Tag: disclosure

Categories
Securities Regulation

The Case for Mandatory Stakeholder Disclosure

There are many sources of information about corporate operations, but one of the most critical is the disclosure required by the federal securities laws.  Whenever a company seeks to raise capital through the public sale of securities, the U.S. Securities and Exchange Commission (“SEC”) requires that it file a detailed description of its business and financial condition, periodically updated with new information about its profits, revenues, assets, and general business activities.  Regulators, competitors, employees, journalists, and members of the community have all grown to depend on securities disclosures to provide a working portrait of the country’s economic life.  Yet securities disclosures are not targeted toward the community at large; they are intended for investors alone, and when investors do not require disclosure, the general public is kept in the dark.  As a result, corporate transparency is a function of the needs of the investing class.  In a recent article, I argue for the creation of a system of mandatory corporate disclosure aimed at non-investor audiences such as workers, consumers, and members of local communities.

One of the great challenges of corporate law has been to develop regulatory systems that enable the productive use of the form while ensuring that corporate wealth and power is channeled in a prosocial direction.  Under the current regime, the structure of the corporation provides managers with strong incentives to maximize profits, even at the expense of other groups with which the corporation interacts.  Shareholders vote for directors – which permits them to oust those who do not pursue their interests with sufficient vigor – and corporate pay packages reward managers for maximizing shareholder wealth. At the same time, managers also have incentives to consider non-shareholder constituencies.  Environmental law, antitrust law, consumer protection law, antidiscrimination law, labor law, and the like all force managers to account for the impact of corporate activity on society as a whole.  These laws may penalize managers directly for lack of compliance, but more commonly, penalties are imposed on corporations themselves, threatening to cut into corporate profits and ultimately diminish shareholder wealth.  Managers are thereby given an incentive to accommodate non-shareholder constituencies as part of their general mandate to act on shareholders’ behalf.

Yet legal rules are necessarily imperfect.  Not every instance of corporate lawbreaking can be the subject of an enforcement action, and it is not practical to outlaw all unethical corporate activity.  In this state of affairs, markets, both economic and social, fill the gaps.  In order to earn profits, corporations not only have to produce goods and services that attract customers, but they also must generate enough reputational capital to maintain relationships with suppliers, employees, and other critical stakeholders.  Corporations that develop poor reputations – for creating harmful products, for mistreating their workforce, for overcharging clients – will find it more difficult to operate.  Journalists will spotlight their behavior; consumers will avoid them; investors and other suppliers of capital will flee; and competitors will challenge their position.  Regardless of whether managers are expected – via fiduciary duties or otherwise – to maximize shareholder wealth, an effective system of “soft” corporate discipline ensures that the pursuit of shareholder wealth is aligned with the well-being of the broader society in which the corporation operates.

The catch is that these markets for corporate responsibility require a baseline level of transparency.  Public disclosures by corporations can expose antisocial practices (which may then be the subject of protest), permit employees to compare working conditions and wage data, and allow competitors to identify monopoly rents and opportunities for innovation.  Transparency also makes legal systems more effective: Firms known to have adopted unsavory business practices may attract scrutiny from regulators, inspiring more precise legal prohibitions or simply a greater enforcement effort.  Corporate secrecy, by contrast, permits antisocial practices to thrive. Yet under our current regulatory regime, only companies that choose to sell their securities to the public are subject to generalized disclosure obligations – and even then, only as to matters that are material to an investor audience.

America’s peculiar system of tying generalized corporate disclosure requirements exclusively to public investment is the result of a series of historical compromises.  Both in the Progressive Era, and again during the 1970s, activists, scholars, and politicians sought to enact corporate disclosure schemes in order to make businesses more accountable to society at large.  Each time, these efforts were redirected towards investor audiences, in the expectation that investors could serve as a proxy for the broader society.

It is now evident that the compromise carried with it the seeds of its own destruction.  Both Congress and the SEC have concluded that the giant institutional investors who dominate contemporary markets require fewer regulatory protections, and they have concomitantly made it easier for issuers to raise capital without becoming subject to mandatory disclosure requirements.  The result is that modern businesses can grow to enormous proportions while shielding the details of their operations from public scrutiny.  Meanwhile, the fact that corporations have generalized disclosure obligations only to investor audiences helps make investors, rather than other constituencies, the central object of corporate concern.  Even if the public demands information about firms’ environmental impact, their treatment of workers, their political activity, and their use of customer data, corporations are under no obligation to provide it absent a showing of relevance to an investor audience.  Investors can then use their informational advantage to influence business decisions, while other stakeholders are left weakened and unprotected.  The result is new demands for corporate accountability to non-investor constituencies.

I therefore recommend that we explicitly acknowledge the importance of disclosure for these stakeholder audiences and design a regulatory regime geared to their interests.  The assumption – stated or unstated – that all public disclosure must necessarily run through the securities laws has distorted the discourse for decades.  There has been little, if any, discussion of the informational needs of the general public, while advocates for myriad causes overburden the SEC with a flood of requests for disclosure of information relevant to their own idiosyncratic interests.  A requirement that large corporations operate with a certain baseline level of public transparency would help align shareholder and stakeholder interests, free the SEC to focus on the needs of investors alone, and ensure a level informational playing field between “public” and “private” companies, thus encouraging more companies to conduct public offerings in the first place.

This post comes to us from Associate Professor Ann M. Lipton at Tulane Law School. It is based on her recent article, “Not Everything is About Investors: The Case for Mandatory Stakeholder Disclosure,” available here.

Categories
Corporate Governance Securities Regulation

Economic Consequences of Corporate Governance Disclosure

Related party transactions (RPTs) refer to a transfer of resources, services, or obligations between a reporting entity and a related party and usually offer insiders a way to expropriate wealth from other investors via self-dealing. Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) require detailed disclosure of material RPTs in annual reports and proxy statements. However, none of these regulators provided specific guidance on firms’ corporate governance related to ensuring that RPTs work in the best interest of the firm and its stakeholders. Investors were often kept in the dark on whether the firm had an RPT governance policy, and how RPTs were reviewed and approved in the firm.

To facilitate investors’ assessment of the potential conflict of interest arising from RPTs, in 2006 the SEC amended its regulations for RPT disclosures by issuing a document titled Executive Compensation and Related Person Disclosure. This document includes a new requirement to disclose RPT governance, including material features of RPT governance policies and procedures (hereafter, RPT governance policies). Specifically, the disclosures should include (1) a statement of whether such policies are in writing and, if not, how they are evidenced; and (2) the persons or groups of persons on the board of directors or otherwise who are responsible for administering the policies. Additionally, the new regulation requires firms to disclose the types of transactions that are covered by the RPT governance policies, the standards to be applied pursuant to such policies, and any transactions that do not follow these policies.

This 2006 SEC document includes amendments to both compensation disclosures and governance disclosures. Although some studies have examined the consequence of the changes in compensation disclosures, the consequences of the changes in RPT governance disclosures have received little attention. In a recent paper, we investigate the economic consequences of the SEC regulation from two perspectives: (1) does the mandatory disclosure of RPT governance change firms’ RPT behaviors; and (2) does the mandatory disclosure of RPT governance help reduce investors’ perceived risks on RPTs?

Before 2006, only a few firms voluntarily disclosed how they monitor their RPTs.  In contrast, the 2006 SEC regulation requires that all firms disclose their RPT governance, representing an exogenous increase in RPT governance disclosure. We define firms that voluntarily disclosed their RPT governance before the 2006 regulation as already-disclosed firms (Control Group) and firms that initiated RPT governance disclosure after the 2006 regulation as newly-disclosed firms (Treatment Group). Because the already-disclosed firms have voluntarily disclosed their RPT governance prior to 2006, we expect that the impact of the 2006 regulation on the already-disclosed firms, on average, is significantly less than that on the newly-disclosed firms.

The conflict-of-interest view considers RPTs as a potentially harmful form of expropriating wealth from shareholders. The 2006 regulation improves internal monitoring because these mandatory disclosures help enhance the implicit contracting between the board and the firm as well as the contracting between firms and investors, thereby mitigating potential opportunistic behaviors of insiders. Consequently, we predict that the mandatory disclosure of RPT governance leads to a lower level of RPTs and lower cost of capital associated with RPTs. We further hypothesize that such effects are more pronounced for firms with weaker corporate governance ex ante (hereafter “low-monitored firms”) and for RPTs that are more likely to represent opportunism.

To test these hypotheses, we hand collect information regarding RPTs and RPT governance for all S&P 1500 non-financial firms from annual proxy statements for fiscal years 2004, 2007, and 2010. We find that, after the 2006 regulation, newly-disclosed firms significantly reduce RPT activities relative to already-disclosed firms. We also find that there is a significant reduction in the implied cost of capital (ICC) for newly-disclosed firms.

Using five proxies for board independence and monitoring incentives, we find evidence that changes in RPTs and ICC are more pronounced for low-monitored firms, suggesting that the effects are associated with the strength of corporate governance. Recognizing that not all RPTs are prone to opportunistic behaviors, we group RPTs into Business RPTs and Non-Business RPTs and find that the SEC regulation leads to more reduction in Non-Business RPTs, which is consistent with the conflict of interest theory.

Firms’ RPT governance varies with respect to whether it is in written form, who is the party responsible for reviewing and approving RPTs, and the extent of (long or short) RPT governance disclosures. Such choices made by the firm could have different consequences on investors’ perception of RPT risks. Hence, in additional analyses, we examine firms’ choices of RPT governance policy in the post-regulation period and assess whether such choices are associated with investors’ adjustment in ICC. We find that investors put a significantly lower RPT risk premium on firms with a written RPT policy, with a formal committee to review RPTs, and with a more extensive RPT governance disclosure, suggesting that RPT firms benefit from creating or maintaining strong RPT governance policies.

In sum, we find that the disclosure of RPT governance policies significantly reduces the occurrence of RPTs and the implied cost of equity capital associated with RPTs. Such changes are associated with strength of board monitoring, types of RPTs, and actual RPT governance policies. All findings suggest that the initiation of RPT governance disclosure required by the regulation significantly enhances firms’ RPT governance, and the quality of firms’ RPT governance matters to investors.

This post comes to us from  Professor Ole-Kristian Hope at the University of Toronto’s Rotman School of Management and Professor Haihao Lu at the University of Waterloo. It is based on their recent paper, “Economic Consequences of Corporate Governance Disclosure: Evidence from the 2006 SEC Regulation on Related-Party Transactions,” available here.  

Categories
Securities Regulation

The Readability of Company Responses to SEC Comment Letters

The Securities and Exchange Commission published its Plain English Handbook in 1998 with a goal of promoting “clearer and more informative disclosure documents” (SEC 1998).  Warren Buffet authored the preface, where he states, in part:

For more than forty years, I’ve studied the documents that public companies file. Too often, I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said. If corporate lawyers and their clients follow the advice in this handbook, my life is going to become much easier. (SEC 1998).

Consistent with the SEC’s goal, a number of studies provide evidence suggesting that more readable disclosures facilitate information processing by investors and other market participants.  For example, Lee (2012) finds that less readable 10-Q reports impede the market response to earnings news, suggesting that low disclosure readability could contribute to post earnings announcement drift.  Similarly, Lehavy, Li, and Merkley (2011) find that less readable 10-K filings are associated with greater analyst forecast dispersion and lower analyst forecast accuracy, suggesting that less readable disclosures are associated with greater user uncertainty.

In a study forthcoming in Review of Accounting Studies, we investigate the implications of the readability of the language used by companies to respond to SEC comment letters that reference 10-K filings.  Sarbanes-Oxley Section 408 formalizes the SEC’s filing review process and requires the SEC to review each registrant’s filings at least once every three years. SEC comment letters are issued when the SEC identifies issues where a company “can improve its disclosure or enhance its compliance with the applicable disclosure requirements.”[1] Companies are required to respond to the comments that are raised in the SEC’s initial letter until the SEC is satisfied – company responses could include the company providing additional information to the SEC or offering to restate filings or amend disclosures. The full conversation between the SEC and the company is made available to the public shortly after the SEC issues the “no further comments” letter.

Relative to prior work that investigates various implications of disclosure readability, our setting offers important empirical advantages because the disclosures we investigate (company responses to SEC comment letters) are preceded by a prompt (the initial set of comments from the SEC). The availability of the prompt allows us to control for a number of contextual factors and better isolate the effects of disclosure readability from the effects of disclosure content. This is a difficult task where disclosures are not preceded by a prompt (e.g., earnings announcements, 10-K filings, etc.).

Our models include controls for the readability of the SEC’s initial comment letter, the readability of the referenced 10-K filing, the number of comments in the SEC’s initial comment letter, the number of filings referenced in the SEC’s initial comment letter, several additional contextual factors derived from the SEC’s initial letter, and several company and auditor characteristics. Using multiple measures of disclosure readability (the Bog index, the Fog index, and the Flesch Reading Ease index), we find consistent evidence that less readable company responses are associated with longer SEC processing times (days from the company response to the subsequent letter from the SEC) and a higher incidence of restatements and amendments stemming from the filing review.

Collectively, our results suggest that comment letter outcomes are less favorable when companies write less readable responses to SEC comment letters. More generally, our results suggest that readability is an important component of corporate disclosures and that companies should strive to follow the SEC’s guidance on the use of plain English.

Despite the empirical advantages of our setting, we acknowledge that concerns about the effects of unobservable factors (e.g., omitted variables, strategic obfuscation, etc.) persist. Thus, we encourage future work that exploits settings that facilitate the investigation of the link between disclosure readability and various corporate outcomes.

ENDNOTE

[1] See https://www.sec.gov/divisions/corpfin/cffilingreview.htm for more information about the Filing Review Process.

REFERENCES

Lee, Y‐J. 2012. The effect of quarterly report readability on information efficiency of stock prices. Contemporary Accounting Research 29 (4): 1137–1170.

Lehavy, R., F. Li, and K. Merkley. 2011. The effect of annual report readability on analyst following and the properties of their earnings forecasts. The Accounting Review 86 (3): 1087–1115.

