;
    • High advisory fees relative to peers; and
    • High registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers.
    • Examinations will also review the boards’ approval of the advisory contract and registered investment company fees.
  • Derivatives risk management and whether registered investment companies and business development companies have adopted and implemented written policies and procedures reasonably designed to prevent violations of the SEC’s fund derivatives rule (Investment Company Act of 1940 (the “Investment Company Act”) Rule 18f-4). Review of compliance with the derivatives rule may include:
    • Review of the adoption and implementation of a derivatives risk management program;
    • Board oversight, and whether disclosures concerning the registered investment companies’ or business development companies’ use of derivatives are incomplete, inaccurate, or potentially misleading; and
    • Procedures for, and oversight of, derivative valuations.

Division staff will also focus on the following areas:

  • Cybersecurity
  • Cryptocurrency assets (focus on a range of activities surrounding crypto assets and related products, including offering, selling, recommending, trading, and providing advice on such assets); and
  • Anti-Money Laundering (“AML”) programs.

Cybersecurity: With respect to cybersecurity, the Division noted that “operational disruption risks remain elevated due to the proliferation of cybersecurity attacks, firms’ dispersed operations, intense weather-related events, and geopolitical concerns.” According to the release, the examination staff will focus on firms’ policies and procedures, internal controls, governance practices, oversight of third-party vendors, and responses to “cyber-related incidents” such as ransomware attacks. Reviews will consider how firms train staff on issues including identity theft prevention and customer records and information protection. Staff will also place a particular focus on “the concentration risk associated with the use of third-party providers, including how registrants are managing this risk and the potential impact to the U.S. securities markets.”

Crypto Assets and Emerging Financial Technology: The release highlights concerns based on the continued growth and popularity of crypto assets (and their associated products and services) and the increase in automated investment tools, artificial intelligence, and trading algorithms or platforms. The Division’s goal is twofold: (1) to ensure that registrants meet their fiduciary duties when recommending or advising about crypto assets; and (2) that compliances, risk disclosures, and operational resiliency practices are routinely reviewed and updated to account for the unique challenges crypto assets provide.

For crypto assets that are funds or securities, this includes ensuring that crypto assets are complying with the custody requirements under the Investment Advisers Act of 1940 (the “Advisers Act”) and whether policies and procedures are reasonably designed, and accurate disclosures are made, relating to technological risks associated with blockchain and distributed ledger technology.

Anti-Money Laundering: The Division will continue to focus on whether broker-dealers and certain registered investment companies have proper AML programs as required by the Bank Secrecy Act. Specifically, the Division will examine whether broker-dealers and investment companies are appropriately tailoring AML programs, conducting independent testing, establishing an adequate customer identification program, and meeting their filing obligations.

SEC Rulemaking

SEC Adopts Amendments to Rules Governing Beneficial Ownership Reporting

The SEC adopted rule amendments governing beneficial ownership reporting under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) on October 10, 2023, requiring market participants to provide more timely information on their positions.

Exchange Act Sections 13(d) and 13(g), along with Regulation 13D-G, require an investor who beneficially owns more than five percent of a covered class of equity securities to publicly file either a Schedule 13D or a Schedule 13G, as applicable. An investor with control intent files Schedule 13D, while “Exempt Investors” and investors without a control intent, such as “Qualified Institutional Investors” and “Passive Investors,” file Schedule 13G.

The adopted amendments (among other things): i) shorten the deadline for initial Schedule 13D filings from 10 days to five business days and require that Schedule 13D amendments be filed within two business days; ii) generally accelerate the filing deadlines for Schedule 13G beneficial ownership reports (the filing deadlines differ based on the type of filer); iii) clarify the Schedule 13D disclosure requirements with respect to derivative securities; and iv) require that Schedule 13D and 13G filings be made using a structured, machine-readable data language.

In addition, the adopting release provides guidance regarding the current legal standard governing when two or more persons may be considered a group for the purposes of determining whether the beneficial ownership threshold has been met, as well as how, under the current beneficial ownership reporting rules, an investor’s use of certain cash-settled derivative securities may result in the person being treated as a beneficial owner of the class of the reference equity securities.

The amendments were published in the Federal Register on November 7, 2023, effective on February 5, 2024. Compliance with the revised Schedule 13G filing deadlines will be required beginning on September 30, 2024. Compliance with the structured data requirement for Schedules 13D and 13G will be required on December 18, 2024. Compliance with the other rule amendments will be required upon their effectiveness.

“Today’s adoption updates rules that first went into effect more than 50 years ago. Frankly, these deadlines from half a century ago feel antiquated,” said SEC Chair Gary Gensler. “In our fast-paced markets, it shouldn’t take 10 days for the public to learn about an attempt to change or influence control of a public company. I am pleased to support this adoption because it updates Schedules 13D and 13G reporting requirements for modern markets, ensures investors receive material information in a timely way, and reduces information asymmetries.”

SEC Adopts Rule to Increase Transparency in the Securities Lending Market

The SEC adopted on October 13, 2023, new Rule 10c-1a, which will require certain persons to report information about securities loans to a registered national securities association (“RNSA”) and require RNSAs to make publicly available certain information that they receive regarding those lending transactions. According to the SEC, the rule is intended to increase transparency and efficiency of the securities lending market.

Rule 10c-1a will require certain confidential information to be reported to an RNSA to enhance the RNSA’s oversight and enforcement functions. The new rule requires that an RNSA make certain information it receives, along with daily information pertaining to the aggregate transaction activity and distribution of loan rates for each reportable security, available to the public. The Financial Industry Regulatory Authority (“FINRA”) is currently the only RNSA.

The adopting release was published in the Federal Register on November 3, 2023. The compliance dates for the new rule are as follows: (1) an RNSA is required to propose rules within four months of the effective date; (2) the proposed RNSA rules are required to be effective no later than 12 months after the effective date; (3) covered persons are required to report information required by the rule to an RNSA starting on the first business day 24 months after the effective date; and (4) RNSAs are required to publicly report information within 90 calendar days of the reporting date.

SEC Adopts Rule to Increase Transparency Into Short Selling and Amendment to CAT NMS Plan for Purposes of Short Sale Data Collection

The SEC adopted, on October 13, 2023, new Rule 13f-2 to provide greater transparency to investors and other market participants by increasing the public availability of short sale related data. Specifically, Rule 13f-2 will require institutional investment managers that meet or exceed certain thresholds to report on Form SHO specified short position data and short activity data for equity securities. The Commission will aggregate the resulting data by security, thereby maintaining the confidentiality of the reporting managers, and publicly disseminate the aggregated data via EDGAR on a delayed basis. This new data will supplement the short sale data that is currently publicly available.

Relatedly, the Commission also adopted an amendment to the National Market System Plan (“NMS Plan”) governing the consolidated audit trail (“CAT”). The amendment to the NMS Plan governing the CAT (“CAT NMS Plan”) will require each CAT reporting firm that is reporting short sales to indicate when it is asserting use of the bona fide market making exception in Rule 203(b)(2)(iii) of Regulation SHO.

The adopting release for Rule 13f-2 and related Form SHO, as well as the notice of the amendment to the CAT NMS Plan, was published in the Federal Register on November 1, 2023. The final rule, Form SHO, and the amendment to the CAT NMS Plan will become effective 60 days after publication of the adopting release in the Federal Register. The compliance date for Rule 13f-2 and Form SHO will be 12 months after the effective date of the adopting release, with public aggregated reporting to follow three months later, and the compliance date for the amendment to the CAT NMS Plan will be 18 months after the effective date of the adopting release.

Clearing Agency Governance and Conflicts of Interest

On November 16, 2023, the SEC adopted Rule 17Ad-25 and related rules under the Exchange Act to improve clearing agency governance to mitigate conflicts of interest that may influence the board of directors or equivalent governing body of a registered clearing agency. The rules identify certain responsibilities of the board of a clearing agency, increase transparency into board governance, and, more generally, improve the alignment of incentives among owners and participants of a registered clearing agency. The rules establish new requirements for board and committee composition, independent directors, management of conflicts of interest, and board oversight.

The adopted rules:

  1. Define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of the board—or 34 percent—be independent directors;
  2. Establish independent director requirements for the compensation of certain other board committees and identify circumstances that would preclude a director from being an independent director;
  3. Require a clearing agency to establish a nominating committee and a written evaluation process for evaluating board nominees and the independence of nominees and directors and specify requirements with respect to its composition, director fitness standards, and documentation of the outcome of the written eval practice;
  4. Require a clearing agency to establish a risk management committee, specify requirements with respect to the committees’ purpose and composition, and include an annual re-evaluation of such composition;
  5. Require policies and procedures for the management of risks from relationships with service providers for core services that directly support the delivery of clearance or settlement functionality or any other purpose material to the business of the registered clearing agency, with delineated roles for senior management and the board; and
  6. Require policies and procedures for the board to solicit, consider, and document its consideration of the views of participants and other relevant stakeholders regarding material developments in the registered clearing agency’s risk management and operations.

The final rule was published in the Federal Register on December 5, 2023, with an expected compliance 12 months after such publication for all requirements except for the independence requirement for the board and board committees, for which the compliance date is 24 months after publication.

SEC Defends Voting Disclosure Changes Before Fifth Circuit

In July of 2022, the SEC adopted amendments to its rules governing proxy voting advice. Specifically, the rule requires mutual funds, ETFs and certain other registered funds to disclose more information about how they cast votes on behalf of investors. (See Blank Rome’s Investment Management Regulatory Update dated October 2022, “SEC Adopts Amendments to Proxy Rules Governing Proxy Voting Advice,” for further discussion). The rule is set to become effective July 1, 2024.

Since passing the rule, four states (Texas, Louisiana, Utah, and West Virginia) have challenged the SEC’s authority to require fund managers to disclose additional information about votes they cast. Their argument to the Fifth Circuit is that the real purpose of the voting disclosure change is to empower corporate activities rather than the investing public. The SEC maintains, however, that the amendments fall within its authority under the Investment Company Act and that the SEC reasonably concluded that the changes would facilitate investors’ ability to access information important to investment decisions and mitigate conflicts of interest.