SEC: Securities and Exchange Commission. 1998. A Plain English Handbook: How to Create Clear SEC Disclosure. SEC Office of Investor Education and Assistance. Washington, D.C.: Government Printing Office.

This post comes to us from professors Cory A. Cassell at the University of Arkansas, Lauren M. Cunningham at the University of Tennessee, and Ling Lei Lisic at Virginia Tech. It is based on their recent article, “The Readability of Company Responses to SEC Comment Letters and SEC 10-K Filing Review Outcomes,” available here.

 

Categories
Securities Regulation

Do Managers Bias Earnings Forecasts in Response to Current Earnings Surprises?

Each quarter, managers provide a summary of their firm’s accounting performance – a disclosure known as a quarterly earnings announcement. Earnings announcements attract significant attention from investors and media outlets because, if earnings are different than market expectations, stock price will change and financial analysts will revise their forecasts of future earnings. These effects are magnified if investors and analysts view the current earnings as persistent.  Managers are therefore justifiably concerned with the extent to which current earnings fall in line with market expectations, and the extent to which investors and analysts view any differences as being persistent.

To assist the assessment of whether current earnings will persist into the future, managers often issue their own forecast of future earnings in the press release or during the conference call that occurs shortly after the current earnings release. Our research study (Baginski, Campbell, Ryu, and Warren 2019) examines if managers use these forecasts of future earnings strategically to influence investors’ interpretation of the current earnings news. We offer three main findings. First, managers tend to release forecasts with their firm’s earnings announcement that turn out to be optimistically biased (i.e., the forecast is higher than what actual future earnings turns out to be) to offset bad current earnings announcement news. Second, managers tend to release forecasts that are pessimistically biased to offset simultaneously released large good current earnings news. We also find that managers engage in more of this behavior when they (1) have more flexibility to insert bias into their forecasts without being detected and (2) have greater career concerns. Finally, we find that, initially, market participants are unable to fully identify the bias that managers insert into their forecasts, but that investors eventually figure it out as news about future performance begins to arrive.

It is intuitive why managers would not want to release bad current earnings announcement news. Specifically, bad earnings news is associated with negative stock price responses and increased likelihood of termination. Thus, if earnings are below expectations, managers have an incentive to soften the blow of the bad news by altering investor assessments of the persistence of the bad news. We find that managers strategically soften the blow by providing an optimistically biased forecast with the bad current earnings news. However, what may be less intuitive is why managers wish to offset large good current earnings news. Notably, exceeding expectations by a large amount can be problematic for two reasons. First, investors perceive managers to be higher quality when they oversee a smooth and persistence earnings trend (Beyer, Cohen, Lys, and Walther 2010), and abnormally large unexpected earnings decrease the smoothness of earnings. Second, managers face pressure to meet or beat market expectations in each period (Brown and Caylor 2005; Bartov, Givoly, and Hayn 2002; Graham, Harvey, and Rajgopal 2005), and abnormally high earnings in the current period are more likely to elevate expectations of next period’s earnings to a level that is not beatable. Consistent with these incentives, we find that managers also strategically offset large good current earnings news by providing pessimistically biased forecasts along with the good news.

Prior academic research suggests that when managers must disclose bad news, they tend to selectively disclose other good news to offset it. However, two things have been left unaddressed. First, prior work does not speak to whether the good news used to offset the bad news is real (i.e., consistent with economic reality), or rather inserted with optimistic bias. Our study suggests that managers strategically bias these good news disclosures to offset the simultaneously released bad earnings announcements. Second, prior research does not examine whether managers also attempt to offset good news disclosures. Our study suggests that managers also strategically insert pessimistic bias to offset abnormally good earnings announcements.  

Overall, our study provides evidence that the simultaneous release of multiple earnings signals can affect the extent to which the disclosure is forthcoming. In recent years, almost 90 percent of management forecasts are disclosed with the earnings announcement (Gong, Li, and Xie 2009; Billings, Jennings, and Lev 2015). By documenting that current earnings news can prompt managers to bias their forecasts, we provide evidence of an alternative to managing earnings directly to avoid bad earnings news in mandatory earnings reports (e.g., Burgstahler and Dichev 1997; Degeorge, Patel, and Zeckhauser 1999; Roychowdhury 2006) or biasing pro forma earnings to influence investor perceptions (Black, Christensen, Joo, and Schmardebeck 2017).

REFERENCES

Baginski, Steve, John Campbell, Patrick Ryu, and James Warren. 2019. “Do Managers Bias their Forecasts of Future Earnings in Response to their Firm’s Current Earnings Announcement Surprises?” Working paper, University of Georgia.

Bartov, Eli, Dan Givoly, and Carla Hayn. 2002. “The Rewards to Meeting or Beating Earnings

Expectations.” Journal of Accounting & Economics 33 (2): 173–204.

Beyer, Anne, Daniel A. Cohen, Thomas Z. Lys, and Beverly R. Walther. 2010. “The Financial Reporting Environment: Review of the Recent Literature.” Journal of Accounting & Economics 50 (2/3): 296–343.

Billings, Mary, Robert Jennings, and Baruch Lev. 2015. “On Guidance and Volatility.” Journal of Accounting & Economics 60 (2/3): 161–80.

Black, Ervin L., Theodore E. Christensen, T. Taylor Joo, and Roy Schmardebeck. 2017. “The Relation Between Earnings Management and Non- GAAP Reporting.” Contemporary Accounting Research 34 (2): 750–82.

Brown, Lawrence D., and Marcus L. Caylor. 2005. “A Temporal Analysis of Quarterly Earnings Thresholds: Propensities and Valuation Consequences.” Accounting Review 80 (2): 423–40.

Burgstahler, David, and Ilia Dichev. 1997. “Earnings Management to Avoid Earnings Decreases and Losses.” Journal of Accounting & Economics 24 (1): 99.

Degeorge, François, Jayendu Patel, and Richard Zeckhauser. 1999. “Earnings Management to Exceed Thresholds.” The Journal of Business 72 (1): 1–33.

Graham, John R., Campbell R. Harvey, and Shiva Rajgopal. 2005. “The Economic Implications of Corporate Financial Reporting.” Journal of Accounting & Economics 40 (1–3): 3–73.

Gong, Guojin, Laura Yue Li, and Hong Xie. 2009. “The Association between Management Earnings Forecast Errors and Accruals.” Accounting Review 84 (2): 497–530.

Roychowdhury, Sugata. 2006. “Earnings Management through Real Activities Manipulation.” Journal of Accounting & Economics 42 (3): 335–70.

This post comes to us from professors Stephen P. Baginski and John L. Campbell at the University of Georgia, and from Patrick Ryu and James Warren, who are PhD candidates at the University of Georgia. It is based on their recent paper, “Do Managers Bias their Forecasts of Future Earnings in Response to their Firm’s Current Earnings Announcement Surprises?” available here.

Categories
Securities Regulation

Gibson Dunn Offers 2019 Mid-Year Securities Enforcement Update

The first half of 2019 has seen a continuation of the Securities and Exchange Commission’s emphasis on protecting the interests of Main Street investors. Chairman Clayton reiterated these themes in his testimony in May before the Financial Services and General Government Subcommittee of the U.S. Senate Committee on Appropriations.[1] In addition to the no less than 43 references to Main Street investors, the Chairman’s testimony highlighted: (1) the Retail Strategy Task Force, formed in 2017, to use data-driven strategies to generate leads for investigation of industry practices that could harm retail investors, as well as (2) the mutual fund share class initiative as an example of returning funds to retail investors through a program to incentivize self-reporting and cooperation. To be sure, the Commission brought a number of enforcement actions focusing on various offering frauds, often with themes related to some form of cryptocurrency or digital asset.[2] The Chairman also noted in his Congressional testimony that the Commission’s FY 2020 budget request contemplates adding add six positions to the Commission’s investigations of conduct affecting Main Street investors.

On June 5, 2019, the SEC adopted a set of rules intended to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers.[3] The new “Regulation Best Interest” requires broker-dealers to act in the best interest of a customer when making recommendations for securities transactions or investment strategies to a retail consumer. This means broker-dealers may not place the financial or other interests of the broker-dealer ahead of the customer. In order to satisfy the fiduciary obligations required by Regulation Best Interest, broker-dealers must: (1) make certain disclosures regarding any conflicts of interest; (2) exercise reasonable diligence, care, and skill in making recommendations; (3) maintain policies and procedures designed to address conflicts of interest; and (4) maintain policies designed to achieve compliance with the regulation.[4] Regulation Best Interest takes effect on September 10, 2019. Firms will have until June 30, 2020 to comply with the regulation.

Full Commission and Other Senior Staffing Updates

During the first six months of this year, there were a number of leadership changes, several of which reflect the advancement of lawyers with many years of experience in the Division of Enforcement to positions of senior leadership.

On June 20, the U.S. Senate confirmed Allison Lee to serve as the fifth Commissioner with a term ending in 2022. Commissioner Lee was sworn in on July 8, bringing the Commission back to its full complement of Commissioners. Commissioner Lee replaces prior Democratic Commissioner Kara Stein. Commissioner Lee previously served at the Commission for over a decade, including as counsel to Commissioner Stein, as well as a Senior Counsel in the Complex Financial Instruments Unit of the Division of Enforcement. How long the full Commission will last is uncertain as there have been reports that Commissioner Robert Jackson, the only other Democratic Commissioner, may be stepping down in the near future to return to teaching and NYU Law School. Commissioner Jackson has not commented on his plans.

Other changes in the senior staffing of the Commission include:

  • In June, David Peavler was appointed Director of the Fort Worth Regional Office. Mr. Peavler rejoined the SEC after serving two years as the General Counsel of HD Vest Inc. He previously worked for 15 years in the Division of Enforcement in the SEC’s Fort Worth Regional Office.
  • In May, Erin Schneider was appointed Director of the San Francisco Regional Office. Ms. Schneider joined the Commission in 2005 as a Staff Attorney in the Division of Enforcement in the San Francisco Office, became an Assistant Director in the Asset Management Unit in 2012 and an Associate Director in the San Francisco Office in 2015.
  • Also in May, Adam Aderton was appointed Co-Chief of the Asset Management Unit of the Division of Enforcement. Mr. Aderton joined the Commission as a staff attorney in the Division of Enforcement in 2008, joined the Asset Management Unit in 2010, and became an assistant Director of the Unit in 2013.

More broadly, until recently, the Commission had been subject to a hiring freeze which led to an approximately 10% decline in staffing both in the Enforcement Division and the Commission overall. Under its FY 2019 budget, the Commission has been able to resume some hiring, but not sufficient to restore staffing levels to their prior levels. Accordingly, the Enforcement Division will continue to endeavor to accomplish more with less for the foreseeable future.

Change to Commission Practice on Consideration of Settlement Offers with Waiver Requests

On July 3, Chairman Jay Clayton announced a change in the process by which the Commission will consider settlement offers from prospective defendants who are also seeking a waiver from a regulatory disqualification that would be triggered by the settlement.[5]  In effect, the new policy actually restores Commission practice to what it had been historically, prior to a change under the last administration, and represents a much-needed, common sense improvement to the Commission’s settlement process.

The issue arises when negotiating a settlement that triggers a regulatory disqualification.  The client can request a waiver from the disqualification.  However, the last administration had revoked the authority previously delegated to the regulatory divisions to decide waivers and required a party to make an unconditional offer of settlement without assurance as to whether the Commission would grant the waiver.  This meant that a party could be bound to a settlement that triggered a disqualification without assurance of receiving a waiver.  In some cases, the risk was significant.

Under the new policy, the Commission will still be the decision-maker on waivers, but will consider the settlement offer and waiver request simultaneously and as a single recommendation.  Most important, if the Commission approves the settlement offer, but not the waiver, the party could withdraw the settlement offer and will not be bound by the offer.

As the Chairman’s statement explains:

… an offer of settlement that includes a simultaneous waiver request negotiated with all relevant divisions . . . will be presented to, and considered by, the Commission as a single recommendation from the staff. . . . [I]n a matter where a simultaneous settlement offer and waiver request are made and the settlement offer is accepted but the waiver request is not approved in whole or in part, the prospective defendant would need to promptly notify the staff (typically within a matter of five business days) of its agreement to move forward with that portion of the settlement offer that the Commission accepted. In the event a prospective defendant does not promptly notify the staff that it agrees to move forward with that portion of the settlement offer that was accepted (or the defendant otherwise withdraws its offer of settlement), the negotiated settlement terms that would have resolved the underlying enforcement action may no longer be available and a litigated proceeding may follow.

In sum, under the new procedure, parties will simply receive the same benefit as any settling party – certainty, finality and the clarity of knowing the full consequences of their offer to settle.

Whistleblower Awards Continue

The Commission continued to issue significant awards to whistleblowers for providing information that led to financial recoveries in enforcement actions. As of June 2019, the SEC has awarded over $384 million to 64 whistleblowers since the program began in 2012.[6]

In March, the Commission announced a pair of awards totaling $50 million to two whistleblowers (one for $37 million and another for $13 million).[7] The $37 million award was the Commission’s third highest award. One of the awards was notable because the Commission finding in its order that the claimant had “unreasonably delayed in reporting the information to the commission,” and had “passively financially benefitted from the underlying misconduct during a portion of the period of delay.”[8]

In May, for the first time, the SEC issued an award under a provision of the whistleblower rules which permits claims by whistleblowers who first report a tip to a company if the whistleblower also reports the same tip to the SEC within 120 days.[9] In this case, the whistleblower sent an anonymous tip to the company, as well as to the SEC. The whistleblower’s report triggered an internal investigation by the company, which resulted in the company reporting its findings to the SEC, resulting in an SEC investigation and action. In calculating the award, the SEC credited the whistleblower “for the company’s internal investigation, because the allegations were reported to the Commission within 120 days of the report to the company.” The whistleblower was awarded more than $4.5 million.

In June, the SEC announced an award of $3 million to whistleblowers for a tip that led to the successful enforcement action related to “an alleged securities law violation that impacted retail investors.”[10]

The key takeaway from these awards is that they provide powerful financial incentives to would be whistleblowers to report suspicions of misconduct – real or perceived – to the Commission staff. The financial incentives and anti-retaliation protections for whistleblowers put a premium on companies implementing a rigorous, proactive and documented response to internal complaints to protect against second-guessing by regulators and prosecutors.

Last year, in Digital Realty Trust v. Somers, the Supreme Court held that Dodd-Frank’s anti-retaliation measures protect only whistleblowers who report their concerns to the SEC and not those who only report internally.[11] In response to the Supreme Court’s decision, on May 8, 2019, the House Committee on Financial Services passed the Whistleblower Protection Reform Act of 2019, H.R. 2515, which would extend the anti-retaliation protections in Dodd-Frank to whistleblowers who report alleged misconduct to a superior.[12]

Notable Litigation Developments

There were a number of litigation developments of note during the first half of this year.

In Lorenzo v. SEC, the Supreme Court held that an individual who is not a “maker” of a misstatement may nonetheless be held primarily liable under Rule 10b-5(a) and (c) for knowingly “disseminating” a misstatement made by another person.[13]  The decision refines the Court’s 2011 decision in Janus v. First Derivative Traders, in which the Court held that liability under Rule 10b-5(b) for a misstatement only extent to the “maker” of a statement which is the “person or entity with ultimate authority over the statement.”

The impact of the Lorenzo decision for Commission enforcement actions may be more academic than practical because the Commission has the ability to bring actions for secondary liability for aiding and abetting or causing a violation by another party.  Nevertheless, Commissioner Hester Peirce has cautioned against the Commission’s use of Lorenzo to expand so-called “scheme” liability beyond the bounds of secondary liability.[14]  The practical import of the decision for private civil litigation may be more significant, since, in the absence of secondary liability, private plaintiffs may be able to craft broader allegations of primary liability against defendants based on their participation in a “device, scheme, or artifice to defraud” under Rule 10b-5(a) or an “act, practice or course of business” that “operates … as a fraud or deceit” under Rule 10b-5(c).

In Robare Group, Ltd. v. SEC, the U.S. Court of Appeals for the D.C. held that a “willful” violation of Section 207 of the Investment Advisers Act of 1940 requires more than proof of mere negligence, even though negligence may be sufficient to establish a violation under Section 206(2) of the Advisers Act.  The decision represents a change from the holding in a 2000 decision by the same court in Wonsover v. SEC, which held that “willfully” means “intentionally committed the act with constitutes the violation” but does not require that “the actor…be aware that he is violating” the law.  In Robare, the court clarified that the willfulness standard could not be met by proof of merely negligent conduct.

Historically, in cases in which parties settle to Commission orders finding willful violations, the settled order often contained a footnote articulating the Wonsover standard of willfulness.  Notably, despite the decision in Robare, the Commission has continued to use the Wonsover formulation.[15]  In the long term, the Commission will likely seek to reconcile the Robare and Wonsover decisions.  In the near term, the Robare decision potentially provides prospective defendants with additional arguments to oppose alleged violations of statutory provisions that require proof of willfulness, and as a consequence, to avoid forms of relief that turn on findings of willful violations.

Finally, over the years, the Commission been continually challenged to conduct investigations and either resolve or commence actions in a timely manner.  In addition, all investigative and prosecutorial agencies have been subject to criticism at various times for “piling on” with seemingly duplicative investigations and enforcement actions in high profile matters.  This year, the Commission’s late arrival to an already crowded regulatory party has become the subject of an unusually pointed judicial inquiry in the Commission’s litigation against Volkswagen.  The Commission filed the action in March 2019, years after the company had already resolved actions by other federal and state governments as well as private civil actions.  In a quote that will likely resonate for some time to come, the court questioned the Commission’s delay in bringing the action and reminded counsel that “the symbol of the SEC is the symbol … of the eagle, not a carrion hawk that simply descends when everything is all over and sees what it can get from the defendant.”  In an unusual step, the court order the Commission to file a declaration stating when the Commission learned of the facts alleged in each paragraph of the 69-page complaint.  On July 8, the Commission filed its submission which seeks to explain the various challenges the Commission faced in its investigation, including delays in obtaining evidence from abroad, that led to the timing of the agency’s action.  Regardless of the outcome of this particular case, perhaps the court’s commentary will lead investigative agencies to undertake a more thoughtful approach to the need to add to multi-agency investigations.

Legislative Response to Supreme Court’s Kokesh Decision

In 2018, in Kokesh v. SEC, the Supreme Court held that a 5-year statute of limitations applies to the Commission’s ability to recover disgorgement of ill-gotten gains from defendants.  In a footnote to the unanimous decision, the Court somewhat cryptically suggested that the Commission’s authority to obtain disgorgement may not be entirely without question.  In particular the Court stated that the decision was limited to the applicability of the statute of limitations, and not reaching the issue of “whether courts possess authority to order disgorgement in SEC enforcement proceedings….”  In its 2018 annual report, the Enforcement Division estimated the Kokesh decision may cause the Commission may forego up to $900 million in disgorgement claims.

The issue of the SEC’s ability to obtain disgorgement is a question that continues to play out in lower courts.  Thus far, the Second Circuit and district courts within the Second Circuit have upheld disgorgement awards post-Kokesh, finding disgorgement to be a proper equitable remedy.[16]  The meaning of Kokesh is also being hashed out in cases involving regulators other than the SEC, such as the CFTC.  For example, in a case from May of this year, a district court found that, contrary to the defendants’ reading of Kokesh, the amount of disgorgement to be paid to the CFTC did not need to be reduced based on costs incurred by the defendants in the commission of their violations.[17]

In March of this year, Senators Mark Warner (D-Va) and John Kennedy (R-La) introduced a bipartisan bill designed to address the concerns sounded by the Commission in the wake of Kokesh.  Titled the Securities Fraud and Investor Compensation Act, the bill would provide explicit statutory authority for the Commission to obtain disgorgement for gains actually received or obtained by a defendant, subject to a 5-year statute of limitations.  Of potentially greater consequence, however, the bill would also authorize the Commission to obtain restitution of losses sustained by investors caused by defendants in the securities industry, such as broker-dealers and investment advisers, and create a 10-year statute of limitations for equitable relief, including restitution, injunctions, bars and suspensions.

Historically, the Commission has not sought to advance an argument for restitution in court.  It is not uncommon for the financial benefit to a defendant to be far less that the alleged harm incurred by an arguable class of victims.  Consequently, for many defendants, the risk of restitution could represent a substantial increase in the potential exposure created by an enforcement action.  As of this writing, the bill has not advanced.

Litigation Challenge to the “Neither-Admit-Nor-Deny” Settlement

The “neither admit nor deny” settlement has long been a staple of the Commission’s enforcement program.  Specifically, prospective defendants typically settle enforcement actions by consenting to either issuance of a Commission order containing findings, or the entry of a civil judgment based on a complaint containing allegations, to which the proposed defendant neither admits nor denies.  Under the prior administration, the Commission had adopted a policy of requiring admissions in certain exceptional cases.  Nevertheless, the neither admit nor deny formulation remained the predominant settlement formulation.

Importantly, as a corollary to not being required to admit to any findings or allegations, parties are also prohibited from denying the findings or allegations.  The requirement is spelled out in a regulation adopted in 1972:

The Commission has adopted the policy that in any civil lawsuit brought by it or in any administrative proceeding of an accusatory nature pending before it, it is important to avoid creating, or permitting to be created, an impression that a decree is being entered or a sanction imposed, when the conduct alleged did not, in fact, occur. Accordingly, it hereby announces its policy not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegations in the complaint or order for proceedings. In this regard, the Commission believes that a refusal to admit the allegations is equivalent to a denial, unless the defendant or respondent states that he neither admits nor denies the allegations.

17 C.F.R. § 202.5(e).

The requirement is also contained in the form of settlement offer executed by a settling party:

Defendant understands and agrees to comply with the Commission’s policy “not to permit a defendant or respondent to consent to a judgment or order that imposes a sanction while denying the allegation in the complaint or order for proceedings.” 17 C.F.R. § 202.5. In compliance with this policy, Defendant agrees not to take any action or to make or cause to be made any public statement denying, directly or indirectly, any allegation in the complaint or creating the impression that the complaint is without factual basis. . . . .  If Defendant breaches this agreement, the Commission may petition the Court to vacate the Final Judgment and restore this action to its active docket.

In a lawsuit filed in January of this year, the Cato Institute is challenging the constitutionality of the so-called “gag rule” as a violation of a defendant’s right to free speech under the First Amendment.[18]  The Cato Institute’s interest in the issue is grounded on its desire to publish a manuscript by a party who settled a Commission enforcement action.  According to the Cato Institute’s complaint, the manuscript describes what the author believes to be the Commission’s overreach in coercing the author into a settlement despite the author’s belief that the charges were without merit in order to avoid crippling litigation expenses.  The complaint alleges that the regulation and policy constitutes an unconstitutional content-based restriction on speech.

Not surprisingly, the Commission filed a motion to dismiss the complaint in May, arguing, among other things, that the plaintiff’s action was flawed in three key ways: (1) the Cato Institute lacked standing under Article III because it was challenging a contract reviewed, approved and entered by a district court—a contract to which the plaintiff was neither a party nor an intended beneficiary; (2) the court lacked jurisdiction on ripeness grounds because the plaintiff’s claims were premised upon speculation about future events that would implicate other courts’ authority, in effect asking the court to invalidate no-deny provisions in every single past consent judgment, regardless of whether all past settling defendants wanted this outcome;  and (3) the Cato Institute did not state a First Amendment claim because the no-deny provisions were negotiated provisions and were not imposed against a defendant’s free will.  The Commission further asserted that there were compelling interests that would justify these no-deny provisions, such as avoiding investor and market confusion and deterring future defendants.

The Cato Institute opposed the Commission’s motion to dismiss, arguing that the Commission’s no-deny provisions amounted to a lifetime ban on speech, and former SEC defendants who want to complain about the SEC’s conduct in their cases are unable to do so because of these provisions.  The Cato Institute asserted three main arguments in response to the Commission’s motion to dismiss: (1) the Cato Institute has standing as a would-be publisher because it is currently required to abstain from constitutionally protected speech; (2)  the court could adjudicate the instant claims without invading the jurisdiction of any other court; and (3) the unconstitutional-conditions doctrine applies to this matter and therefore the Cato Institute has properly pleaded a justiciable claim under the First Amendment.

Needless to say, the lawsuit has had no impact whatsoever on the Commission’s continued practice of settling actions on a neither-admit-nor-deny basis.

Public Company Disclosure, Accounting and Audit Cases

Internal Controls

In late January, the SEC announced a settlement with four public companies based on the companies’ alleged failure to maintain adequate internal controls over financial reporting (“ICFR”).[19]  The SEC alleged that, although the companies disclosed material weaknesses in their ICFR, the took months or years to remedy the issues, including after SEC staff notified the companies of the issues.  Without admitting or denying the allegations, all four companies agreed to a cease and desist order and to pay civil penalties Ranging from $35,000 to $200,000.  One company, a Mexican steel manufacturer and processor, continues to remediate material weaknesses and, as part of the settlement, has undertaken to have an independent consultant to review the remediation.

Company Disclosures Concerning the Business

In March, the SEC instituted a settled action against a U.S. home improvement company based on allegations that the company made misstatements regarding its products’ compliance with regulatory standards.[20]  Following a media report on certain of the company’s products in 2015, the company stated that third-party test results demonstrated its products were in compliance with regulatory standards.  The company also stated that individuals featured in the media reporting were not employees of the company’s suppliers.  The SEC alleges that the company knew that one of its Chinese suppliers had failed third-party testing and had evidence that the individuals featured in the media reporting were employees of the company’s suppliers.  Without admitting or denying the findings in the SEC’s order, the company agreed to pay a $6 million penalty.  On the same day the SEC instituted its settled action, the Department of Justice announced that the company entered into a deferred prosecution agreement and agreed to pay $33 million in forfeiture and criminal fines.

As discussed above in our introductory section, in March of this year, the SEC filed an unsettled complaint against a car manufacturer, two of its subsidiaries, and its former CEO for alleged misstatements concerning the compliance of the company’s vehicles with emissions standards at a times when the company issues bonds and asset backed securities.[21]  The complaint alleges that the misstatements enabled the company to issue bonds as a lower interest rate than otherwise.  As discussed above, the litigation remains pending.

Financial Reporting Cases

In early April, the SEC brought a settled action against the founder and former CEO of a Silicon Valley mobile payment startup based on allegations that he overstated the company’s revenues and then sold shares he owned to investors in the secondary market.[22]  The former CEO agreed to settle the charges without admitting wrongdoing, agreeing to pay more than $17 million in disgorgement and penalties and to be barred from serving as an officer or director of a publicly traded U.S. company.  The SEC instituted a separate settled administrative action against the company’s former CFO for based on allegations that he failed to exercise reasonable care in the company’s financial statements and signed stock transfer agreements that inaccurately implied that the company’s board of directors had approved the CEO’s stock sales.  The CFO, who had also sold some of his shares in the company, entered into a cooperation agreement with the SEC and, in connection with his settlement, agreed to pay approximately $420,000 in disgorgement and prejudgment interest.

Also in April, the SEC filed an unsettled action against the former CFO and two former employees of a publicly traded transportation company.[23]  The SEC’s complaint alleges that the former CFO hid expenses and manipulated the company’s finances, while the other two employees failed to write-off overvalued assets and overstated receivables at one of the company’s operating companies.  The complaint also alleges that the defendants misled the company’s outside auditor, causing the company to misstate financial results in periodic reports filed with the SECs.  The U.S. Department of Justice’s Fraud Section also filed parallel criminal charges against the three individuals.

Later in April, the SEC instituted a settled proceeding against a Silicon Valley market place lender that, through its website, sold securities linked to performance of its consumer credit loans.[24]  According to the SEC’s administrative order, the company excluded certain non-performing charged off loans from its performance calculations reported to investors, and as a result, overstated its net returns.  Pursuant to the settlement, the company agreed to pay $3 million.