SEC Adopts Rule to Prohibit Conflicts of Interest in Certain Securitizations

On November 27, 2023, the SEC adopted Dodd-Frank rules against trader conflicts. Securities Act Rule 192 implements Section 27B of the Securities Act of 1933 (the “Securities Act”), a provision added by the Dodd-Frank Act. The Rule seeks to prevent the sale of asset-backed securities (“ABS”) that pose a material conflict of interest. Specifically, it prohibits a securitization participant, for a period of time, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the participant and an investor in the relevant ABS. Rule 192 provides exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities of a securitization participant.

Under new Rule 192, conflicted transactions include a short sale of the relevant ABS, the purchase of a credit default swap or other credit derivative that entitles the securitization participant to receive payments upon the occurrence of specified credit events in respect of the ABS, or a transaction that is substantially the economic equivalent of the aforementioned transactions, other than any transaction that only hedges general interest rate or currency exchange risk.

SEC Adopts Rules to Improve Risk Management in Clearance and Settlement and Facilitate Additional Central Clearing for the U.S. Treasury Market

The SEC adopted rules on December 13, 2023, to enhance risk management practices for central counterparties in the U.S. Treasury market and facilitate additional clearing of U.S. Treasury securities transactions. The rule changes update the membership standards required of covered clearing agencies for the U.S. Treasury market with respect to a member’s clearance and settlement of specified secondary market transactions. Additional rule changes are designed to reduce the risks faced by a clearing agency and incentivize and facilitate additional central clearing in the U.S. Treasury market.

According to the release, the amendments require that covered clearing agencies in the U.S. Treasury market adopt policies and procedures designed to require their members to submit for clearing certain specified secondary market transactions. These transactions include: (i) all repurchase and reverse repurchase agreements collateralized by U.S. Treasury securities entered into by a member of the covered clearing agency, unless the counterparty is a state or local government or another clearing organization or the repurchase agreement is an inter-affiliate transaction; (ii) all purchase and sale transactions entered into by a member of the clearing agency that is an interdealer broker; and (iii) all purchase and sale transactions entered into between a clearing agency member and either a registered broker-dealer, a government securities broker, or a government securities dealer.

Further, the amendments permit broker-dealers to include customer margin required and on deposit at a clearing agency in the U.S. Treasury market as a debit in the customer reserve formula, subject to certain conditions. In addition, the amendments require covered clearing agencies in this market to collect and calculate margin for house and customer transactions separately. Finally, the amendments require policies and procedures designed to ensure that the covered clearing agency has appropriate means to facilitate access to clearing, including for indirect participants. The amendments also include an exemption for transactions in which the counterparty is a central bank, sovereign entity, international financial institution, or natural person.

ENFORCEMENT ACTIONS AND CASES

SEC Charges Investment Adviser with Failing to Properly Disclose Investments by Publicly Traded Fund

The SEC charged an investment adviser, on October 24, 2023, for failing to accurately describe investments in the entertainment industry that comprised a significant portion of a publicly traded fund it advised. The investment adviser settled the charges and agreed to pay a $2.5 million penalty.

According to the SEC’s order, from 2015 to 2019, one of the investment adviser’s trusts made significant investments, through a lending facility, in Aviron Group, LLC, a company that developed print and advertising plans for one to two films per year. According to the SEC’s order, the investment advisor inaccurately described Aviron as a “Diversified Financial Services” company in many of the trust’s annual and semi-annual reports. In addition, according to the order, the investment adviser stated that Aviron paid a higher interest rate than was actually the case, and in 2019, the investment adviser identified these inaccuracies and the trust accurately reported the Aviron investment in reports going forward.

Per the SEC’s order, the investment adviser willfully violated fraud-based disclosure prohibitions under Section 34(b) of the Investment Company Act and Section 206(4) of the Advisers Act and related Rule 206(4)-8. Without admitting or denying the SEC’s findings, the investment adviser agreed to a cease-and-desist order and a censure in addition to a monetary penalty.

Previously, in 2022, the SEC charged and then resolved its action against William Sadleir, the founder of Aviron, for misappropriating the trust’s funds invested in Aviron.

“Retail and institutional investors rely on accurate disclosures of the companies that make up a closed-end or mutual fund’s portfolio to evaluate a current or prospective investment in the fund,” said Andrew Dean, co-chief of the Enforcement Division’s Asset Management Unit. “Investment advisers have a responsibility to provide this vital information, and [the adviser here] failed to do so with the Aviron investment.”

SEC Charges President/CCO of Asset Management Advisory Firm with Fraud

The SEC charged a president and chief compliance officer of registered investment adviser, Prophecy Asset Management LP (“Prophecy”), on November 2, 2023, for his involvement in a multi-year fraud that concealed losses of hundreds of millions of dollars from investors.

Prophecy advised multiple hedge funds and reported more than $500 million in assets under management. The SEC’s complaint alleged that the president and Prophecy misled the funds’ investors, auditors, and administrator about the funds’ trading practices, risk, and performance—all while collecting more than $15 million in fees.

According to the SEC’s complaint, the president led investors to believe that their investments were protected from loss, telling them the funds’ capital was shared among dozens of sub-advisers who traded in liquid securities and posted cash collateral to offset any trading losses they incurred. However, the SEC alleged that in reality, most of the funds’ capital went to one sub-adviser, who incurred massive trading losses that far exceeded the cash collateral he had contributed. In addition, the complaint alleged that the president caused the funds to invest in highly illiquid investments, which also resulted in substantial losses to the funds, concealed these losses by fabricating documents and engaging in a series of sham transactions, and deceived investors about the diversification and trading strategies in two other funds. The complaint pleads by 2020, after losses in funds that Prophecy managed amounted to more than $350 million, the president and Prophecy indefinitely suspended redemptions by investors.

The SEC’s complaint charged the president with violations of Section 17(a) of the Securities Act, Rule 10b-5, Section 206(1) and (2) of the Advisers Act, and Rule 206(4)-8 of the Advisers Act.

SEC Announces Enforcement Results for FY23

The SEC announced on November 14, 2023, its enforcement results for fiscal year 2023. The SEC filed 784 total enforcement actions in fiscal year 2023, a three percent increase over fiscal year 2022. These included 501 original, or “stand-alone,” enforcement actions, an eight percent increase over the prior fiscal year; 162 “follow-on” administrative proceedings seeking to bar or suspend individuals from certain functions in the securities markets based on criminal convictions, civil injunctions, or other orders; and 121 actions against issuers who were allegedly delinquent in making required filings with the SEC.

The stand-alone enforcement actions ranged from billion-dollar frauds to emerging market investments involving crypto asset securities and cybersecurity. The pool of charged individuals or entities included a diverse array of market participants from public companies and investment firms to gatekeepers (such as auditors and lawyers) to social media influencers. Notably, fiscal year 2023 was record-breaking for the SEC’s Whistleblower Program with awards totaling nearly $600 million and more than 18,000 whistleblower tips, which is nearly 50 percent more tips than in the previous fiscal year.

In total, the SEC obtained orders for $4.949 billion in financial remedies, second only to the record-setting $6.439 billion in fiscal year 2022. Of this $4.949 billion, $3.369 billion was obtained in disgorgement and prejudgment interests and $1.580 billion in civil penalties. The SEC also obtained orders barring 133 individuals from serving as officers and directors of public companies, the highest number of bars obtained in a decade.

Crypto Currency Exchange Agrees to pay $4.3 Billion in Fines for Violations of the Bank Secrecy Act

On November 21, 2023, the largest Crypto Currency Exchange (the “Exchange”) in the world agreed to pay a historic $4.3 billion fine for failing to register as a money-transmitting business and allowing users to evade U.S. sanctions against Iran. The Exchange’s founder pled guilty to failing to maintain an effective anti-money laundering program in violation of the Bank Secrecy Act. This agreement marks the end of the Department of Justice’s yearlong investigation over alleged money laundering, bank fraud, and sanctions violations.

The Exchange also agreed to pay several other penalties to resolve enforcement actions by the CFTC and Treasury Department. Under the CFTC’s proposed orders, the Exchange will pay $2.7 billion, the founder will pay $150 million, and former CCO will pay $1.5 million for ignoring potential money launder and terrorists financing on its platform and for failing to register with the CFTC.

Additionally, the FinCEN settlement will require the Exchange to pay $3.4 billion in civil money penalty and will be subject to a five-year monitorship. Office of Foreign Assets Control will require the Exchange to pay a $968 million penalty. The Treasury will also retain access to the company’s books, records, and systems for the five-year monitorship.

SEC Charges Real Estate Fund Adviser with $35 Million Fraud

The SEC filed a complaint in the U.S. District Court for District of Arizona, on November 28, 2023, charging an adviser, his investment company, and related entities controlled by the adviser with violating the antifraud provisions of the federal securities laws.

The SEC alleged that the adviser misappropriated more than $35 million from private real estate funds and other investment vehicles by using a substantial portion of the funds to pay for his family members’ personal expenses and to fund private jets, yachts, and expensive residences. Further, the adviser issued a press release from another wholly owned LLC that stated the company’s intention to purchase 51 percent of all minority shares in an unrelated public company, at $9 a share, more than nine times the company’s then-current trading price. The shares jumped over 150 percent in after-hours trading shortly after the press release was issued. The adviser had purchased more than 72,000 call options in the company at a price far below the stock price in the days leading up to the press release, hoping to exercise the options at a profit after manipulating the stock price.

Global Bank and Affiliated Entities to Pay $10 Million for Providing Prohibited Mutual Fund Services

The SEC announced, on December 13, 2023, that a global bank and two affiliated entities (“Entities”) agreed to pay $10 million to settle the SEC’s charges that they provided prohibited underwriting and advising services to mutual funds.

In October 2022, the Superior Court of New Jersey entered a consent order that resolved a case alleging that the Entities violated the antifraud provisions of the New Jersey securities laws in connection with its role as underwriter to residential mortgage-backed securities. According to the SEC’s order, the global bank and its affiliates were prohibited from serving as a principal underwriter or investment adviser to mutual funds or employees’ securities companies pursuant to the Investment Company Act unless an exemptive order was received. The SEC order found, however, that the Entities continued serving in these prohibited roles until the SEC granted them time-limited exemptions on June 7, 2023. Without admitting or denying the SEC’s findings, the Entities agreed to pay more than $6.7 million in disgorgement and prejudgment interest and civil penalties totaling $3.3 million.