Also in April, the SEC filed a settled action against a U.S. truckload carrier with accounting fraud, books and records, and internal control violations.[25]  The SEC’s complaint alleges that the company avoided recognizing impairment charges and losses by selling and buying used trucks at inflated prices from third-parties, which enabled the company to overstate its pre-tax and net income and earnings per share in one annual and two quarterly reports.  In the settlement, the company agreed to pay $7 million in disgorgement, which is deemed satisfied by the company’s payment of restitution in settlement of a parallel action brought by the Department of Justice.  This is also one of the few settled SEC actions under this administration in which the defendant admitted to the violations alleged in the SEC’s complaint.

In May, the SEC instituted settled administrative proceedings against a New Hampshire-based manufacturer and its former CEO based on allegations that the company misled investors regarding the company’s ability to supply “sapphire glass” for Apple’s iPhones.[26]  According to the SEC’s orders, the company entered into an agreement with Apple to provide sapphire glass that met certain standards, but that the company failed to meet the standards required by the Apple contract, which triggered Apple’s right to withhold payment and accelerate a large repayment from the New Hampshire company.  Despite Apple’s exercise of this withholding and repayment, the company reported that it expected to meet performance targets and receive payment from Apple.  In settlement, the former CEO agreed to pay approximately $140,000 in disgorgement and penalties.  The company, which had since filed for, and exited from, bankruptcy as a private company, was not assessed a penalty.

Cases Against Audit Firms

In February, the SEC instituted a settled administrative proceeding against a large Japanese accounting firm and two of the firm’s former executives (the former CEO and the former Reputation and Risk Leader and Director of Independence) based on allegations that the firm violated certain provisions of the SEC’s audit independence rules.[27]  The SEC’s order alleges that the firm issued audit reports for a client notwithstanding that certain personnel within the accounting firm were aware that the client’s subsidiary maintained dozens of bank accounts for employees of the accounting firm with balances that exceeded depositary insurance limits.  The SEC’s order alleges that the firm’s quality control system did not provide reasonable measures to help ensure the firm was independent from its audit clients.  Without admitting or denying the allegations, the firm agreed to pay a $2 million penalty.  The former executives agreed to be suspended from appearing or practicing before the SEC as accountants with a right to apply for reinstatement after two years in the case of the former CEO and one year in the case of the former Reputation Risk Leader and director of Independence,

In June, the SEC instituted a settled administrative proceeding against an international accounting firm based on allegations that certain former firm personnel obtained confidential lists of inspection targets from a now former employee of the Public Company Accounting Oversight Board (PCAOB) and used the information to alter past audit work papers to reduce the likelihood of deficiencies being found during the PCAOB inspections.[28]  Last year, the SEC had previously instituted enforcement actions against the former personnel of the audit firm and the PCAOB.  The SEC’s settled order against the firm also alleges that a number of the firm’s audit professionals engaged in misconduct in connection with internal training exams.  Pursuant to the settlement, the firm agreed to pay a $50 million penalty, to retain an independent consultant to review and evaluate the firm’s quality controls relating to ethics and integrity, and other remedial measures.  The firm also admitted the facts in the SEC’s order and acknowledged that its actions violated a PCAOB rule requiring integrity.

Cases Against Investment Advisers

Representation Concerning Brokerage Commissions

In March, the SEC instituted a settled action against a dually registered broker-dealer and investment adviser in connection with the activity of a firm it had acquired.[29]  According to the SEC, the firm represented to advisory clients that they were receiving a discount off the firm’s retail commission rates.  However, according the SEC’s order, the firm did not adequately disclose that clients could have chosen other outside brokerage options at lower commission rates.  The SEC alleged that the firm charged commissions on average 4.5 times more than what clients would have paid using other brokerage options, but did not provide any additional services to advisory clients using its in-house brokerage than it did to advisory clients who chose other brokerages with considerably lower commission rates.  Without admitting or denying the findings, the firm agreed to pay approximately $5.2 million in disgorgement and prejudgment interest, and a $500,000 civil penalty.

Conflicts of Interest

In March, the SEC instituted settled proceedings against a registered investment adviser and its former Chief Operating Officer, alleging they manipulated the auction of a commercial real estate asset on behalf of one client for the benefit of another client.[30]  According to the SEC, instead of identifying bona fide bidders, the COO used the firm’s affiliated private fund client for one bid and assured two other bidders that they would not win if they participated.  According to the SEC, the selling client was thereby deprived of the ability to receive multiple genuine offers which could maximize its profit.  Without admitting or denying the findings in the order, the investment adviser agreed to pay approximately $83,000 in disgorgement and prejudgment interest, and a $325,000 civil penalty.  The former COO, without admitting or denying the findings in the order, agreed to pay a $65,000 civil penalty and a 12-month industry suspension.

Advisory Fees

In March, the SEC filed an unsettled complaint against the former Chief Operating Officer of an investment adviser for allegedly aiding and abetting the advisory firm’s overbilling of advisory clients in order to generate additional revenue and improperly inflate his own pay.[31]  The U.S. Attorney’s Office for the Southern District of New York brought accompanying criminal charges on the same day the SEC action was announced.

In May, the SEC announced a settled action against a now-defunct registered investment adviser in North Carolina alleging that the adviser overcharged clients for advisory fees, misrepresented the reason the adviser’s custodian arrangement ended (the custodian observed irregular billing practices), and overstated assets under management in Commission filings.[32]  Without admitting or denying the findings in the SEC’s order, the owner agreed to pay approximately $400,000 in disgorgement and prejudgment interest, and a $100,000 civil penalty.

Misuse of Client Funds

In March, the SEC instituted a settled administrative proceeding against a Seattle-based registered investment adviser and its principal.[33]  According to the SEC, the company’s principal misused more than $3 million from a private client fund to pay business and personal expenses, sent fraudulent account statements and tax documents to investors, overstated assets in the fund and falsely represented that the fund had undergone an independent audit.  The settled order provides that the investment adviser’s registration is revoked, the principal is barred from the securities industry, and the company and owner are liable jointly and severally for disgorgement and prejudgment interest of approximately $1.2 million, but with an allowance for offset as to the principal by the amount of any restitution ordered against him in a parallel criminal action in which he agreed to plead guilty.

Compliance Policies and Procedures

In June, the SEC instituted a settled administrative proceeding against a private fund manager and its Chief Investment Officer alleging that the manager failed to adopt and implement policies and procedures to address the risk that the traders’ pricing of illiquid mortgage-backed bonds may not conform to generally accepted accounting principles.[34]    Without admitting or denying the findings in the SEC’s order, the fund manager agreed to a civil penalty of $5,000,000 and the CIO agreed to pay a civil penalty of $250,000.

Cases Against Broker-Dealers

Cases Concerning ADRs

The SEC continued a 2018 initiative focused on investigating practices related to American Depositary Receipts (“ADR”)—U.S. securities that represent foreign shares of a foreign company and that require foreign shares in the same quantity to be held in custody at a depositary bank.  Pre-released ADRs are issued without the deposit of foreign shares, but require that either a customer owns the number of foreign shares in equal amounts to the number of shares represented by the ADRs, or that the broker receiving the shares has an agreement with a depository bank.  The SEC settled three cases involving pre-released ADRs in the first half of 2019—one in March and two in June.

In March, a broker-dealer agreed to pay more than $8 million in disgorgement and penalties to settle charges of improperly handling pre-released ADRs.[35]  According to the SEC’s order, the broker-dealer improperly borrowed pre-released ADRs from other brokers when it should have known that the middlemen did not own the foreign shares required to support the ADRs.  As a result of borrowing these pre-released ADRs, there was inappropriate short selling and other improper trading activity.

In June, the SEC settled with a broker-dealer subsidiary of a large bank, and the $42 million that the broker-dealer agreed to pay in disgorgement and penalties resulted in the largest recovery against a broker in connection with ADRs to date.[36]  In that matter, the broker-dealer improperly bought pre-released ADRs.  The SEC alleged that the broker-dealer falsely represented that the company or its customers owned the requisite number of foreign shares to justify pre-release transactions.

A few days later in June, the SEC instituted settled proceedings against a broker-dealer.  The SEC Order alleged that, for approximately two years, the firm failed to take reasonable steps to ensure that the parties who received pre-released ADRs owned the corresponding shares.  Without admitting or denying the charges, the broker-dealer agreed to pay $7.3 million in disgorgement and penalties.[37]  The Commission noted that the firm undertook voluntary remediation efforts by discontinuing pre-release activity even before the staff began its investigation.

Other Broker-Dealer Cases

The SEC also instituted several proceedings against broker-dealers unrelated to ADRs in the first half of 2019.  The SEC has filed a number of enforcement actions relating to “blank check” companies, the most recent of which was in February.  In February, the SEC announced charges against a broker-dealer, three of the firm’s principals, and a transfer agent, alleging that the firm and transfer agent helped create and sell at least 19 sham companies, and that the individuals signed the false applications and failed to investigate.[38]  According to the SEC, those charged created these “blank check” companies from 2009 to 2014.

In March, the SEC settled charges with a broker-dealer headquartered in California for allegedly failing to take appropriate measures to supervise one of its registered representatives, who was found to be involved in a pump-and-dump scheme.[39]  The SEC instituted proceedings in March 2018, since which time the firm undertook remedial measures such as revising its policies and procedures, and changes to senior leadership.  Without admitting or denying the charges, to settle the pending administrative proceeding, the firm agreed to pay a $250,000 penalty and be censured.

In May, a Manhattan jury ruled in favor of the SEC in a case in which the SEC had charged a brokerage firm and its indirect owner and president with fraud and related charges for making material misrepresentations and omissions in a financial company’s private placement offering and continuing to use the offering documents to solicit sales despite knowing they were inaccurate.[40]  The jury found the firm and individuals liable on all counts.

Insider Trading Cases

Cases Involving Lawyers

In the first half of 2019, the SEC and Department of Justice twice brought insider trading charges against attorneys who traded on nonpublic information regarding upcoming financial disclosures.  In February, the SEC filed an unsettled insider trading action against a former senior attorney at a major technology company, alleging that he traded securities in the company after reviewing confidential information regarding upcoming earnings announcements.[41]  The SEC characterized the alleged conduct as particularly serious because the attorney’s prior responsibilities included executing the company’s insider trading compliance program.  The U.S. Attorney’s Office for the District of New Jersey announced a parallel criminal complaint on the same day.

In April, the SEC filed a partially-settled insider trading action against a former senior attorney of an entertainment company, for allegedly trading on nonpublic information after reviewing confidential drafts of an earnings release showing better than expected revenues.[42]  The attorney consented to a permanent injunction, with penalties and disgorgement to be determined by the district court.  The Department of Justice filed a parallel criminal complaint on the same day.

In May, the SEC filed a settled insider trading action against a defendant who had been a houseguest of the general counsel of a company.  According to the complaint, the defendant misappropriated nonpublic information, misappropriated from the general counsel’s home office, concerning a pending merger involving the general counsel’s company, and then traded on the basis of that information in accounts in the name of his ex-wife and an ex-girlfriend.[43]  The defendant agreed to a settlement including a penalty of $253,000.  The SEC also named as relief defendants the defendant’s ex-wife and ex-girlfriend in whose accounts he had traded.  They agreed to disgorge the alleged profits of $250,000, along with prejudgment interest.

Continued Fallout from Newman Decision

In criminal insider trading cases, the impact of the Second Circuit’s 2014 ruling in United States v. Newman,[44] since abrogated in part by the Supreme Court in United States v. Salman,[45] continues to have an impact.  In Newman, the Court held that, in cases against a defendant who is a downstream tippee, the government must prove the defendant knew the insider source of the information received a personal benefit in exchange for the tip in breach of their duty of confidentiality.  In June of this year, the District Court for the Southern District of New York overturned the 2012 guilty plea and conviction of a tippee in light of Newman, finding the record plea factually insufficient because “nothing in the record . . . speaks directly or indirectly to [the defendant’s] knowledge of any personal benefit the corporate insiders received as a result of divulging confidential information.”[46]  By contrast, in January of this year, the Second Circuit upheld the 2012 conviction of a former executive, finding inter alia that he was not prejudiced by the pre-Newman jury instructions in that case.[47]

Other Cases Involving Tipper and Tippee Liability

The SEC filed several other insider trading actions involving tipper/tippee liability.  In April, the SEC instituted a settled administrative proceedings against a respondent who purchased options in a grocery store chain after learning about its impending acquisition from his wife, who had in turn learned about it from a family member who was a corporate insider.[48]  In the settlement, the respondent agreed to pay approximately $57,000 in disgorgement and prejudgment interest.

In June, the SEC obtained final judgments by consent against three defendants — an executive and two of his friends.[49]  The executive had been entrusted by a friend, an employee at Concur Technologies, with confidential information of a forthcoming merger.  The executive then tipped one of his friends, who then tipped his brother.  The two brothers and other family members then placed short-term trades in call options in Concur, resulting in over $500,000 in profits, a portion of which they gave to their executive friend.  The three defendants agreed to pay disgorgement and prejudgment interest all of which was deemed satisfied by orders of forfeiture entered against each of the three individuals in parallel criminal actions in which they pleaded guilty and were sentenced to prison terms ranging from six to twenty-four months.

Also in June, the SEC obtained consent judgments against two defendants, an executive at a pharmaceutical company and a business associate of the executive, in an insider trading case filed last year.[50]  The SEC’s complaint alleged that the executive tipped the business associate regarding nonpublic negotiations of a licensing agreement, and that the business associate then tipped other defendants who traded on the information, resulting in $1.5 million in gains.  Without admitting or denying the allegations in the complaint, the pharmaceutical executive consented to a civil monetary penalty of $750,000 and a five-year officer and director bar.  The amount of monetary relief as to the business associate remains to be determined by the court.  All but one of other defendants have agreed to partial settlements with the SEC.

Also in June, the SEC filed an amended complaint adding a Swiss businessman as a defendant to an insider trading case filed last year.[51]  The defendant allegedly purchased out of the money call options in the target company based on a tip regarding a pending merger from the son of a senior executive of the acquirer.  The proceeds of the transaction were previously frozen in the United States and Switzerland.  The U.S. Attorney’s Office for the Southern District of New York announced a parallel criminal action against the defendant on the same day the SEC filed the amended complaint.

Also in June, the SEC filed a settled insider trading action against a defendant who allegedly sold shares in an energy company after learning about a proposed secondary offering from individuals either at the company or affiliated with an investment bank that endeavored to participate in the offering.[52]  According to the complaint, after acquiring the information and before the public announcement, the defendant sold over 9,000 shares of company stock, avoiding approximately $46,000 in losses.  The defendant, without admitting or denying the allegations, agreed to pay disgorgement, prejudgment interest, and a one-time civil penalty.

Trading by Insiders

In February, the SEC filed a settled insider trading action against a former employee of a biotech company, alleging he sold stock in the company after learning the FDA had recommended withdrawal of two of the company’s products, thereby avoiding a loss of approximately $70,000.[53]  In the settlement, the defendant agreed to pay approximately $146,000 in disgorgement, prejudgment interest, and a civil penalty.

Cases Concerning Cryptocurrency and Cybersecurity

The SEC has focused on cybersecurity and cryptocurrency issues throughout the first half of the year.  In addition to bringing enforcement actions, in May, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”)[54] hosted a public forum on distributed ledger technology and digital assets.[55]  The forum focused on engagement with market participants on new financial technologies, including initial coin offerings.

CyberSecurity

In January, the SEC brought its first enforcement action of the year alleging that a Ukrainian hacker along with eight persons and entities engaged in a scheme to extract nonpublic information from the SEC’s EDGAR filing system.[56]  The SEC alleged that by hacking into the EDGAR system, the accused were able to access documents that had been filed with the SEC, but that had not yet been released publicly, and pass the documents to traders who traded on the nonpublic information to the benefit of $4.1 million.  This action follows 2015 charges against the same hacker and other traders for engaging in a similar scheme involving hacking into newswire services for nonpublic information about impending corporate earnings announcements.  The U.S. Attorney’s Office for the District of New Jersey brought accompanying criminal charges on the same day the SEC action was announced.

Failure to Register Initial Coin Offerings

In February, the SEC continued its recent trend of enforcement actions against companies who fail to register an initial coin offering (“ICO”) pursuant to federal securities law.[57]  Unlike the two ICO-related actions the SEC settled last year,[58] the company at issue in February self-reported its late-2017 unregistered ICO.  The company had raised $12.7 million from the sale of these instruments after the Commission had publicly articulated its position that ICOs can constitute securities offerings.  The company agreed to fully cooperate with the investigation, to register the token offering, and to compensate any investors who request a return of funds.  Because of its self-reporting and remediation measures, the SEC did not impose a penalty.

Other Offerings Involving Digital Assets

In May, the SEC obtained a temporary restraining order, asset freeze, and appointment of a receiver against several related companies engaged in an alleged international Ponzi scheme involving cryptocurrency and diamond mines.[59]  The principal is accused of using $10 million of the proceeds from an unregistered cryptocurrency offering by one of his companies to repay the investors in his previous diamond company and to fund his personal expenses.

Also in May, the SEC filed a civil injunctive action charging an individual with operating a $26 million pyramid scheme.[60]  The complaint alleges that for over a year the individual conducted an unregistered securities offering where investors purchased instructional business packages as well as “points” that could be converted into a digital asset.  Investors earned more of these points through cash investments and by recruiting new investors to purchase digital assets and join the pyramid scheme.

In June, the SEC filed a complaint alleging the defendant company raised $55 million from U.S. investors through an unregistered offering of a digital currency.[61]  Investors were allegedly told that the currency’s value would increase when the company created a transaction service based on the currency that would be available within and without the company.  The SEC alleges these services were never offered and that the value of the currency has decreased by nearly half since it was initially offered.

In June, the SEC filed an amended complaint against a company and its CEO for allegedly conducting a fraudulent IPO and for engaging in accounting fraud by recording more than $66 million in excess revenue.[62]  In connection with the original complaint filed last year, the court granted the SEC’s request for preliminary relief freezing more than $27 million raised from the allegedly fraudulent offering.[63]  Also in June, the U.S. Attorney’s Office for the District of New Jersey brought parallel criminal charges against the CEO.

Municipal Securities Cases

New Actions

In March, the SEC filed a settled action against a former County Manager, alleging that he provided an unfair advantage to an investment adviser who was selected to manage county pension funds.[64]  The complaint alleges the County Manger, who allegedly had a romantic interest in an associate of the adviser, provided access to competitor’s proposals, and also failed to disclose the conflict of interest in selecting the adviser.  The County Manager consented to a judgment enjoining him from further violations of the Investment Advisers Act and from involvement with the management of public pensions, the selection of underwriters and municipal advisers, and the offering of municipal securities, as well as a $10,000 civil penalty.

Also in March, the SEC announced partially settled charges against the former controller of a not-for-profit college, alleging he misrepresented the college’s finances in statements published in connection with its continuing disclosure obligations to investors pursuant to a bond issuance in 1999.[65]  According to the SEC’s complaint, the former controller created false financial records, and his actions resulted in overstating the college’s net assets by almost $34 million in the 2015 fiscal year.  The former controller agreed to a permanent injunction, with monetary relief to be determined at a later date.  In a parallel criminal action, the former controller agreed to plead guilty.  The college was not charged, in light of its cooperation and efforts to remediate the misconduct.

In June, the SEC filed an unsettled action against a municipal adviser and managing partner based on allegations of breach of fiduciary duty in connection with a municipal bond offering for a public library.[66]  The complaint alleges the adviser failed to provide sufficient advice on selecting the underwriter for the offering and on pricing bonds, resulting in mispriced bonds which will cost the library additional interest over the life of the bonds.  In a related action, the SEC also instituted a settled administrative proceeding against the broker-dealer that underwrote the bonds based on allegations of a failure to act with reasonable care in underwriting the offering.  The broker-dealer agreed to a $50,000 civil penalty and to engage an independent compliance consultant.

Settlements in Previously Filed Actions

In March, in an action previously filed in 2016, the SEC resolved litigation against a financial institution that had been the placement agent for a municipal bond offering intended to finance a finance startup video game company.[67]  The SEC alleged that the institution had failed to disclose that the project faced a shortfall in financing and that the institution was receiving compensation tied to the issuance of the bonds from the startup.  Pursuant to the settlement, without admitting or denying the allegations in the complaint, the financial institution agreed to pay approximately $800,000 in civil penalties.  The SEC’s litigation against the lead banker on the deal is ongoing.

In June, the SEC announced a settlement of a 2017 action against the Town of Oyster Bay, New York for allegedly failing to disclose an agreement to guarantee $20 million of loans to a third-party restaurant and concession stand operator in connection with certain municipal securities offerings.[68]  In addition to consenting to an injunction, the Town agreed to retain an independent compliance consultant to advise on its disclosures for securities offerings.  The litigation against the former town supervisor is continuing.

ENDNOTES

    [1]  Testimony of Chairman Jay Clayton before the Financial Services and General Government Subcommittee of the U.S. Senate Committee on Appropriations, (May 8, 2019), available at https://www.sec.gov/news/testimony/testimony-financial-services-and-general-government-subcommittee-us-senate-committee.

   [2]   See, e.g., SEC Charges Issuer With Conducting $100 Million Unregistered ICO, Press Rel. No. 2019-87 (June 4, 2019), available at https://www.sec.gov/news/press-release/2019-87; SEC Sues alleged Perpetrator of Fraudulent Pyramid Scheme Promising investors Cryptocurrency Riches, Press Rel. No. 2019-74 (May 23, 2019), available at https://www.sec.gov/news/press-release/2019-74; SEC Obtains Emergency Order Halting Alleged Diamond Related ICO Scheme Targeting Hundreds of Investors, Press Rel. No. 2019-72 (May 21, 2019), available at https://www.sec.gov/news/press-release/2019-72.

   [3]   SEC Press Release, SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships with Financial Professionals (June 5, 2019), available at https://www.sec.gov/news/press-release/2019-89.

   [4]   SECURITIES AND EXCHANGE COMMISSION, Regulation Best Interest: The Broker-Dealer Standard of Conduct, Rel. No. 34-86031 (June 5, 2019) (to be codified at 17 CFR §§ 240.15l-1, 240.17a-3, and 240.17a-4), available at https://www.sec.gov/rules/final/2019/34-86031.pdf (“Final Rule”).

[5] See Statement by Chairman Jay Clayton Regarding Offers of Settlement (July 3, 2019), available at https://www.sec.gov/news/public-statement/clayton-statement-regarding-offers-settlement.

   [6]   SEC Press Release, SEC Awards $3 Million to Joint Whistleblowers (June 3, 2019), available at https://www.sec.gov/news/press-release/2019-81.

   [7]   SEC Awards $50 Million to Two Whistleblowers, Press Rel. 2019-42 (Mar. 26, 2019), available at https://www.sec.gov/news/press-release/2019-42.

   [8]   In the Matter of the Claims for Award in connection with [redacted] Notice of Covered Action [redacted], Order Determining Whistleblower Award Claims, Rel. No. 85412 (Mar. 26, 2019), available at https://www.sec.gov/rules/other/2019/34-85412.pdf.

   [9]   SEC Press Release, SEC Awards $4.5 Million to Whistleblower Whose Internal Reporting Led to Successful SEC Case and Related Action (May 24, 2019), available at https://www.sec.gov/news/press-release/2019-76.

[10]   SEC Press Release, SEC Awards $3 Million to Joint Whistleblowers (June 3, 2019), available at https://www.sec.gov/news/press-release/2019-81.

[11]   See Gibson, Dunn & Crutcher LLP 2018 Mid-Year Securities Enforcement Update (July 30, 2018), available at https://www.gibsondunn.com/2018-mid-year-securities-enforcement-update/.

[12]   House Financial Services Committee Passes Bill to Expand Dodd-Frank Whistleblower Protection to Internal Whistleblowers (May 30, 2019), available at https://www.jdsupra.com/legalnews/house-financial-services-committee-88658/.

[13]   Lorenzo v. SEC, 587 U.S. ___, No. 17-1077 (U.S. Mar. 27, 2019).

[14]   See Speech by Commissioner Hester M. Peirce, “Reasonableness Pants,” (May 8, 2019), available at https://www.sec.gov/news/speech/speech-peirce-050819 (“Congress defined aiding and abetting liability to be the provision of ‘substantial assistance’ to a securities law violator. It is important for us and the courts not to ascribe primary liability to every violation and thus write aiding and abetting out of the statute.”) (footnote omitted).

[15]   See, e.g., Matter of Deer Park Road Management Company, LP, Rel. No. 5245 (June 4, 2019), n. 7 (“A willful violation of the securities laws means merely ‘that the person charged with the duty knows what he is doing…. There is no requirement that the actor ‘also be aware that he is violating one of the Rules or Acts.’”) (citations omitted).

[16]   See, e.g., SEC v. Rio Tinto plc and Rio Tinto Limited, Thomas Albanese, and Guy Robert Elliott, No. 17 Civ. 7994 (AT), 2019 WL 1244933, at *22 (S.D.N.Y. Mar. 18, 2019) (collecting cases).

[17]   CFTC v. Southern Trust Metals, Inc., 2019 WL 2295488, at *4-5 (S.D. Fla. May, 30, 2019).

[18]   Cato Institute v. SEC, et al., Case 1:19-cv-00047 (D.D.C. Jan. 9, 2019).

[19]   SEC Press Release, SEC Charges Four Public Companies with Longstanding ICFR Failures (Jan. 29, 2019), available at https://www.sec.gov/news/press-release/2019-6.

[20]   SEC Press Release, SEC Charges Lumber Liquidators with Fraud (Mar. 12, 2019), available at https://www.sec.gov/news/press-release/2019-29.

[21]   SEC Press Release, SEC Charges Volkswagen, Former CEO with Defrauding Bond Investors During “Clean Diesel” Emissions Fraud (Mar. 14, 2019), available at https://www.sec.gov/news/press-release/2019-34.

[22]   SEC Press Release, SEC Charges Former CEO of Silicon Valley Startup with Defrauding Investors (Apr. 2, 2019), available at https://www.sec.gov/news/press-release/2019-50.

[23]   SEC Press Release, SEC Charges Transportation Company Executives with Accounting Fraud (Apr. 3, 2019), available at https://www.sec.gov/news/press-release/2019-51.

[24]   SEC Press Release, Silicon Valley Company Settles Fraud Charge for Misstating Returns to Investors (Apr. 19, 2019), available at https://www.sec.gov/news/press-release/2019-58.

[25]   SEC Press Release, SEC Charges Truckload Freight Company with Accounting Fraud (Apr. 25, 2019), available at https://www.sec.gov/news/press-release/2019-60.

[26]   SEC Press Release, SEC Charges Sapphire Glass Manufacturer and Former CEO with Fraud (May 2, 2019), available at https://www.sec.gov/news/press-release/2019-66.

[27]   SEC Press Release, Deloitte Japan Charged with Violating Auditor Independence Rules (Feb. 13, 2019), available at https://www.sec.gov/news/press-release/2019-9.

[28]   SEC Press Release, KPMG Paying $50 Million Penalty for Illicit Use of PCAOB Data and Cheating on Training Exams (June 17, 2019), available at https://www.sec.gov/news/press-release/2019-95.

[29]   SEC Press Release, BB&T to Return More Than $5 Million to Retail Investors and Pay Penalty Relating to Directed Brokerage Arrangements (Mar. 5, 2019), available at www.sec.gov/news/press-release/2019-26.

[30]   SEC Press Release, SEC Charges Registered Investment Adviser and Former Chief Operating Officer With Defrauding Client (Mar. 15, 2019), available at www.sec.gov/news/press-release/2019-36.

[31]   SEC Press Release, SEC Charges New Jersey Man With Fraudulently Causing Advisory Firm to Overbill Clients (Mar. 28, 2019), available at www.sec.gov/news/press-release/2019-44.