“Today’s action holds the [Entities] accountable for not complying with eligibility requirements,” said Corey Schuster, Asset Management Unit co-chief. “This action reinforces the need for entities to properly monitor for events that may cause disqualification and proactively seek and obtain waivers from the Commission before becoming disqualified, or refrain from performing prohibited services.”

BarnBridge DAO Agrees to Stop Unregistered Offer and Sale of Structured Finance Crypto Product

The SEC announced on December 22, 2023, that BarnBridge DAO (“BarnBridge”), a purportedly decentralized autonomous organization, and its two founders will pay more than $1.7 million to settle charges that they failed to register BarnBridge’s offer and sale of structured crypto asset securities known as SMART Yield bonds. The SEC also charged the respondents with violations stemming from operating BarnBridge’s SMART Yield pools as unregistered investment companies.

According to the SEC’s orders, the respondents compared the SMART Yield bonds to asset-backed securities and marketed them broadly to the public. Investors could purchase “Senior” or “Junior” SMART Yield bonds through BarnBridge’s website application. SMART Yield pooled crypto assets deposited by the investors and used those assets to generate fixed or variable returns to pay investors. A BarnBridge white paper, published by one of the founders, claimed that SMART Yield bonds would “mirror the safety and security of highly rated debt instruments offered by traditional finance…while still providing the outsized return” through its smart contract protocols. According to the orders, SMART Yield attracted more than $509 million in investments from investors, and BarnBridge was paid fees by the investors based on the size of their investment and their choice of yield.

To settle the SEC’s charges, BarnBridge agreed to disgorge nearly $1.5 million of proceeds from the sales, and its two founders each agreed to pay $125,000 in civil penalties.

Without admitting or denying the SEC’s findings, BarnBridge and its two founders agreed to cease-and-desist orders prohibiting them from violating and causing violations of the registration provisions of the Securities Act and the Investment Company Act. The SEC orders referenced remedial actions initiated by the founders.

SEC BuyBack Disclosure Rule Vacated by Appeals Court

The Fifth U.S. Circuit Court of Appeals in New Orleans, on December 19, 2023, granted a motion filed by business groups to vacate the SEC’s new rule that required companies to provide timelier disclosures on stock buybacks. Prior to this ruling, on October 31, 2023, the court found that the SEC “acted arbitrarily and capriciously” and in so doing violated the Administrative Procedure Act by failing to conduct a proper cost-benefit analysis when drafting the rule. The SEC was given 30 days to “correct the defects in the rule” but did not file a new draft. On December 7, 2023, business groups filed a motion for the court to vacate the rule.

The SEC’s finalized rule in May 2023 required companies to disclose daily stock buyback information either quarterly or semiannually to include the number of shares repurchased each day and the average price paid on that day. In addition, the rule required companies to indicate whether certain directors or officers traded the relevant securities within four days before or after public announcement of an issuer’s buyback plan or program.

© 2023 Blank Rome LLP
For more on SEC regulations, visit the NLR Securities & SEC section.

2024 Regulatory Update for Investment Advisers

In 2023, the Securities and Exchange Commission issued various proposed rules on regulatory changes that will affect SEC-registered investment advisers (RIAs). Since these rules are likely to be put into effect, RIAs should consider taking preliminary steps to start integrating the new requirements into their compliance policies and procedures.

1. Updates to the Custody Rule

The purpose of the custody rule, rule 206(4)-2 of the Investment Advisers Act of 1940 (Advisers Act), is to protect client funds and securities from potential loss and misappropriation by custodians. The SEC’s recommended updates to the custody rule would:

  • Expand the scope of the rule to not only include client funds and securities but all of a client’s assets over which an RIA has custody
  • Expand the definition of custody to include discretionary authority
  • Require RIAs to enter into written agreements with qualified custodians, including certain reasonable assurances regarding protections of client assets

2. Internet Adviser Exemption

The SEC also proposed to modernize rule 203A-2(e) of the Advisers Act, whose purpose is to permit internet investment advisers to register with the SEC even if such advisers do not meet the other statutory requirements for SEC registration. Under the proposed rule:

  • Advisers relying on this exemption would at all times be required to have an operational interactive website through which the adviser provides investment advisory services
  • The de minimis exception would be eliminated, hence requiring advisers relying on rule 203A-2(e) to provide advice to all of their clients exclusively through an operational interactive website

3. Conflicts of Interest Related to Predictive Data Analytics and Similar Technologies

The SEC proposes new rules under the Adviser’s Act to regulate RIAs’ use of technologies that optimize for, predict, guide, forecast or direct investment-related behaviors or outcomes. Specifically, the new rules aim to minimize the risk that RIAs could prioritize their own interest over the interests of their clients when designing or using such technology. The new rules would require RIAs:

  • To evaluate their use of such technologies and identify and eliminate, or neutralize the effect of, any potential conflicts of interest
  • To adopt written policies and procedures to prevent violations of the rule and maintain books and records relating to their compliance with the new rules

4. Cybersecurity Risk Management and Outsourcing to Third Parties

The SEC has yet to issue a final rule on the 2022 proposed new rule 206(4)-9 to the Adviser’s Act which would require RIAs to adequately address cybersecurity risks and incidents. Similarly, the SEC still has to issue the final language for new rule 206(4)-11 that would establish oversight obligations for RIAs that outsource certain functions to third parties. A summary of the proposed rules can be found here: 2023 Regulatory Update for Investment Advisers: Miller Canfield

© 2023 Miller, Canfield, Paddock and Stone PLC
For more news on 2024 Updates for Investment Advisers, visit the NLR Securities & SEC section.

Regulatory Update and Recent SEC Actions

REGULATORY UPDATES

Recent SEC Leadership Changes

On January 10, 2023, the Securities and Exchange Commission (the “SEC”) announced the appointment of Cristina Martin Firvida as director of the Office of the Investor Advocate, effective January 17, 2023. Ms. Martin Firvida was most recently the vice president of financial security and livable communities for government affairs at the American Association of Retired Persons (“AARP”). As the investor advocate, Ms. Martin Firvida will lead the office that assists retail investors in interactions with the SEC and with self-regulatory organizations (“SROs”), analyzing the impact on investors of proposed rules and regulations, identifying problems that investors have with financial service providers and investment products, and proposing legislative or regulatory changes to promote the interests of investors.

On January 11, 2023, the SEC announced that Paul Munter has been appointed as chief accountant. He has served as acting chief accountant since January 2021. In addition to continuing to lead the Office of the Chief Accountant (“OCA”), he will also assist the SEC in its oversight of the Financial Accounting Standards Board (“FASB”) and the Public Company Accounting Oversight Board (“PCAOB”). Mr. Munter joined the SEC in 2019 as deputy chief accountant in charge of OCA’s international work. Before joining the agency, Mr. Munter was a senior instructor of accounting at the University of Colorado Boulder. He had previously retired from KPMG, where he served as the lead technical partner for the U.S. firm’s international accounting and International Financial Reporting Standards (“IFRS”) activities and served on the firm’s panel responsible for establishing firm positions on the application of IFRS.

On January 13, 2023, the SEC announced that Renee Jones, director of the Division of Corporation Finance, departed the agency and was replaced by Erik Gerding, effective February 2, 2023. Mr. Gerding previously served as the Division’s deputy director. Mr. Gerding joined the SEC in October 2021 and led the Legal and Regulatory Policy in the Division of Corporation Finance. He has taught as professor of law and a Wolf-Nichol Fellow at the University of Colorado Law School, where he has focused in the areas of securities law, corporate law, and financial regulation. Mr. Gerding previously taught at the University of New Mexico School of Law. He also practiced in the New York and Washington, D.C., offices of Cleary Gottlieb Steen & Hamilton LLP, representing clients in the financial services and technology industries in an array of financial transactions and regulatory matters.

Boards File Comment Letters Asking SEC to Withdraw Swing Pricing Rule Proposal

Over thirty (30) fund boards have submitted comment letters to the SEC with respect to the controversial swing pricing rule proposal. Industry participants have noted that this level of direct board participation in the comment process for a rule proposal of this type is unprecedented in recent SEC history. Many of the letters call for a withdrawal of the rule proposal, with some arguing that millions of American investors will not get the best price for their trades. Many letters also stated that requiring swing pricing would burden fund complexes and harm mutual fund investors without solving the liquidity problems that the SEC aimed to resolve. A vast majority of the comment letters indicated that swing pricing is not needed and that current tools for managing liquidity worked well, even during the volatile 2020 markets.

The comment letters also noted that investors who hold fund shares through intermediaries may have to place their orders earlier as a result of the proposed hard close requirement, which would put them at a disadvantage over the investors who buy shares directly from a fund. Several commenters also expressed concern that the hard close could cause intermediaries to drop mutual funds from their offerings in favor of less-regulated investment vehicles, such as collective investment trusts (“CITs”). Some letters pointed out that one of the justifications the SEC raises for the new rule is the market volatility during the early part of the COVID-19 pandemic and its impact on fund liquidity risk management, yet the SEC then goes on to say that it did not have specific data about fund dilution during that period. Letters also alleged that the SEC did not provide an accurate cost benefit analysis, and noted that the SEC states in the rule proposal that it “cannot predict the number of investors that would choose to keep their investments in the mutual fund sector nor the number of investors that would exit mutual funds and instead invest in other fund structures such as ETFs, close-end funds, or CITs.”

SEC Proposes Rule to Prohibit Conflicts of Interest in Certain Securitizations

The SEC issued a proposed rule (the “proposed rule”) to prohibit material conflicts of interest in the sale of asset-backed securities (“ABS”). The proposed rule, Rule 192 under the Securities Act of 1933 (the “Securities Act”), was issued on January 25, 2023, to implement Section 27B of the Securities Act, a provision added by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Specifically, the proposed rule would prohibit securitization participants from engaging in certain transactions that could incentivize a securitization participant to structure an ABS in a way that would put the securitization participant’s interests ahead of those of ABS investors. The SEC originally proposed a rule to implement Section 27B in September 2011. If adopted, the proposed rule would prohibit an underwriter, placement agent, initial purchaser, or sponsor of an ABS, including affiliates or subsidiaries of those entities, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in such ABS. Under the proposed rule, such transactions would be considered “conflicted transactions” and include, for example, a short sale of the ABS or the purchase of a credit default swap or other credit derivative that entitles the securitization participant to receive payments upon the occurrence of specified credit events in respect of the ABS.

The prohibition on conflicted transactions would commence on the date on which a person has reached, or has taken substantial steps to reach, an agreement that such person will become a securitization participant with respect to an ABS, and it would end one year after the date of the first closing of the sale of the relevant ABS. The proposed rule would provide certain exceptions for risk-mitigating hedging activities, bona fide market-making activities, and certain commitments by a securitization participant to provide liquidity for the relevant ABS. 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.

Division of Examinations Publishes Risk Alert on Regulation Best Interest

On January 30, 2023, the Division of Examinations published a Risk Alert (the “Risk Alert”) to highlight observations from examinations related to Regulation Best Interest, which had a June 30, 2020, compliance date and to assist broker-dealers in reviewing and enhancing their compliance programs related to Regulation Best Interest. The Risk Alert discusses deficiencies noted during examinations conducted, as well as examples of weak practices that could result in deficiencies. Regulation Best Interest established a new, enhanced standard of conduct under the Securities Exchange Act of 1934 (the “Exchange Act”) for broker-dealers (“broker-dealers” or “firms”) and associated persons that are natural persons (“financial professionals”) of a broker-dealer when making recommendations of securities transactions or investment strategies involving securities (including account recommendations) to retail customers. Regulation Best Interest requires compliance with four component obligations: (1) providing certain prescribed disclosure, before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the broker-dealer (“Disclosure Obligation”); (2) exercising reasonable diligence, care, and skill in making the recommendation to, among other things, understand the potential risks, rewards, and costs associated with a recommendation, and having a reasonable basis to believe that the recommendation is in the best interest of a retail customer (“Care Obligation”); (3) establishing, maintaining, and enforcing written policies and procedures reasonably designed to identify and address conflicts of interest; and (4) establishing, maintaining, and enforcing written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest. The Risk Alert set out specific examples of practices, policies, and procedures that were deficient in complying with requirements under the Regulation, including:

  • Policies and Procedures Relating to the Disclosure Obligation. Some broker-dealers did not have written policies and procedures reasonably designed to achieve compliance with the Disclosure Obligation. The SEC noted that examples of policies and procedures that may contain deficiencies or weaknesses include policies and procedures that did not specify when or how disclosures should be created or updated.
  • Policies and Procedures Relating to the Care Obligation. Examples of policies and procedures that may contain deficiencies or weaknesses include policies and procedures that directed financial professionals to consider reasonably available alternatives without providing any guidance as to how to do so; directed financial professionals to consider costs without providing any guidance as to how to do so; or created systems that allowed financial professionals to evaluate costs or reasonably available alternatives but did not mandate their use or, in some instances, could not determine whether or not financial professionals used the systems.
  • Conflict of Interest. The SEC observed a number of deficiencies related to the requirement that broker-dealers have written policies and procedures reasonably designed to address conflicts of interest associated with their recommendations to retail customers. For example: some broker-dealers did not have written policies and procedures reasonably designed to specify how conflicts are to be identified or addressed; some broker-dealers limited the identified conflicts to conflicts associated with prohibited activities (e.g., churning) or used high-level, generic language that did not identify the actual conflict (e.g., “we have conflicts related to compensation differences”) and did not reflect all conflicts of interest associated with the recommendations made by the firm or its financial professionals; and some broker-dealers inappropriately relied on disclosure to “mitigate” conflicts that appeared to create an incentive for the financial professional to place its interest ahead of the interest of the retail customer, and did not establish any mitigation measures.

SEC Releases Staff Guidance on Differential Advisory Fee Waivers

The staff of the Division of Investment Management (“Staff”) issued guidance (“Guidance”) on February 2, 2023, to mutual funds, their boards of directors/trustees (“Boards”), and their legal counsel about the implications under the Investment Company Act of 1940, as amended (the “Investment Company Act”), regarding fee waiver and expense reimbursement arrangements that result in different advisory fees being charged to different share classes of the same fund. The Guidance noted that Rule 18f-3 permits fee waivers and expense reimbursements provided that such arrangements do not result in cross-subsidization of fees among classes. The Staff stated that whether a differential advisory fee waiver presents a prohibited means of cross-subsidization between classes is a facts-and-circumstances determination that a mutual fund’s board, in consultation with the investment adviser and legal counsel, should consider making and documenting after considering all relevant factors.

For example, a fund’s Board may be able to conclude that a long-term waiver of an advisory fee for one class of shares, but not other classes of shares, does not provide a means for cross subsidization in contravention of Rule 18f-3 if the Board finds that (1) shareholders in the waived class pay fees to the adviser at the investing fund level in a funds-of-funds structure for advisory services, and (2) that such fees, when added to the advisory fees that are paid by the waived class, after giving effect to the waiver, are at least equal to the amount of advisory fees paid by the other classes, such that the waiver for the waived class is demonstrably not being subsidized by other classes. For a fund that already has such differential advisory fee waivers in place, the Staff said the fund’s board may wish to consider, specifically within the context of Rule 18f-3, whether: (i) such waivers present a means for cross-subsidization, (ii) the steps they are taking to monitor such waivers to guard against cross-subsidization are (and continue to be) effective, and/or (iii) alternative fee arrangements may be appropriate. Relatedly, the Staff suggested that a fund should consider the extent to which the Board’s consideration of these issues under Rule 18f-3 should be disclosed to its shareholders.

SEC Division of Examinations Announces 2023 Priorities

On February 7, 2023, the SEC’s Division of Examinations (the “Division”) announced its 2023 examination priorities. The Division publishes its examination priorities annually to provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets. The following are a selection of the Division’s 2023 priorities:

  • New Investment Adviser and Investment Company Rules:The Division will focus on the new Marketing Rule (Rule 206(4)-1 under the Investment Advisers Act of 1940, as amended (the “Advisers Act)) and whether registered investment advisers (“RIAs”) have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers and their supervised persons of the new Marketing Rule and whether RIAs have complied with the substantive requirements.

    The Division will also focus on new rules applicable to investment companies (“funds”), including the Derivatives Rule (Rule 18f-4 under the Investment Company Act) and the Fair Valuation Rule (Investment Company Act Rule 2a-5). If a fund relies on the Derivatives Rule, the Division will, among other things: (1) assess whether registered investment companies, including mutual funds (other than money market funds), exchange-traded funds (“ETFs”) and closed-end funds, as well as business development companies (“BDCs”), have adopted and implemented policies and procedures reasonably designed to manage the funds’ derivatives risks and to prevent violations of the Derivatives Rule pursuant to Investment Company Act Rule 38a-1; and (2) review for compliance with Rule 18f-4, including the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate, or potentially misleading.

    Under the new Fair Valuation Rule, the Division will, among other things: (1) assess funds’ and fund boards’ compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value determinations; and (2) review whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.

  • RIAs to Private Funds – Examinations will include a review of issues under the Advisers Act, including an adviser’s fiduciary duty, and will assess risks, focusing on compliance programs, fees and expenses, custody, the new Marketing Rule, conflicts of interest, and the use of alternative data. The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations, focusing on conflicts and disclosures around these areas. In addition, the Division will focus on RIAs to private funds with specific risk characteristics, including highly leveraged private funds and private funds managed side-by-side with BDCs.
  • Retail Investors and Working Families – Examinations will focus on how registrants are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of the interests of retail investors.
  • Registered Investment Companies  ̶  The Division will review compliance programs and governance practices, disclosures to investors, and accuracy of reporting to the SEC of the registered investment companies, including ETFs and mutual funds. The Division will also focus on funds with specific characteristics, such as: (1) turnkey funds, to review their operations and assess effectiveness of their compliance programs; (2) mutual funds that converted to ETFs, to assess governance and disclosures associated with the conversion to an ETF; (3) non-transparent ETFs, to assess compliance with the conditions and other material terms of their exemptive relief; (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (5) medium and small fund complexes that have experienced excessive staff attrition, to focus on whether such attrition has affected the funds’ controls and operations. The Division will also monitor the proliferation of volatility-linked and single-stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures, among other things. In addition, the Division will focus on adviser compensation, practices and processes for assessing and approving advisory and other fund fees, the effectiveness of derivatives risk management and liquidity risk management programs.
  • Environmental, Social, and Governance (“ESG”) – The Division will focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures, whether ESG products are appropriately labeled, and whether recommendations of such products for retail investors are made in the investors’ best interests.
  • Information Security and Operational Resiliency – The Division will review broker-dealers’, RIAs’, and other registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. Reviews of broker-dealers and RIAs will include a focus on the cybersecurity issues associated with the use of third-party vendors, including registrant visibility into the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers.
  • Emerging Technologies and Crypto-Assets – The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies or employing new practices, including technological and on-line solutions to meet the demands of compliance and marketing and to service investor accounts. Examinations of registrants will focus on the offer, sale or recommendation of, or advice regarding trading in, crypto or crypto-related assets and include whether the firm (1) met and followed its standard of care when making recommendations, referrals, or providing investment advice; and (2) routinely reviewed, updated, and enhanced its compliance, disclosure, and risk management practices.

As in recent past years, the Division noted that it prioritizes RIAs and investment companies that have never been examined, including recently registered firms or investment companies, and those that have not been examined for a number of years.

“Our priorities reflect the changing landscape and associated risks in the securities market and are the product of a risk-based approach to examination selection that balances our resources across a diverse registrant base. We will emphasize compliance with new SEC rules applicable to investment advisers and investment companies as well as continue our focus on emerging issues and rules aimed at protecting retail investors,” said Division of Examinations’ Director Richard R. Best. “Our examination program continues moving forward and remains committed to furthering investor protection through high-quality examinations and staying abreast of the latest industry trends and emerging risks to investors and the markets.”