[32]   SEC Press Release, SEC Charges Investment Adviser With Fraud (May 28, 2019), available at www.sec.gov/news/press-release/2019-77.

[33]   SEC Press Release, Investment Adviser Charged With Stealing Millions From Private Fund (Mar. 28, 2019), available at www.sec.gov/news/press-release/2019-45.

[34]   SEC Press Release, Hedge Fund Adviser to Pay $5 Million for Compliance Failures Related to Valuation of Fund Assets (June 4, 2019), available at www.sec.gov/news/press-release/2019-86.

[35]   SEC Press Release, Merrill Lynch to Pay Over $8 Million for Improper Handling of ADRs (Mar. 22, 2019), available at https://www.sec.gov/news/press-release/2019-40.

[36]   SEC Press Release, Industrial and Commercial Bank of China Affiliate to Pay More Than $42 Million for Improper Handling of ADRs (June 14, 2019), available at https://www.sec.gov/news/press-release/2019-94.

[37]   Admin. Proc. File No. 3-19205, In re Wedbush Securities, Inc. (June 18, 2019), available at https://www.sec.gov/litigation/admin/2019/33-10650.pdf.

[38]   SEC Press Release, SEC Charges Broker-Dealer and Transfer Agent in Microcap Shell Factory Fraud (Feb. 20, 2019), available at https://www.sec.gov/news/press-release/2019-16.

[39]   SEC Press Release, Wedbush Settles Failure to Supervise Charge (Mar. 13, 2019), available at https://www.sec.gov/news/press-release/2019-32.

[40]   SEC Press Release, Jury Rules in SEC’s Favor, Finds Brokerage Firm and Two of Its Executives Liable for Fraud (May 15, 2019), available at https://www.sec.gov/news/press-release/2019-70.

[41]   SEC Press Release, SEC Charges Former Senior Attorney at Apple with Insider Trading (Feb. 13, 2019), available at https://www.sec.gov/news/press-release/2019-10.

[42]   SEC Press Release, SEC Charges Former SeaWorld Associate General Counsel with Insider Trading (Apr. 9, 2019) available at https://www.sec.gov/news/press-release/2019-53.

[43]   SEC Press Release, SEC Charges Nevada Man Who Traded on Confidential Information Taken from Lifetime Friend (May 7, 2019), available at https://www.sec.gov/news/press-release/2019-67.

[44]   773 F.3d 438 (2d Cir. 2014).

[45]   137 S. Ct. 420 (2016).

[46]   United States v. Lee, No. 13-cr-539 (S.D.N.Y. June 21, 2019); see also Jody Godoy, Newman Cited in Tossing Ex-SAC Capital Exec’s Guilty Plea, Law 360 (June 21, 2019), available at https://www.law360.com/articles/1171838/newman-cited-in-tossing-ex-sac-capital-exec-s-guilty-plea.

[47]   Gupta v. United States, No. 15-2707 (2d. Cir. Jan 7, 2019) (affirming district court denial of motion to vacate conviction).

[48]   Admin. Proc. File No. 3-19134, In re Yang, (Apr. 5, 2019), available at https://www.sec.gov/litigation/admin/2019/34-85525.pdf.

[49]   SEC Litigation Release, SEC Obtains Final Judgments in Insider Trading Case Against Former Software Executive and Two Friends (June 12, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24499.htm.

[50]   SEC Litigation Release, SEC Obtains Judgements Against Insider Trading Ring Defendants (June 11, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24498.htm.

[51]   SEC Litigation Release, SEC Charges Swiss Resident in Insider Trading Case Involving Bioverativ Acquisition (June 13, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24500.htm.

[52]   SEC Litigation Release, SEC Charges New Jersey Investor with Insider Trading (June 18, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24503.htm.

[53]   SEC Litigation Release, SEC Settles with Biotech Insider Trader (Feb. 21, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24406.htm.

[54]   SEC Press Release, FINHUB Strategic Hub for Innovation and Financial Technology (last modified June 13, 2019), available at https://www.sec.gov/finhub.

[55]   SEC Press Release, SEC Staff to Hold Fintech Forum to Discuss Distributed Ledger Technology and Digital Assets (Mar. 15, 2019), available at https://www.sec.gov/news/press-release/2019-35; SEC Press Release, SEC Staff Announces Agenda for May 31 FinTech Forum (April 24, 2019), available at https://www.sec.gov/news/press-release/2019-59.

[56]   SEC Press Release, SEC Brings Charges in EDGAR Hacking Case (Jan. 15, 2019), available at https://www.sec.gov/news/press-release/2019-1.

[57]   SEC Press Release, Company Settles Unregistered ICO Charges After Self-Reporting to SEC, available at https://www.sec.gov/news/press-release/2019-15.

[58]   See Gibson Dunn 2018 Year-End Review (Jan. 15, 2019), available at https://www.gibsondunn.com/2018-year-end-securities-enforcement-update/#_edn1; SEC Press Release, Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities (Nov. 16, 2018), available at https://www.sec.gov/news/press-release/2018-264.

[59]   SEC Press Release, SEC Obtains Emergency Order Halting Alleged Diamond-Related ICO Scheme Targeting Hundreds of Investors (May 21, 2019), available at https://www.sec.gov/news/press-release/2019-72.

[60]   SEC Press Release, SEC Sues Alleged Perpetrator of Fraudulent Pyramid Scheme Promising Investors Cryptocurrency Riches (May 23, 2019), available at https://www.sec.gov/news/press-release/2019-74.

[61]   SEC Press Release, SEC Charges Issuer With Conducting $100 Million Unregistered ICO (June 4, 2019), available at https://www.sec.gov/news/press-release/2019-87.

[62]   SEC Press Release, SEC Adds Fraud Charges Against Purported Cryptocurrency Company Longfin, CEO, and Consultant (June 5, 2019), available at https://www.sec.gov/news/press-release/2019-90.

[63]   SEC Litigation Release, SEC Obtains Emergency Freeze of $27 Million in Stock Sales of Purported Cryptocurrency Company Longfin (May 2, 2018), available at https://www.sec.gov/litigation/litreleases/2018/lr24130.htm. See also Gibson Dunn 2018 Mid-Year Review (July 30, 2018), available at https://www.gibsondunn.com/2018-mid-year-securities-enforcement-update/; SEC Press Release, SEC Obtains Emergency Freeze of $27 Million in Stock Sales of Purported Cryptocurrency Company Longfin (Apr. 6, 2018), available at https://www.sec.gov/news/press-release/2018-61.

[64]   SEC Press Release, SEC Charges Former Municipal Officer with Fraud in Connection with Public Pension Funds (Mar. 15, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24424.htm.

[65]   SEC Press Release, SEC Charges College Official for Fraudulently Concealing Financial Troubles from Municipal Bond Investors (Mar. 28, 2019), available at https://www.sec.gov/news/press-release/2019-46.

[66]   SEC Litigation Release, SEC Charges Municipal Advisor with Breaching Fiduciary Duty (June 27, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24520.htm.

[67]   SEC Press Release, Court Penalizes Wells Fargo Securities for Disclosure Failures in 38 Studios Bond Offering (Mar. 20, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24428.htm.

[68]   SEC Litigation Release, Town of Oyster Bay, New York, Agrees to Settle SEC Charges (June 7, 2019), available at https://www.sec.gov/litigation/litreleases/2019/lr24494.htm.

This post comes to us from Gibson, Dunn & Crutcher LLP. It is based on the firm’s memorandum, “2019 Mid-Year Securities Enforcement Update,” dated July 18, 2019, and available here. Lindsey Geher, Alyssa Ogden, Zoey Goldnick, Erin Galliher, and Trevor Gopnik also contributed to the memorandum.

Categories
Uncategorized

Arnold & Porter Discusses Federal Reserve Developments on Confidential Supervisory Information

The Board of Governors of the Federal Reserve System (FRB) issued two notable documents over the past two weeks involving confidential supervisory information (CSI):  a cease and desist order against a former bank employee for improper handling of CSI and a request for comment on proposed changes to the FRB’s rules governing the disclosure of CSI.

Cease and Desist Order Against Former Bank Employee

First, in a stark reminder to employees in the financial services industry, the FRB issued a cease and desist order against a former employee of a non-bank subsidiary of a bank holding company for violation of its rules relating to confidential supervisory information.[1]  Specifically, the order stated that the former employee, while employed at the company, removed CSI and other proprietary information from his office without authorization and in violation of company policy.  The specific acts giving rise to the violation were that the employee sent the CSI to his personal email address and kept copies of the documents at his residence.  It was further reported that removal of information was done as a matter of convenience to allow the employee to work from home.

The FRB’s pursuit of this action highlights the seriousness in which the FRB, as well as other federal and state banking agencies, approach their rules governing CSI and the particular prohibition under 12 C.F.R. § 261.20(g) from making copies of CSI or removing CSI from the workplace:

No person obtaining access to confidential supervisory information pursuant to this section may make a personal copy of any such information; and no person may remove confidential supervisory information from the premises of the institution or agency in possession of such information except as permitted by specific language in this regulation or by the Board.

Although emailing yourself records or taking documents home for additional review may seem benign and even common, doing so with documents that fall into the broad category of CSI proved can be perilous.  All institutional affiliated parties, including any director, officer, employee, or controlling stockholder of an insured depository institution, should take notice for this enforcement action and familiarize themselves with the rules and restrictions state and federal banking regulators impose on the handling of CSI.  Similarly, financial institutions should review their policies, procedures, and employee training to assure they appropriately address employee conduct and expectations regarding CSI.

Notice of Proposed Rulemaking on CSI

The Federal Reserve Board also recently issued a notice of proposed rulemaking (NPRM) in an effort to update the rules governing the Board’s disclosure of confidential supervisory and other nonpublic information.[2]  The most notable proposed changes are those that would expand the ability of a supervised financial institutions to share CSI with its affiliates, auditors, and outside legal counsel, and those that would expand the ability of the FRB to disclose CSI to other federal and state banking agencies. Specifically:

  • Section 261.20 would be revised to provide that all CSI and other nonpublic information made available under the FRB’s CSI rules (Subpart C) remains the property of the FRB, that any disclosure under Subpart C does not constitute a waiver by the FRB of any applicable privileges, and that Subpart C does not limit or restrict the FRB’s authority to impose additional conditions or limitations on the use and disclosure of CSI or other nonpublic information.
  • Section 261.21 would authorize supervised financial institutions to disclose CSI to directors, officers, or employees of their affiliates, to the extent such individuals have a need for the information in the performance of their official duties. Under current Section 261.20(b), disclosure may only be made to a parent holding company.
  • Section 261.21 would also eliminate the current requirement under Section 261.20(b)(2)(i) that certified public accountants or legal counsel review CSI only on the premises of the supervised financial institution . Instead, it would provide that CSI could be viewed off-site subject to written agreement and a requirement to destroy, return, or cease access to the CSI at the conclusion of the engagement.
  • Section 261.22(a) would update the list of state and federal agencies to which the FRB could provide CSI, and provide that such provision of CSI could be made with or without a request from such agency.
  • Section 261.22(b) would permit the FRB to disclose CSI to the Department of Justice or the Department of Housing and Urban Development in furtherance of specific statutory responsibilities, such as the fair lending laws under the Fair Housing Act and the Equal Credit Opportunity Act.

Finally, although several revisions to the definition of CSI are proposed, the FRB stated that the such revisions are for clarification purposes only and would not expand or reduce the information that falls within the definition.

Supervised financial institutions should carefully review the NPRM and evaluate whether the proposed revisions address any concerns of the institution or whether there are additional concerns that should be addressed in the revised rule.  In addition, in light of the FRB’s enforcement action, supervised financial institutions should use the NPRM to evaluate its current practices and procedures relating to CSI.

All comments on the NPRM must be submitted within 60 days of the date of publication in the Federal Register.

ENDNOTES

[1] In the Matter of Youlei Tang, a.k.a. Alex Tang (Docket Nos. 19-010-B-I).

[2] FRB Press Release (Jun. 14, 2019).  The NPRM also requests public comment on technical, clarifying updates regarding its Freedom of Information Act procedures.

This post comes to use from Arnold & Porter Kaye Scholer LLP. It is based on the firm’s memorandum, “Federal Reserve Developments Relating to Confidential Supervisory Information,” dated June 18, 2019, and available here. David F. Freeman, Jr., Christopher L. Allen, and Erik Walsh also contributed to the memorandum.

Categories
Corporate Governance M & A Securities Regulation

Deals, Activism, and SEC Regulation Get Lively Airing at M&A and Corporate Governance Conference

A host of top attorneys, judges, scholars, regulators, and advisers debated the latest issues in corporate and securities law on June 7 at a Columbia Law School conference in New York, offering cutting-edge thoughts on everything from cybersecurity to shareholder activism to the potential regulation of proxy advisers.

The day-long event featured a keynote conversation with U.S. Securities and Exchange Commissioner Robert J. Jackson, Jr., who among other topics discussed whether the SEC’s new Regulation Best Interest went far enough in protecting retail investors. Appearing on panels about M&A, Delaware law developments, and shareholder activism were the likes of Delaware Chancellor Andre Bouchard and Vice-Chancellor Kathaleen McCormick. At day’s end, Professor John C. Coffee, Jr., of Columbia Law School led a discussion on securities regulation.

In his keynote conversation with Columbia Law School Professor Joshua Mitts, Jackson acknowledged the “very contestable and difficult” questions raised by Regulation Best Interest, which the SEC adopted on June 5 to ensure that broker-dealers act in the best interest of retail customers when recommending securities investments. Jackson dissented from the rule, however, because it did not make “utterly unambiguous” that “investment professionals should be required by law to put their clients’ interests first,” he said.

He also criticized the commission for not making clear enough that the Investment Company Act of 1940 requires investment advisers to put clients first as well. He acknowledged his colleagues’ desire “to preserve access for investors,” but asked, “Access to what? Access to financial advisers who are confused about who comes first in this relationship?” He added that leaving any ambiguity about the duties of investment professionals invites “practices at the margin that don’t make much sense.” In any event, he predicted, regardless of what the SEC says, many advisers will commit to putting investors’ needs first, because “the market demands it.”