SEC Reopens Comment Period for Proposed Cybersecurity Risk Management Rules and Amendments for Registered Investment Advisers and Funds

The SEC reopened the comment period on proposed rules and amendments related to cybersecurity risk management and cybersecurity-related disclosure for registered investment advisers, registered investment companies, and BDCs that were proposed by the SEC on February 9, 2022. The initial comment period ended on April 11, 2022. Per the SEC’s March 15, 2023, announcement, the reopened comment period will allow interested persons additional time to analyze the issues and prepare comments in light of other regulatory developments, including whether there would be any effects of other SEC proposals related to cybersecurity risk management and disclosure that the SEC should consider. The comment period will remain open until 60 days after the date of publication of the reopening release in the Federal Register.

SEC Finalizes Rules to Reduce Broker-Dealer Settlement Cycle from (T+2) to (T+1)

The SEC adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions in securities from two business days after the trade date (“T+2”) to one (“T+1”). The SEC indicates that the final rules, adopted on February 15, 2023, are designed to reduce the credit, market, and liquidity risks in securities transactions faced by market participants. The final rules will: (i) require a broker-dealer to either enter into written agreements or establish, maintain, and enforce written policies and procedures reasonably designed to ensure the completion of allocations, confirmations, and affirmations as soon as technologically practicable and no later than the end of the trade date; (ii) require registered investment advisers to make and keep records of the allocations, confirmations, and affirmations for certain securities transactions; (iii) add a new requirement to facilitate straight-through processing, which applies to certain types of clearing agencies that provide central matching services; and (iv) require central matching service providers to establish, implement, maintain, and enforce new policies and procedures reasonably designed to facilitate straight-through processing and require them to submit an annual report to the SEC that describes and quantifies progress with respect to straight-through processing. The final rules will become effective 60 days after publication in the Federal Register. The compliance date for the final rules is May 28, 2024.

SEC Proposes Enhanced Custody Rule for Registered Investment Advisers

The SEC proposed rule changes to enhance protections of customer assets managed by registered investment advisers. If adopted, the changes would amend and redesignate rule 206(4)-2, the SEC’s current custody rule (the “custody rule”), as new rule 223-1 under the Advisers Act (the “proposed rule”) and amend certain related recordkeeping and reporting obligations. According to the SEC’s announcement on February 15, 2023, the SEC exercised its authority under the Dodd-Frank Act in broadening the application of the custody rule. The proposed rule would change the current rule’s scope in two important ways. First, it would expand the types of investments covered by the rule. The proposed rule would extend the rule’s coverage beyond client “funds and securities” to client “assets” so as to include additional investments held in a client’s account, e.g. digital assets, including crypto assets. Second, an adviser would be deemed to have “custody” of client assets whenever the adviser has discretionary authority to trade client assets.

The proposed rule would also require qualified custodians to provide certain standard custodial protections when maintaining an advisory client’s assets and additional protections for certain securities and physical assets that cannot be maintained by a qualified custodian. The proposed rule would also provide exceptions to the surprise examination requirement in instances in which the adviser’s sole reason for having custody is because it has discretionary authority or because the adviser is acting according to a standing letter of authorization. In addition, the proposed rule would expand the scope of who can satisfy the custody rule’s surprise examination requirement through financial statement audits. Finally, the proposed rule would update related recordkeeping requirements for advisers and amend Form ADV to align reporting obligations with the proposed rule and to improve the accuracy of custody-related data available to the SEC, its staff, and the public. The comment period on the proposal will remain open for 60 days following publication of the proposing release in the Federal Register.

“I support this proposal because, in using important authorities Congress granted us after the financial crisis, it would help ensure that advisers don’t inappropriately use, lose, or abuse investors’ assets,” said SEC Chair Gary Gensler. “In particular, Congress gave us authority to expand the advisers’ custody rule to apply to all assets, not just funds or securities. Further, investors would benefit from the proposal’s changes to enhance the protections that qualified custodians provide. Thus, through this expanded custody rule, investors working with advisers would receive the time-tested protections that they deserve for all of their assets, including crypto assets, consistent with what Congress envisioned.”

Republican Leaders Request Information from Gensler on Climate Disclosure Proposal

On February 22, 2023, the chairman of the House Financial Services Committee, Patrick McHenry (R-NC); the ranking member of the Senate Committee on Banking, Housing, and Urban Affairs, Tim Scott (R-SC); and the chairman of the Subcommittee on Oversight and Investigations, Bill Huizenga (R-MI), sent a letter to the SEC Chair Gary Gensler demanding records and other information related to the proposed climate disclosure rule, including responses to previous requests by numerous members of both the House and the Senate that Chair Gensler had failed to provide. The Republican leaders argued that the proposed rule exceeds the SEC’s mission, expertise, and authority and—if finalized in any form—will unnecessarily harm consumers, workers, and the U.S. economy. In addition, the Republican members of the House Appropriations subcommittee pushed to cut the agency’s budget and requested that the SEC expand its enforcement efforts, reduce the pace of its rulemaking, and refrain from regulation. According to the opening statement of Steve Womack (R-Ark.), chair of the Financial Services and General Government subcommittee, who opened the March 29, 2023, hearing, the SEC budget is too big, the agency costs too much to run, and it focuses too much on the implementation and enforcement of new regulations rather than on trying to encourage the flow of investment capital into markets.

“The blistering pace of the SEC rulemaking is a cause for concern,” Womack wrote, “especially when the SEC is wading into areas that are not within their expertise and constitutionally questionable, such as requiring public companies to report on greenhouse gas emissions while claiming private enterprises won’t be impacted.”

SEC Fee Rate Advisories

The SEC announced that, starting on February 27, 2023, the fee rates applicable to most securities transactions would be set at $8.00 per million dollars. Per the January 23, 2023, announcement, the then-current rate of $22.90 per million dollars would remain in effect on charge dates through February 26, 2023. The assessment on security futures transactions remained unchanged at $0.0042 for each round-turn transaction. Subsequently, on March 1, 2023, the SEC announced that a mid-year adjustment to the fee rate for fiscal year 2023 was not required. As a result, the fiscal 2023 fee rate will remain at $8.00 per million dollars until September 30, 2023, or 60 days after the enactment of a regular FY 2024 appropriation, whichever occurs later. Similarly, the SEC confirmed that the Section 31 assessment on round-turn transactions in security futures also would remain at $0.0042 per transaction.

SEC Proposes Changes to Reg S-P to Enhance Protection of Customer Information

The SEC proposed amendments to Regulation S-P (“Reg S-P”) that would, among other things, require broker-dealers, investment companies, registered investment advisers, and transfer agents (collectively, “covered institutions”) to provide notice to individuals affected by certain types of data breaches that may put them at risk of identity theft or other harm. Reg S-P currently requires broker-dealers, investment companies, and registered investment advisers to adopt written policies and procedures for the protection of customer records and information (the “safeguards rule”). Reg S-P also requires the proper disposal of consumer report information (the “disposal rule”). If adopted, the SEC’s proposal, which was announced on March 15, 2023, would (i) update current requirements to address the expanded use of technology and corresponding risks since the SEC originally adopted Reg S-P in 2000; (ii) require covered institutions to adopt written policies and procedures for an incident response program to address unauthorized access to or use of customer information; (iii) require, with certain limited exceptions, covered institutions to provide notice to individuals whose sensitive customer information was or is reasonably likely to have been accessed or used without authorization; (iv) require a covered institution to provide such notice as soon as practicable, but not later than 30 days after the covered institution becomes aware that an incident involving unauthorized access to or use of customer information has occurred or is reasonably likely to have occurred; and (v) make a number of additional changes to Reg S-P, including:

(a) broadening and aligning the scope of the safeguards rule and disposal rule to cover “customer information,” a new defined term which would extend the protections of the safeguards and disposal rules to both nonpublic personal information that a covered institution collects about its own customers and nonpublic personal information that a covered institution receives about customers of other financial institutions;

(b) extending the safeguards rule to transfer agents registered with the SEC or another appropriate regulatory agency, and expanding the existing scope of the disposal rule to include transfer agents registered with another appropriate regulatory agency rather than only those registered with the SEC; and

(c) conforming Reg S-P’s existing provisions regarding the delivery of an annual privacy notice with a statutory exception created by the U.S. Congress in 2015.

The public comment period for the proposed amendments will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

SEC Proposes New Requirements to Address Cybersecurity Risks to the U.S. Securities Markets

The SEC proposed requirements (the “proposal”) for broker-dealers, clearing agencies, major security-based swap participants, the Municipal Securities Rulemaking Board, national securities associations, national securities exchanges, security-based swap data repositories, security-based swap dealers, and transfer agents (collectively, “Market Entities”) to address their cybersecurity risks. In its March 15, 2023, announcement of the proposal, the SEC noted that Market Entities increasingly rely on information systems to perform their functions and provide their services and that the interconnectedness of Market Entities increases the risk that a significant cybersecurity incident can simultaneously impact multiple Market Entities causing systemic harm to the U.S. securities markets.

Proposed new Rule 10 under the Exchange Act would require all Market Entities to (i) establish, maintain, and enforce written policies and procedures that are reasonably designed to address their cybersecurity risks, (ii) review and assess, at least annually, the design and effectiveness of their cybersecurity policies and procedures, including whether they reflect changes in cybersecurity risk over the time period covered by the review, and (iii) provide the SEC with immediate written electronic notice of a significant cybersecurity incident upon having a reasonable basis to conclude that the significant cybersecurity incident has occurred or is occurring. The proposal includes additional requirements for Market Entities other than certain types of small broker-dealers (collectively, “Covered Entities”), including the requirement that Covered Entities utilize a proposed new Form SCIR to (a) report and update information about any significant cybersecurity incident and (b) publicly disclose summary descriptions of their cybersecurity risks and the significant cybersecurity incidents they experienced during the current or previous calendar year. The public comment period for the proposal will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

SEC Proposes to Expand and Update Regulation SCI

The SEC proposed amendments to expand and update Regulation Systems Compliance and Integrity (“Regulation SCI”). Regulation SCI requires certain U.S. securities markets entities (“SCI entities”) to take corrective action with respect to systems disruptions, systems compliance issues, and systems intrusions and to notify the SEC of such events. In the SEC’s March 15, 2023, announcement of the proposed amendments, the SEC explained that trading and technology have evolved since Regulation SCI’s adoption in 2014 and that the growth in electronic trading allows ever-increasing volumes of securities transactions in a broader range of asset classes at increasing speed by competing trading platforms, including those offered by broker-dealers that play multiple roles in the markets. The proposed amendments would expand the scope of SCI entities covered by Regulation SCI to include registered security-based swap data repositories, all clearing agencies that are exempt from registration, and certain large broker-dealers (in particular, those that exceed a total assets threshold or a transaction activity threshold in national market system stocks, exchange-listed options contracts, U.S. Treasury Securities, or Agency Securities).

The proposed amendments would require that an SCI entity’s policies and procedures include the maintenance of a written inventory and classification of all SCI systems and a program for life cycle management; a program to prevent unauthorized access to such systems and information therein; and a program to manage and oversee certain third-party providers, including cloud service providers, of covered systems. The proposed amendments would also expand the types of SCI events experienced by an SCI entity that would trigger immediate notification to the SEC, update the rule’s annual SCI review and business continuity and disaster recovery testing requirements, and update certain of the Regulation’s recordkeeping provisions. The public comment period for the proposed amendments will remain open until 60 days after the date of publication of the proposing release in the Federal Register.

The SEC Issues Frequently Asked Questions for Registration of Municipal Advisors

On March 20, 2023, the SEC updated its Registration of Municipal Advisors Frequently Asked Questions (“FAQs”) page which provides general interpretive staff guidance on various aspects of the SEC’s municipal advisor registration rules. The updated page provides answers to questions across several categories, including the following topics: (i) independent registered municipal advisor exemption; (ii) registered investment adviser exclusion; (iii) issuance of municipal securities/post-issuance advice; (iv) completion of Form MA, Form MA-I, and Form MA-NR; (v) withdrawal from municipal advisor registration; and (vi) investment strategies and proceeds of municipal securities.

SEC Issues Statement Regarding Risk Legend Used by Non-Transparent ETFs

Under the terms of the SEC’s exemptive relief granted to actively managed ETFs that do not provide daily portfolio transparency (“non-transparent ETFs”), each non-transparent ETF is required to include in its prospectus, fund website, and any marketing materials a risk legend  highlighting the differences between the non-transparent ETF and fully transparent actively managed ETFs, as well as certain costs and risks unique to non-transparent ETFs. Recognizing that the standardized risk legend required by the exemptive orders may be difficult to place in certain digital advertisements (e.g., banner advertisements) due to space limitations, the SEC issued new disclosure language on March 29, 2023, which may be used in digital advertisements by non-transparent ETFs in place of the standardized risk legend currently provided in the exemptive orders. Requirements relating to placement of the risk legend or new disclosure language in a prominent location remain as prescribed in the exemptive orders.

SEC ENFORCEMENT ACTIONS

SEC Charges Former Investment Adviser Managing Director and Co-Portfolio Manager with Undisclosed Conflict of Interest

The SEC charged a former managing director (the “defendant”) of a New York-based investment adviser (the “Adviser”), with failing to disclose a conflict of interest arising from his relationship with a film distribution company in which the fund he managed for the Adviser invested millions of dollars. The SEC’s order, issued on January 5, 2023, found that, from 2015 to 2019, a closed-end publicly traded fund (the “fund”), invested in Aviron Group, LLC subsidiaries by loaning the subsidiaries, which were in the business of funding advertising budgets of motion pictures, as much as $75 million. The defendant, a co-portfolio manager of the fund, had a significant role in recommending and overseeing the fund’s loans to the Aviron subsidiaries. At the same time, the defendant asked Aviron to help advance his daughter’s acting career. Aviron helped defendant’s daughter obtain a small role in a film produced in 2018. The defendant did not disclose to the fund’s board of trustees or the Adviser’s compliance and legal teams that he asked Aviron to help advance his daughter’s acting career or that Aviron helped his daughter obtain a film role. The defendant consented to the entry of the SEC’s order finding that he violated Section 206(2) of the Advisers Act. Without admitting or denying the SEC’s findings, the defendant agreed to a cease-and-desist order, a censure, and a $250,000 penalty.

SEC Charges Former SPAC CFO for Orchestrating Fraud Scheme

The SEC announced fraud charges against Cooper J. Morgenthau, the former CFO of African Gold Acquisition Corp. (“African Gold”), a special purpose acquisition company (“SPAC”), alleging that he stole more than $5 million from African Gold and from investors in two other SPACs that he incorporated. The SEC’s January 3, 2023, complaint alleged that from June 2021 through July 2022, Morgenthau embezzled money from African Gold and stole funds from another SPAC series to pay for his personal expenses and to trade in crypto assets and other securities; concealed unauthorized withdrawals by falsifying African Gold’s bank account statements; and raised money from the other SPAC’s investors based on misrepresentations. The SEC’s complaint alleged that Morgenthau violated antifraud provisions of the federal securities laws, lied to African Gold’s auditor and accountants in violation of the Exchange Act, knowingly falsified African Gold’s books and records, and filed false certifications with the SEC. Morgenthau consented to a judgment enjoining him from further federal securities laws violations and barring him from serving as an officer or director of a publicly traded company, with monetary remedies to be determined at a later date. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York, on the same day the SEC issued its complaint, announced criminal charges against Morgenthau.

In a related matter, on February 22, 2023, the SEC announced that it settled charges against African Gold for internal controls, reporting, and recordkeeping violations. Per the SEC, it was due to these failures that Morgenthau was able to embezzle money from the company’s operating bank account as discussed in the above complaint. The SEC noted that African Gold made materially false filings with the SEC and maintained inaccurate books and records. According to the SEC’s order, African Gold’s only liquid asset was the money held in its operating bank account, and thus potential fraud by management posed one of the company’s most significant risks of material misstatements in its financial statements. The SEC’s order alleged that, despite this risk, African Gold gave Morgenthau control over nearly all aspects of its operating bank account and financial reporting process with little to no oversight. The SEC’s order found that African Gold violated Exchange Act provisions relating to internal controls, reporting, and recordkeeping. Without admitting or denying the SEC’s findings, African Gold agreed to a cease-and-desist order and to pay a $103,591 civil monetary penalty.

SEC Settles Charges Against Investment Adviser for Alleged Conflicts of Interest Arising Out of Revenue Sharing and Incentive Arrangements

The SEC issued an order instituting and settling administrative and cease-and-desist proceedings against Moors & Cabot, Inc. (“Moors & Cabot”), a registered investment adviser and broker-dealer. Per the January 19, 2023, order, between at least February 2017 and September 2021, Moors & Cabot failed to fully and fairly disclose material facts and conflicts of interest associated with certain revenue-sharing payments and financial incentives that Moors & Cabot received from two unaffiliated clearing brokers. According to the order, Moors & Cabot also failed to implement written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act in connection with the disclosure of revenue sharing, fee markups, financial incentives, and associated conflicts of interest, as well as disciplinary histories. Moors & Cabot is charged with willfully violating Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder.

Company to Pay $5 Million for Misleading Disclosures About Its Valuation Methodologies for Fixed Income Securities

The SEC announced settled charges against a privately held financial, software, data and media company headquartered in New York (the “Company”) for misleading disclosures relating to its paid subscription service, which provides daily price valuations for fixed income securities to financial services entities. The SEC’s January 23, 2023, order found that from at least 2016 through October 2022, the Company failed to disclose to its subscription service customers that the valuations for certain fixed income securities could be based on a single data input, such as a broker quote, which did not adhere to methodologies it had previously disclosed. The order found that the Company was aware that its customers, including mutual funds, may utilize subscription service prices to determine fund asset valuations, including for valuing fund investments in government, supranational, agency, and corporate bonds, municipal bonds, and securitized products, and that subscription service prices, therefore, can have an impact on the price at which securities are offered or traded. The SEC’s order found that the Company violated section 17(a)(2) of the Securities Act. Without admitting or denying the findings, the Company agreed to cease and desist from future violations and to pay a $5 million penalty. The SEC’s order noted that the Company voluntarily engaged in remedial efforts to improve its subscription service line of business.

Twenty-five States File Lawsuit to Block DOL’s ESG Rule

Twenty-five states are suing the Biden Administration in an attempt to block the Department of Labor (“DOL”) rule that allows fiduciaries to consider ESG factors when choosing retirement investments (“DOL ESG Rule”). According to the lawsuit filed in Texas federal court on January 26, 2023, the attorneys general claim that the DOL ESG Rule violates Employment Retirement Income Security Act (“ERISA”), which requires that retirement plans invest solely for financial gain, and runs afoul of the Administrative Procedure Act (“APA”) as arbitrary and capricious because the DOL failed to assess either the harm it poses for plan participants and beneficiaries or the advantage of superseding the 2020 DOL rule effectively banning ESG considerations in plan investment selections. Among the twenty-five states are Alabama, Alaska, Arkansas, Florida, Georgia, Indiana, Idaho, and Iowa. In addition to the states, listed plaintiffs include two energy companies, an energy industry trade group, and an individual participant in an unnamed workplace plan.

The claimants argue that the DOL is deviating from prior policy because its 2020 DOL rule still required that financial factors take precedence. It is argued in the complaint that the DOL justified the 2022 rule by noting that it would cure a “chill” or “confusion” allegedly caused by the 2020 rule. Per the claimants, the DOL never identified who was confused, what the source of confusion was, or whether the alleged confusion caused a reduction in the financial returns for plan participants. Claimants further allege that the DOL did not consider alternatives and failed to consider that the solution to the purported concerns caused by the 2020 rules would be to issue clarifying sub-regulatory guidance. The claimants request the court to postpone the DOL ESG Rule’s effective date and to impose a preliminary injunction and declare the DOL ESG Rule in violation of the APA and ERISA.

SEC Charges Options Clearing Corporation with Rule Failures

The SEC announced that The Options Clearing Corporation (“OCC”) will undertake remedial efforts and pay $17 million in penalties to settle charges that it failed to comply with its own SEC-approved stress testing and clearing fund methodology rule during certain times between October 2019 and May 2021. According to the SEC’s February 16, 2023, order, Chicago-based OCC’s failure to implement and comply with its own rule was the result of its failure to properly establish, implement, and enforce written policies and procedures reasonably designed to manage certain operational risks. The SEC’s order further found that OCC failed to modify its comprehensive stress testing system and did not provide timely notification to the SEC of this failure as required by Regulation SCI. The SEC also found that OCC failed to comply with its margin methodology, margin policy, and stress testing and clearing fund methodology relating to specific wrong way risk and holiday margin.