Jackson went on to discuss stock prices and the conflicts of interest created when exchanges offer relatively slow public feeds of stock prices while selling faster feeds to the likes of high-frequency traders. “That’s like letting Barnes & Noble run the public library and then being astonished when there are no books in the library…They have every powerful interest in making sure the library’s empty.” Jackson also addressed stock buybacks, the desire of boards for guidance on their obligations to prevent and disclose cyber-attacks, and potential reforms to the proxy-advisory process.

Later in the day, Professor Coffee convened an all-start panel to address the latest developments in securities regulation. Leading off was, again, Jackson, who continued his discussion of proxy-adviser regulation. He questioned the conflicts in advisers’ dual roles of advising corporate boards while also making voting recommendations to investors, the risks that regulation would “entrench incumbent” advisers in an already uncompetitive industry, and the wisdom of not allowing companies to challenge advisers’ criticisms of their actions. He also urged boards to explain more clearly the business reasons for excluding certain shareholder proposals from ballots, criticized a general lack of board diversity, and reiterated his opposition to allowing companies to issue perpetual dual-class shares.

Next up on Coffee’s panel was U.S. District Judge Jed Rakoff, whom, Coffee explained, doesn’t specialize in corporate governance, but “he specializes in wisdom.” Rakoff addressed the issues surrounding the May 2, 2019, decision in United States v. Connolly, which dealt with the risks of outsourcing the government’s criminal or regulatory investigations to private law firms.

In reviewing the history behind the case,  the judge explained how the corporate sentencing guidelines’ incentives for companies to cooperate, the rise of deferred prosecution and non-prosecution agreements, and prosecutors’ desire to save resources resulted in more investigations being done by companies’ private law firms, which then handed the findings to the government. Problems arose, however, when, as in the Connolly case, the government became too involved in shaping the questions asked of witnesses, who were under threat of being fired if they did not testify. Company lawyers were accused of effectively acting as an arm of the government and coercing testimony in violation of the Fifth Amendment. In Connolly, Rakoff said the problem was not serious enough to overturn the decision, but warned that the case “suggests strongly” that too much government involvement “will taint the process.”

Coffee next called on Joshua Mitts to talk about his research  on what he calls “short and distort,” the phenomenon of short sellers crossing the line from offering useful criticism about a company and its stock to manipulating the market in violation of the law. Mitts discussed what, short of an outright lie, might qualify as “the something more” that would push such investors over the line but explained that regulators were hesitant to act against the practice for fear of discouraging short selling.

Finally, Joel Seligman, the former president of the University of Rochester and a renowned expert on the securities laws, spoke about the complexities of shareholder voting and the proxy process, the conflicts of interest in the business of proxy advisers, and the fight to force the board of Johnson & Johnson to allow a shareholder vote on a proposal requiring arbitration for disputes between the company and its stockholders.

The event was sponsored by the law firms of Gibson, Dunn & Crutcher and Wachtell, Lipton, Rosen & Katz. The co-chairs of the conference were Coffee, Eduardo Gallardo of Gibson Dunn, former Delaware Supreme Court Justice Jack B. Jacobs, and William Savitt of Wachtell Lipton.

Other participants included Professor Eric Talley of Columbia Law School; Albert Garner of Lazard Freres; Kelly Sullivan of Joele Frank, Wilkinson Brimmer Katcher; Susan Wood Waesco of Morris, Nichols, Arsht & Tunnel; Jessica Zeldin of Rosenthal, Monhait and Goddess; Ted Yu of the SEC; Ryan McLeod of Wachtell Lipton; Joames Moloney of Gibson Dunn; Karessa Cain of Wachtell Lipton; David Dubner of Goldman Sachs; Margaret Foran of Prudential Financial; Cristiano Guerra of Institutional Shareholder Services; and Elizabeth Ising of Gibson Dunn.

Categories
Corporate Governance

Facilitating Tacit Collusion: A New Perspective on Common Ownership and Voluntary Disclosure

Common ownership (competing firms with overlapping ownership) has become increasingly prevalent over the last several decades. Recent studies of the phenomenon have produced two important findings.  First, common ownership is associated with less intense competition. Studies posit that managers act in accordance with the preference of common owners for anti-competitive actions that lead to higher group profits rather than cutthroat actions that maximize individual firm profits. Second, common ownership is associated with more voluntary disclosure, which recent work has  attributed to the lower costs of disclosure arising from the reduced competition and common owners’ demand more disclosure. We predict and find support for an alternative explanation for the increased disclosure: Commonly owned firms increase disclosure to facilitate tacit collusion.

Our study proposes that competing firms with common owners are more likely to take coordinated actions (i.e., tacitly collude) to facilitate higher profits, which helps explain why commonly owned firms provide more disclosure. We predict that communication facilitates both coordinating anti-competitive behavior (e.g., pricing strategy) as well as monitoring defection from the common strategy. While many forms of private communication among firms are illegal, we conjecture that public disclosure serves as an allowable alternative coordinating and monitoring mechanism.

We conduct several analyses that suggest the positive relation between common ownership and disclosure is, at least in part, attributable to tacit collusion. First, we expect the relationship between common ownership and disclosure to weaken in industries with characteristics that would make tacit collusion more difficult. Collusion should be more difficult in industries with many firms (it is more challenging to coordinate across large groups), with uncertain demand (boom-bust cycles give firms incentives to defect from collusive strategies), and in which firms have variable cost structures (it is more difficult to find a focal point around which to collude). Consistent with these predictions we find the positive relation between common ownership and disclosure weakens in industries with many firms, uncertain demand, and varied cost structures.

Second, we consider the influence of alternative non-public communication channels that should alter the need for public disclosure to coordinate and monitor the anti-competitive actions required for tacit collusion. On one hand, these channels could act as substitutes for public disclosure, rendering public disclosure less necessary for coordinating and monitoring. Alternatively, they could act as complements when public disclosure alone is insufficient to both coordinate and monitor. Our results suggest having more overlapping directors mitigates the need for public disclosure (i.e., acts as a substitute). However, having more trade association events enhances (i.e., complements) the positive association. One plausible interpretation for why trade associations would complement public disclosure is that tacit collusion requires communication for two purposes: coordinating and monitoring. The types of interactions occurring at trade events (e.g., discussion forums on recent sales trends) may better serve the monitoring role, leaving public disclosure to facilitate the more forward-looking coordinating role.

Finally, we evaluate alternative measures of disclosure that are likely to contain information useful in tacit collusion. In the majority of our analysis we use management forecasts, as they are  a well-established measure of forward looking information that is used by a diverse set of firms. We also evaluate three text-based disclosure measures: the amount of sales guidance in the earnings announcement, whether managers cite outstanding confidential treatment requests in the 10-Q or 10-K, and the proportion of numbers in the earnings announcement. These measures should aid in the coordinating and monitoring required for tacit collusion.  First, sales related disclosure facilitates communication about market-wide demand and competitor pricing strategies. Second, firms engaged in collusive behaviors are less likely to redact information. Finally, greater specificity (i.e., a higher proportion of numbers in the text) makes it easier to identify a focal point, coordinate actions, and monitor for defection from the coordinated strategy. We find common ownership is associated with each of these measures, as expected.

Our study provides new insight into the role of shareholders in management decision-making and expands the growing literature on strategic firm behaviors, especially as related to tacit collusion or coordination among firms. Moreover, while existing literature shows common ownership is associated with anti-competitive outcomes, it is inconclusive on how these anti-competitive outcomes are achieved. In this study, we provide evidence consistent with tacit collusion facilitating anti-competitive outcomes via public disclosure.

Finally, existing literature has shown that the competitive dynamics around common ownership are associated with increased disclosure. In addition to competition changing the costs and benefits of disclosure, we provide evidence that disclosure plays a direct role in the common ownership-competition relation by allowing managers of commonly owned firms to maximize joint profits through tacit collusion.

This post comes to us from professors Andrea Pawliczek at the University of Missouri at Columbia, A. Nicole Skinner at the University of Georgia, and Sarah Zechman at the University of Colorado at Boulder. It is based on their recent article, “Facilitating Tacit Collusion: A New Perspective on Common Ownership and Voluntary Disclosure,” available here.

Categories
Securities Regulation

SEC Commissioner Jackson Comments on Proposed Rule on Financial Disclosures for Mergers and Acquisitions

Let me begin by thanking the staff in the Division of Corporation Finance, including Division Director Bill Hinman, for their hard work in developing the May 3 release and for helpful briefings throughout this process.

The May 3 proposal governs the financial information firms give investors relating to mergers and acquisitions, among other things. It provides several necessary updates to our rules. But I’m concerned that the proposal treats mergers as an unalloyed good—ignoring decades of data showing that not all acquisitions make sense for investors. Thus, while I vote to open this proposal for public comment, I urge investors to help us engage more carefully and critically with longstanding evidence that corporate insiders use mergers as a means to advance their private interests over the long-term interests of investors.

*          *          *          *

Mergers and acquisitions offer substantial benefits for public companies and investors, creating economies of scale and scope that make firms more efficient.[1] But research has long shown that they can also be used by executives to build empires, even if giving management a larger domain is not in investor interests.[2] Our disclosure rules should balance these benefits and costs, requiring information after mergers close that allows investors to hold management accountable for their mistakes. The prospect of that accountability makes management more likely to pursue only those mergers that make long-term sense for investors.

In two ways, the May 3 proposal ignores evidence on how corporate insiders use mergers to extract private benefits at investor expense. First, our rules historically have required certain disclosure related to the acquisition of “significant” businesses—that is, those with sufficiently large implications for the firm’s financial future to make more detailed disclosure necessary.[3] For decades, we have determined the “significance” of the merger by reference to the audited value of the acquirer’s assets according to its last-filed annual financial statements. The proposal would, among other things, determine a deal’s significance based upon the market value of the acquirer’s equity.[4]

The problem with this change is that it could result in less disclosure about acquisitions made by companies whose market value is significantly different from their book value. The evidence shows that those are the mergers that are more likely to be bad deals—precisely the type of mergers for which we should require the most transparency.[5] That’s especially true in light of evidence suggesting that managers prefer to hide information about underperforming mergers in order to avoid accountability to investors.[6] So it’s not clear to me why we should change our rules to give investors less information about these deals, since doing so risks giving executives more freedom to pursue mergers that harm the long-term health of the company.

Second, the economic analysis in the release reflects a troubling trend of one-sided thinking in our rulemaking.[7] To justify changes, the economic analysis goes on at length about the benefits of rolling back certain disclosures. But it says nothing about the foundational theory or evidence showing that mergers also come with substantial agency costs.[8] The failure to grapple with these costs suggests that our regulatory choices reflect one-sided advocacy rather than sound economic analysis.

For example, the release describes the obvious fact that target companies receive a substantial premium when they’re acquired.[9] But the release ignores the other half of this well-known equation: that acquiring companies’ stocks tend to take a hit upon the announcement of a merger.[10] Looking at the performance of the combined company, which is more logically—and economically—sound, shows that many mergers are not in investors’ long-term interests.[11]

Equally troubling is the release’s reliance on decades-old research, failing to engage with more recent evidence that tends to undermine to the proposal’s premise. Many of the older papers cited in the release suffer from well-known methodological problems.[12] Those studies also exclude evidence from the merger waves of the 1980s and 1990s—evidence that shows that many of those mergers harmed investors over the long run.[13] Ignoring that history puts investors at unnecessary risk of the harm that would come from repeating it.[14]

*          *          *          *

Contrary to the ideological intuition evident in the May 3 release, mergers come with both benefits and costs. Some acquisitions create important efficiencies; others allow managers to build empires and extract value from investors. Our disclosure rules should give investors the tools to tell the difference. That’s why it’s so important that commenters come forward with detailed ideas about how this proposal can be improved in ways that will empower investors to hold executives accountable—particularly for those mergers that harm investors over the long run.

I am grateful to members of the staff for their hard work on this proposal. And I look forward to hearing from commenters about how it can be improved in ways that would reflect a more balanced perspective about the implications of mergers and acquisitions for ordinary investors.

ENDNOTES

[1]See, e.g., Michael C. Jensen & Richard S. Ruback, The Market for Corporate Control: The Scientific Evidence, 11 J. Fin. Econ. 5 (1983) (famously noting that an active takeover market can create efficiencies by transferring inefficiently managed assets to more efficient management—or by creating synergies through economies of scale or scope).

[2]For the foundational citations, see Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, 3 J. Fin. Econ. 305 (1976) (explaining that managers have private incentives to conduct mergers and acquisitions to increase the size of the firm in order to extract more pay or perquisites at shareholder expense); George Lucas, dir., Star Wars, Episode IV: A New Hope (1976) (providing a contemporaneous interpretation of the costs of empire-building). For empirical evidence, see Sandra B. Betton, Espen Eckbo & Karin S. Thornburn, Corporate Takeovers, in Handbook of Empirical Corporate Governance 291 (2008) (surveying the empirical literature on mergers and acquisitions, including the “stylized fact” of economically and statistically meaningful long-term stock-price underperformance after mergers—suggesting that mergers are not, on average, value-creating for investors); see also Ole-Kristian Hope & Wayne B. Thomas, Managerial Empire-Building and Firm Disclosure, 46 J. Acct. Rsrch. 591 (2008).

[3]Instructions for the Presentation and Preparation of Pro Forma Financial Information and Requirements for Financial Statements of Businesses Acquired or To Be Acquired, Release No. 33-6413 (Jun. 24, 1982); 17 CFR 210.3-05.

[4]Securities & Exchange Commission, Amendments to Financial Disclosures about Acquired and Disposed Businesses, Release No. No. 33-10635 (May 3, 2019) (hereinafter, “Release”).

[5]See, e.g., Fangjian Fu, Leming Lin & Micah S. Officer, Acquisitions Driven by Stock Overvaluation: Are They Good Deals?, 109 J. Fin. Econ. 24 (2013) (“[O]vervalued acquirers significantly overpay for their targets. These acquisitions do not, in turn, lead to synergy gains. Moreover, these acquisitions seem to be concentrated among acquirers with the largest governance problems. CEO compensation, not shareholder value creation, appears to be the main motive behind acquisitions by overvalued acquirers.”).