According to the SEC, in addition to the $17 million penalty, OCC has undertaken several remedial measures, including revising its model validation policies and procedures; enhancing its approach to risk data governance; implementing changes to elements of its control environment, including processes, procedures, and controls; and conducting appropriate training on the changes. This is the SEC’s second enforcement action against OCC. In a September 2019 settled action, the SEC charged OCC with failure to establish and enforce policies and procedures involving financial risk management, operational requirements, and information-systems security, and imposed remedial measures and a $15 million penalty.

Republican Attorney-Generals Ask Court to Set Aside SEC Proxy Voting Disclosure Rules

Texas Attorney General Ken Paxton and three other Republican attorneys general filed a petition on February 21, 2023, against the SEC in the federal appeals court opposing the new proxy voting disclosure rules. Among other changes, the new rules amend Form N-PX by expanding the number of voting categories to include information about votes in certain standardized categories, including various ESG-related topics such as environment or climate, and diversity, equity and inclusion. Though the petition does not detail the states’ legal arguments against the proxy voting disclosure rules, Attorney General Paxton claimed in a statement that the rules are politically motivated. According to the office of Utah’s attorney general, the rules “will put shareholders at increased risk of loss, encouraging political activism and raising administrative costs.” The SEC’s two Republican commissioners, Hester Peirce and Mark Uyeda, both voted against adopting the rules, which the SEC’s three Democrats supported.

SEC Charges a Church and Its Investment Management Company for Disclosure Failures and Misstated Filings

The SEC announced charges against an exempt investment adviser (the “Adviser”), a non-profit entity operated by a religious organization (the “Church”) to manage the Church’s investments, for failing to file forms that would have disclosed the Church’s equity investments, and for instead filing forms for shell companies that obscured the Church’s portfolio and misstated the Adviser’s control over the Church’s investment decisions. The SEC also announced charges against the Church for causing these violations. To settle the charges, the Adviser agreed to pay a $4 million penalty and the Church agreed to pay a $1 million penalty. The SEC’s order, issued on February 21, 2023, found that from 1997 through 2019, the Adviser failed to file Forms 13F. According to the SEC’s order, the Church was concerned that disclosure of its portfolio, which by 2018 had grown to approximately $32 billion, would lead to negative consequences and in order to obscure the amount of the Church’s portfolio, and with the Church’s knowledge and approval, the Adviser filed Forms 13F in the names of shell LLCs which it had created rather than in the Adviser’s name.

The order found that the Adviser maintained investment discretion over all relevant securities, that it controlled the shell LLCs, and that it directed nominee “business managers,” most of whom were employed by the Church, to sign the SEC filings. The SEC found that the shell LLCs’ Forms 13F misstated, among other things, that the LLCs had sole investment and voting discretion over the securities, when in reality the Adviser retained control over all investment and voting decisions. The Adviser agreed to settle the SEC’s allegation that it violated Section 13(f) of the Exchange Act and Rule 13f-1 thereunder by failing to file Forms 13F and by misstating information in these forms. The Church also agreed to settle the SEC’s allegation that it caused the Adviser’s violations through its knowledge and approval of the Adviser’s use of the shell LLCs.

SEC Charges Private Fund Auditor and Audit Engagement Partner with Improper Professional Conduct

The SEC announced settled charges against Spicer Jeffries LLP, an audit firm based in Denver, and an audit engagement partner Sean P. Tafaro, for their improper professional conduct in connection with audits of two private funds. According to the SEC’s March 29, 2023, order, during the audit planning stages, Spicer Jeffries and Tafaro assessed that valuation of investments was a significant fraud risk but did not implement the planned audit approach to respond to the risk. The order further finds that Spicer Jeffries and Tafaro failed to obtain sufficient audit evidence about the method of measuring fair value, the valuation models, and whether alternative valuation assumptions were considered. According to the order, due to these failures and others, Spicer Jeffries and Tafaro did not exercise due care, including professional skepticism. The order also found that Spicer Jeffries’ deficient system of quality control led to failures to adhere to professional auditing standards. Without admitting or denying the findings, Spicer Jeffries and Tafaro consented to the SEC’s order finding that they engaged in improper professional conduct. Spicer Jeffries agreed to be censured and to implement undertakings to retain an independent consultant to review and evaluate certain of its audit, review, and quality control policies and procedures. Tafaro agreed to be suspended from appearing and practicing before the SEC as an accountant. The SEC’s order permits Tafaro to apply for reinstatement after one year.

Cyber Fraud and Crypto Asset Enforcement Actions

The SEC brought charges against various individuals and entities relating to cyber fraud and crypto assets, including blockchain and lending programs. For example, these include:

  1. The SEC charged five individuals and three entities for their involvement in a fraudulent investment scheme named CoinDeal that raised more than $45 million from sales of unregistered securities to tens of thousands of investors worldwide. According to the SEC’s complaint filed on January 4, 2023, the five individuals allegedly disseminated false and misleading statements to investors about extravagant returns from investing in a blockchain technology called CoinDeal; the purported value of CoinDeal; the parties involved in the supposed sale of CoinDeal; and the use of investment proceeds. The complaint further alleged that no sale of CoinDeal ever occurred and no distributions were made to CoinDeal investors, and that the defendants collectively misappropriated millions of dollars of investor funds for personal use. In June 2022, the U.S. Department of Justice indicted one of the individuals on three counts of wire fraud and two counts of monetary transaction in unlawful proceeds for his involvement in CoinDeal. The SEC’s complaint charged each party with different violations of the antifraud and registration provisions of the Securities Act and Exchange Act; and aiding and abetting under the antifraud provisions of the Exchange Act; and under the antifraud and registration provisions of the Securities Act and Exchange Act.
  2. The SEC charged a crypto asset-related financial products and services corporation (the “Corporation”), with failing to register the offer and sale of its retail crypto asset lending product. To settle the SEC’s charges, the Corporation agreed to pay a $22.5 million penalty and cease its unregistered offer and sale of its product to U.S. investors. In parallel actions announced the same day, the Corporation agreed to pay an additional $22.5 million in fines to settle similar charges by state regulatory authorities. The SEC’s January 19, 2023, order found that the Corporation marketed its product as a means for investors to earn interest on their crypto assets, and that the Corporation exercised its discretion to use investors’ crypto assets in various ways to generate income for its own business and to fund interest payments to investors. The order also found that the Corporation’s product is a security and that the offer and sale of the Corporation’s product did not qualify for an exemption from SEC registration. Without admitting or denying the SEC’s findings, the Corporation agreed to a cease-and-desist order prohibiting it from violating the registration provisions of the Securities Act.
  3. The SEC charged Avraham Eisenberg with orchestrating an attack on a crypto asset trading platform, Mango Markets, by manipulating the MNGO token, a so-called governance token that was offered and sold as a security. Eisenberg is facing parallel criminal and civil charges in the Southern District of New York brought by the U.S. Department of Justice and the Commodities Futures Trading Commission (“CFTC”). The SEC’s complaint alleged that beginning on October 11, 2022, Eisenberg engaged in a scheme to steal approximately $116 million worth of crypto assets from the Mango Markets platform. The SEC’s complaint, filed in federal district court in Manhattan, charged Eisenberg with violating antifraud and market manipulation provisions of the securities laws and sought permanent injunctive relief, a conduct-based injunction, disgorgement with prejudgment interest, and civil penalties.
  4. The SEC charged Singapore-based Terraform Labs PTE Ltd and Do Hyeong Kwon with orchestrating a multibillion-dollar crypto asset securities fraud involving an algorithmic stablecoin and other crypto asset securities. According to the SEC’s complaint filed on February 16, 2023, from April 2018 until the scheme’s collapse in May 2022, Terraform and Kwon raised billions of dollars from investors by offering and selling an inter-connected suite of crypto asset securities, many in unregistered transactions. The complaint charged the defendants with violating the registration and antifraud provisions of the Securities Act and the Exchange Act.
  5. The SEC announced charges against former NBA player Paul Pierce for touting EMAX tokens, crypto asset securities offered and sold by EthereumMax, on social media without disclosing the payment he received for the promotion and for making false and misleading promotional statements about the same crypto asset. The SEC’s February 17, 2023, order found that Pierce violated the anti-touting and antifraud provisions of the federal securities laws. Without admitting or denying the SEC’s findings, Pierce agreed to settle the charges and pay over $1.4 million in penalties, disgorgement, and interest. Pierce also agreed not to promote any crypto asset securities for three years.
  6. The SEC charged the former co-lead engineer (the “defendant”) of an Antigua- and Barbuda-based company that operated a global crypto asset trading platform (the “Company”), for his role in a multiyear scheme to defraud equity investors. According to the SEC’s complaint, issued on February 28, 2023, the defendant created software code that allowed Company customer funds to be diverted to a quantitative trading firm specializing in crypto assets (a “crypto hedge fund”) owned by co-founders and officers of the Company, despite false assurances to investors that the Company was a safe crypto asset trading platform with sophisticated risk mitigation measures to protect customer assets and that the crypto hedge fund was just another customer with no special privileges. The complaint alleged that the defendant knew or should have known that such statements were false and misleading, and that the defendant actively participated in the scheme to deceive the Company’s investors
    The SEC’s complaint charged the defendant with violating the antifraud provisions of the Securities Act and the Exchange Act. The defendant consented to a bifurcated settlement, subject to court approval, which would permanently enjoin him from violating the federal securities laws, a conduct-based injunction, and an officer and director bar. In a parallel action, the U.S. Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission (“CFTC”) announced charges against the defendant on the same day the SEC’s complaint was filed.
  7. The SEC charged the crypto asset trading platform beaxy.com (the “Beaxy Platform”) and its executives for failing to register as a national securities exchange, broker, and clearing agency. The SEC also charged the founder of the platform, Artak Hamazaspyan, and a company he controlled, Beaxy Digital, Ltd., with raising $8 million in an unregistered offering of the Beaxy token (“BXY”) and alleged that Hamazaspyan misappropriated at least $900,000 for personal use, including gambling. Finally, the SEC charged market makers operating on the Beaxy Platform as unregistered dealers. Pursuant to the Consents filed on March 29, 2023, the charged market makers have agreed to perform certain undertakings, including ceasing all activities as an unregistered exchange, clearing agency, broker, and dealer; shutting down the Beaxy Platform; providing an accounting of assets and funds for the benefit of customers; transferring all customer assets and funds to each respective customer; and destroying any and all BXY in possession.

Thomas R. Westle and Stacy H. Louizos would like to thank Margaret M. Murphy and Hiba Hassan for their contributions to this update.

© 2023 Blank Rome LLP
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Caremark Liability Following the SEC’s New ESG Reporting Requirements

Recent developments in the Court of Chancery concerning a corporate board’s duty to monitor and provide oversight over a corporation’s operations, so-called Caremark claims, are likely to intersect with the Securities and Exchange Commission’s (“SEC”) proposed new ESG disclosure obligations to create a new category of corporate risk.  In this article, we discuss the recent trends in Delaware law that have led to a revitalization of Caremark and the SEC’s current proposals for enhanced ESG disclosure, the intersection of which can be expected to result in litigation and other corporate risk, and some commonsense steps corporations can take to mitigate this potential new category of risk.

The “Caremark” Doctrine

One of the more notable developments in Delaware case law in recent years has been the revitalization of “Caremark duty” claims.  Caremark actions traditionally were notoriously difficult to plead—in explaining the doctrine, the Chancery Court famously called it “the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”  In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996). In recent years, however, the Delaware courts have breathed new life into the Caremark doctrine by allowing these types of claims to proceed to discovery.

Specifically, the Caremark doctrine was returned to potency in 2019 following the Delaware Supreme Court’s decision in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019).  Although Marchand did not change the Caremark standard, it demonstrated the Delaware courts’ greater willingness to permit Caremark claims to pass the motion to dismiss phase if they could be plausibly pled.  Marchand ultimately laid the groundwork for a number of subsequent rulings demonstrating the renewed vitality of Caremark claims—not only have at least four Caremark suits survived a motion to dismiss since Marchand, but there are also several ongoing Caremark suits in Delaware.

Under Caremark, there are two distinct types of claims.  The first type concern a board’s failure to implement a system of controls to prevent some unlawful misconduct that occurred.  The second type of claims concern a failure to monitor by the directors.  It is imperative, therefore, that boards focus on:  (1) establishing adequate information and reporting systems to monitor “mission critical” aspects of their company’s business; and (2) monitoring those systems once in place.

The SEC’s Proposed New Climate-Related Disclosures

On March 21, 2022, the SEC proposed new rules requiring companies to report extensive line-item disclosures on climate-related ESG issues, entitled: “The Enhancement and Standardization of Climate-Related Disclosures for Investors.”  If implemented as written, the proposed rules would require registrants to make significant additional disclosures regarding the impact of climate-related risks on their business.

Among other things, under the proposed rules, registrants would be required to disclose:

  1. Greenhouse gas (“GHG”) emissions, regardless as to whether those emissions are deemed material by the company.  Emissions would now be reported by “scope” or type.

  2. “Climate-related risks” that are “reasonably likely to have a material impact,” including climate-related conditions and events that impact financial statements, business operations, or value chains.

  3. Governance disclosures related to climate risk, including how the board and management assess and manage these climate-related risks.

  4. Any targets or goals related to the reduction of GHG emissions.

These proposed new rules are part of the Biden Administration’s efforts to “advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk.”  Yet the sheer breadth, specificity, and complexity of the proposed rules would result in one of the most profound changes to public companies’ disclosure obligations in the history of the SEC.

Additional Caremark Exposure

The SEC’s climate-related disclosure rules will likely fuel ESG-related Caremark claims.  In particular, heightened disclosure requirements will provide ammunition for derivative or class action lawsuits and may expose companies to specific indirect risks, including heightened exposure to pre-suit discovery and proxy contests.

Direct Litigation Risk

The SEC’s new reporting requirements are likely to create new grounds for investors to assert liability claims against corporations and their boards of directors and management. Shareholders can be expected to leverage the new disclosures to seek to hold companies accountable for failing to properly oversee, mitigate or eliminate climate-related risk.  The revitalized Caremark doctrine is likely to be employed to allege boards and managers failed to oversee so-called “mission-critical” aspects of their business that generate climate-related risk.

In this vein, plaintiffs may choose to use disclosures required by the SEC’s proposed rules as the basis for a breach of duty to monitor or Caremark claim through either a derivative suit, brought on behalf of the company against its directors and officers, or a class action suit, brought on behalf of a class of injured shareholders or investors.  Caremark claims will likely arise if and when a board fails to exercise proper oversight with respect to climate-related risks or to consider proper mitigating steps. This new threat will be amplified for companies that (i) have yet to fully examine how ESG issues factor into their mission-critical operations or (ii) have yet to devote resources and personnel to measuring (using consistent, comparable and reliable data) and analyzing their own ESG-related risks. Companies need to be able to ascertain and address their most pressing ESG-related risks to avoid future Caremark liability.

Indirect Risks

Indirect risks from the proposed new disclosure regime may manifest in a variety of ways..  They can result in the disclosure of embarrassing or harmful information about a company, its board, or managers, and lead to the replacement of key company executives or directors by aggrieved shareholders.  Moreover, they give rise to issues that are expensive and resource-intensive to address.  While these risks are indirect to companies, they pose a direct threat to board members and managers.

Pre-Suit Discovery.  Boards can expect new disclosure requirements to enable shareholders to gain greater access to pre-suit discovery.  Section 220 of Delaware’s General Corporate Law provides shareholders with a qualified right to inspect a company’s books and records for suspected corporate wrongdoing or mismanagement, and need only demonstrate a “credible basis” to proceed.  The new ESG reporting requirements will likely provide shareholders with even more information as ammunition to fuel Section 220 demands.  Opening a company’s books to pre-suit discovery could expose boards, management, or companies to serious reputational harm, as well as provide fodder for future lawsuits against the current board.

Proxy Contests.  New ESG-related disclosures are also likely to generate greater turmoil in the form of proxy battles at the board level.  Historically, shareholder activists have been focused on addressing short-term profit, stock price and total shareholder return.  Yet activist campaigns containing an environmental or social objective have doubled as a proportion of campaigns overall during the five years between 2016 and 2021, including a successful campaign against Exxon to place directors on its board.  The proliferation of new ESG reporting requirements is expected to further fuel these contests, particularly with respect to companies that are perceived to be lagging on ESG commitments or expectations.

Avoiding Environmental-Caremark Claims

Companies should take several steps in preparation for the increased pressure expected to arise from the need to address ESG issues.

First, companies should be aware of the obligations and risks they face with regard to ESG issues.  That means determining what ESG-related risks could detrimentally impact a “mission-critical” aspect of a company’s business.  What is determined to be “mission-critical” will necessarily vary by company.

Second, once companies are cognizant of the ESG-related risks they face, they will need to start implementing appropriate governance structures so that they are aware of, and can take steps to address, ESG risks.  Directors should establish responsible committees and internal information and reporting procedures to ensure board members have proper oversight of these efforts.  This will allow boards to demonstrate their engagement in response to potential Caremark claims, as well as to respond to any ESG risks arising in the company’s operations.

Third, with these governance structures in place, companies must focus on generating, collecting, and analyzing consistent and comparable data on the ESG-related risks they face.  These data should be actively monitored by managers and board members so they can identify and address ESG risks before they result in catastrophic situations and resulting litigation.  And, if Caremark claims ensue, boards will be able to use these governance structures and reporting regimes to demonstrate that they have satisfied their oversight obligations.

Finally, once these systems are in place, companies should take steps to prepare for the adoption of the SEC’s new climate-related disclosure requirements.  The development of governance and reporting structures will undoubtedly aid in the collection of information for these purposes.  While taking these steps, it is advisable that corporate executives and boards seek input from subject matter experts and experienced legal counsel to help design and implement robust compliance and monitoring regimes that can help to discourage or forestall future litigation in the form of Caremark or other claims related to ESG issues.

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Are Loans Securities?

We have been following a case that has been winding its way through New York federal courts for some time that players in the syndicated loan market have described as everything from “a potential game changer” to an “existential threat” to the syndicated loan market.

The case in question is Kirschner v. JPMorgan Chase Bank, N.A., which is before the United States Court of Appeals for the Second Circuit. In this case, the Court will consider an appeal of a 2020 decision by the United States District Court for the Southern District of New York which held that the syndicated term loan in question was not a security. Significantly, this ruling indicated that because syndicated term loans are not securities, they are therefore not subject to securities laws and regulations.

The consequence of a determination that syndicated loans are securities would be significant. It would mean, among other things, that the syndicated loan market would have to comply with various state and federal securities laws. This would significantly change the cost of these transactions as well as the means by which syndication and loan trading take place. The Loan Syndications and Trading Association (LSTA) filed an amicus brief in this case in May of this year, which we covered here. The LSTA argued in its brief, among other things, that beyond the increased cost, regulating syndicated loans as securities would fundamentally change other aspects of the syndicated loan market. Specifically, the LSTA pointed to the importance of a borrower’s ability to have veto rights and other control in determining which entities will hold its debt. The LSTA also noted the importance of quick access to funding on flexible terms specific to the borrower in question – something we know is at the heart of so many fund finance transactions – which would be greatly compromised within a securities regulatory regime. The LSTA brief also discusses potential negative impacts on the CLO market.

Those in favor of a change in regulation point to features such as nonbank lender participation in the market, the fact that the test to determine whether a loan is a security may be outdated, and the overall size of the syndicated loan market – at $1.4 trillion – which could be a risk to the larger global financial system potentially warranting more stringent regulation.

Most experts believe that the Second Circuit will not overturn the decision issued in the lower court, but the issue in question is significant enough that market players should keep an eye on this one. Oral arguments will take place early next year. We will continue to watch as this case develops and update you here.

Article By Leah Edelboim of Cadwalader, Wickersham & Taft LLP

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