[6]See, e.g., Ron Shalev, The Information Content of Business Combination Disclosure Level, 84 The Acctng. Rev. 239 (2009) (showing that acquirers who disclose more financial information have better subsequent firm and stock-price performance, consistent with the theoretical argument that managers attempt to hide financial information about merger mistakes).

[7]See, e.g., Statement of Commissioner Robert J. Jackson, Jr. on Final Rules Implementing FAST Act (March 26, 2019) (noting the Commission’s recent tendency to “ignor[e] facts in favor of belief that the SEC can deliver a free lunch in finance”).

[8]For compelling proof of this possibility that evaded even the basic literature review in today’s proposal, see Hope & Thomas, supra note 2 (showing that, after the adoption of new accounting rules eliminating mandatory disclosure of financials for geographic segments of public, multinational companies, “nondisclosing firms, relative to firms that continue to disclose geographic earnings, experience greater expansion of foreign sales, produce lower foreign profit margins, and have lower firm value”).

[9]See Release, at n. 282; see also Gershon Mandelker, Risk and Return: The Case of Merging Firms, 1 J. Fin. Econ. 303 (1974).

[10]See Gregor Andrade, Mark Mitchell & Erik Stafford, New Evidence and Perspectives on Mergers, 15 J. Econ. Persp. 2 (2001) (survey paper showing that between 1973 and 1998 the stock price reactions for the acquirer firm was minus 3 or 4 percent and that the joint value shows no clear pattern).

[11]See id.

[12] For thoughtful and important reasons for caution about studies of exactly the type relied upon in today’s release, see S.P. Kothari & Jerold B. Warner, Measuring Long-Horizon Security Price Performance, 43 J. Fin. Econ. 301 (1997) (“Conclusions from [earlier] long-run horizon studies require extreme caution.”).

[13] Ran Duchin & Breno Schmidt, Riding the Merger Wave: Uncertainty, Reduced Monitoring, and Bad Acquisitions, 107 J. Fin. Econ. 69 (2013) (showing that the “average long-term performance of acquisitions initiated during merger waves is significantly worse,” and providing evidence that firms conducting mergers during waves feature corporate-governance arrangements that give managers more discretion in choosing merger targets).

[14]Cf. George Santayana, The Life of Reason 14 (1905) (“Those who cannot remember the past are doomed to repeat it.”).

This post comes to us from Robert J. Jackson, Jr., a commissioner of the U.S. Securities and Exchange Commission.

Categories
Securities Regulation

SEC Chief Accountant Talks the Future of Financial Reporting

I’m grateful for the opportunity to visit Baruch College’s Zicklin School of Business and speak at the annual financial reporting conference for the fourth time. Many students who were starting their collegiate work here when I first spoke at this conference are now members of the graduating class.

I could use other examples in tracking changes to make the same point: the world stops for no one. Financial reporting is not exempt from change. This conference also provides an opportunity to talk about current issues in financial reporting and to peer into the future together and explore the role of financial reporting in a rapidly changing society. I’ll use a four-year timeframe to describe changes.

Next week is National Small Business Week. It’s a week when the U.S. Small Business Administration takes the opportunity to highlight the impact of outstanding entrepreneurs, small business owners, and community members from all 50 states and U.S. territories.

This year also marks the launch of a new office at the Securities and Exchange Commission (“SEC” or the “Commission”), the Office of the Advocate for Small Business Capital Formation, with the mission of advocating for the interests of small businesses and small business investors.[1]  It’s a good time for all of us to consider ways to do more for small businesses and their investors in the area of financial reporting.

Before I continue, let me remind you that the views expressed today are my own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff.

Let me also express my gratitude to my colleagues in OCA for continuing to provide thoughtful advice to the Commission regarding accounting and auditing matters and acknowledge in particular the assistance of Ying Compton and Carlton Tartar in preparing me to make today’s remarks.

My ambition today is to provoke thought about 1) where we have been over time and 2) several trends and ideas to incorporate in planning for the future of financial reporting.

In doing so, I will use as an essential starting point, an understanding of the overall financial reporting structure – the blueprint – which I introduced last year with a video.[2]  Management is the starting point for robust, accountable financial reporting, along with effective board and audit committee oversight.  Regular, reliable, and independent audits enhance investors’ confidence in the quality and reliability of financial statements.

Over time, the quality and reliability of the overall U.S. financial reporting structure has been strengthened through comprehensive efforts – including requirements for public companies to strengthen audit committees, evaluate the effectiveness of internal control over financial reporting, make directors and officers liable for accuracy of financial statements, and financially support the Financial Accounting Standards Board (“FASB”) and Public Company Accounting Oversight Board (“PCAOB”), among many other things.

We all go to work every day recognizing the enormous responsibility that we and others have to foster decision-useful financial reporting for investors— including sophisticated institutional investors and, importantly, Main Street investors.  Our work has the far-reaching impacts in our society: in 2018, almost 45 percent of U.S. households owned some type of registered fund.[3] Many of these people are saving for a home, retirement, or school; they are parents, veterans, teachers, and first responders.

While I remain optimistic about the long-term role of financial reporting in the United States and the world, the backdrop is complex. In my view, we face a long term trend of less overall trust and confidence in virtually all institutions, from corporations to audit firms. This trend must be reversed, and we must all work to do so. The future must be met with all of us involved in financial reporting being clear-minded, evidence-based, courageous, and frank regarding the objectives, responsibilities, and sensible expectations for each involved in financial reporting. Confusion or lack of action in this regard undermines purpose, trust, quality, confidence, and ultimately increases costs borne by shareholders.

Financial Reporting and Our Work in Advancing It

Confidence in financial reporting is essential to a healthy economy, including in the capital markets.  However, financial reporting is a means to an end; it is not the end.  Its purpose is to measure, reflect, describe, interpret, or otherwise disclose business events that have taken place in a decision-useful manner.  High-quality, general-purpose financial statements are designed to help investors make well-informed investment decisions.

A company’s control environment is a pervasive and vital aspect of getting reporting done right, acknowledging the inherent limitations of any financial reporting process.[4]  Ultimately, I believe, it is self-defeating for management to issue materially misstated financial statements, or an auditor to certify those financial statements. For instance, materially misstated financial statements that create false expectations of future results could increase the pressure on management to continue to engage in improper accounting practices when the business performance does not turn around. Unless management addresses the issue, the position becomes untenable and can eventually lead to a restatement. The costs of financial reporting failure can be substantial.

While most professionals are doing the right thing, instances of financial statement fraud, though relatively infrequent, do occur. When they occur, they can have profound effect on investors. Thus, it helps policymakers and practitioners alike to ask the question, how can we analyze previous failures, understand the root causes, learn from them, and find effective and efficient ways to limit failure while restricting burdens and costs on honestly- and well-run companies? In answering this question, it is also essential that the correct lesson be learned by the party with the corresponding responsibility to limit failure: management is responsible for preparing financial statements, subject to board and audit committee oversight; the independent external auditors then evaluate the fair presentation of these financial statements in relation to a financial reporting framework.

Work in advancing financial reporting

Our work over the past four years has emphasized several well-established themes:

#1.  Talent and integrity.  Perhaps the biggest challenge and focus area facing the auditing profession, and to some extent accounting more generally, is an apparent decline in the attractiveness of auditing, particularly to students. The decline has been influenced by issues of understanding the purpose and meaning (the “why”) of auditing, education requirements, compensation, heavy workloads, and a perception that other career opportunities are more exciting and rewarding.

We all have an opportunity to inspire the future generation of accountants –convincingly demonstrating the worth of careers in accounting and audit that serve a vital role in society, incorporate technology, and provide a basis for developing other specialized skills. We also need to focus on the diversity of background, perspectives, and thinking.

This is an effort that will require intense collaboration among audit firms, professional societies, government, and the academic community.  It is in everyone’s interest that the “best” people enter the profession, excited and ready to contribute.  To achieve that, we should be asking if our best accounting practitioners and educators are exciting students and stimulating minds?  Similarly, do seasoned practitioners inspire less tenured ones to see the purpose and importance of their work and how it is meaningful to the financial well-being of millions?

We also look to accountants and others who participate in our capital markets to act with the highest level of integrity and accountability.  While the vast majority of accountants meet our high standards, the Commission will continue to protect investors from the minority of individuals who do not meet their professional responsibilities using all tools available.  Relatedly, any efforts to subvert a Commission or PCAOB process are unacceptable.  In the past several years, the PCAOB brought several actions where attempts to manipulate workpapers in advance of inspections reached the highest levels of a firm.[5]  Also, just last year, the Commission brought charges against six certified public accountants – including former staffers at the PCAOB and former senior individuals at KPMG– arising from their participation in a scheme to misappropriate and use confidential information relating to the PCAOB’s planned inspections of KPMG.[6]  Such alleged behavior has no place in our markets.

#2.  Accounting standards (“New-GAAP”).  Necessary to the reliability and comparability of financial information is the maintenance of a set of accounting standards and practices that are oriented to the needs of investors.  Investors are now receiving (or soon will receive) financial statements based on several comprehensive new standards, including many that have largely converged with International Financial Reporting Standards (“IFRS”).  Since 2015, the FASB has issued significant updates including enhancements in the following areas:

  • revenue recognition,
  • leases,
  • current expected credit losses,
  • targeted improvements to hedging activities, and
  • investments in equity securities.

These new standards are at various stages of implementation.  I believe they have enhanced and will continue to enhance financial reporting.

#3.  Non-GAAP.  Non-GAAP is a form of voluntary reporting, designed to supplement (and must be reconciled to, though not supplant, with presentation not more prominent than,) the comparable GAAP numbers.  When done properly, the reporting can add critical insight for investors to the company’s performance from management’s perspective.

Investors benefit from understanding business performance from various perspectives:  financial measures of GAAP and non-GAAP and operational measures.  When taken together, these perspectives can establish a strong foundation for decision-making.  When taken in isolation, however, insights into business performance is limited.

Operational measures are generally the direct results of actions, although they are not necessarily direct measures of economic value. Financial measures are historical, generally-accepted measures of economic value, integrated across a company’s financial position, performance, and cash flows. Thus, it can be useful for investors to receive a mosaic of information – to receive operational and financial measures as a signal of activity and value.

Integrity and consistency in the non-GAAP and key operational figures are essential characteristics. In 2016, the SEC staff released new and revised guidance on the use of non-GAAP financial measures to address the concern regarding practices seen as potentially misleading. The SEC staff also has emphasized the essential role of appropriate and effective disclosure controls and procedures, which should be designed to provide timely information to management to allow for timely decisions regarding required disclosures.

#4.  Internal control over financial reporting (“ICFR”).  ICFR fosters reliability in the financial reporting process and has benefited from time and attention.  In 2015, concerns were raised regarding how companies and auditors should address requirements to maintain effective ICFR.[7]  My colleagues at the SEC and I have worked diligently, together with the PCAOB and others, in an accessible manner, to communicate to companies, audit committees, and auditors about resources, such as the COSO’s 2013 framework,[8] the SEC’s interpretative guidance on management’s report,[9] and other available publications.[10]

The SEC also announced settled enforcement actions relating to the requirements to maintain ICFR and evaluate its effectiveness.[11]  The SEC has also issued a Report of Investigation pertaining to the statutory requirement to devise and maintain internal accounting controls that reasonably safeguard companies and, ultimately, investor assets from cyber-related frauds.[12]  Separately, the disclosure of material weaknesses in ICFR does not obviate the need to remediate those weaknesses in a reasonable period of time.

#5.  Auditor independence.  Independence is fundamental to the credibility of audit reports and investor confidence in them.  The judgments auditors make in the course of their audit work must be objective and impartial.

The auditor independence rules and standards must be reviewed over time to ascertain whether they meet the needs of evaluating auditor independence in a changing environment.  In May 2018, the Commission proposed amendments to the Commission’s auditor independence rules to refocus the analysis that must be conducted when an auditor has a lending relationship with certain shareholders of an audit client.[13]  Issuance of final rules is on the Commission’s agenda for 2019.[14]

Also, in this area, I understand that auditors are being asked with some frequency in the fund industry to consider providing permissible tax services to the fund, subject to pre-approval.  Auditors and independent audit committees, of course, must take care to adhere to the law in both the process and conclusions.[15]  In doing so, attention should be given to avoiding scope creep into prohibited services, such as bookkeeping or other services related to the accounting records or financial statements.

#6.  Audit regulation.  Auditors are subject to a system of public regulation, self-regulation, and controls that, taken as a whole, constitutes the regulation of the profession.  Attention in this area is premised in the role of an auditor as a vital gatekeeper in financial reporting.[16]  Preserving and enhancing confidence in the quality of audit services is essential to the public interest and all Americans.

The independent auditor helps to build confidence in financial statements.  As of December 31, 2018, there were 1,862 public accounting firms registered with the PCAOB, which means that they are authorized to audit U.S. public companies.[17]

The SEC appointed five new Board members to join the PCAOB in 2018, the first time five new members joined the Board in the same year since the PCAOB was established.  The appointments provided a significant opportunity—a chance for the PCAOB to learn from the fresh and diverse thinking of the new Board members, to innovate, and ultimately to enhance its oversight of the auditing profession in an increasingly dynamic and demanding environment.

The PCAOB’s work has been substantial over time, including with:

  • improvements to the transparency of audits – requiring disclosure of certain audit participants on a new PCAOB form, and establishing AuditorSearch, a public database of engagement partners and audit firms participating in audits of U.S. public companies; and
  • changes to the auditor’s report– some of the most significant amendments in 70 years.

#7.  Audit firm governance.  Last year at this conference I mentioned that the leaders of many of the largest, most complex audit firms, had earlier appointed (or would be appointing) independent directors or independent advisory council members with meaningful governance responsibilities.[18] Those remarks provide context for these comments on the same topic.

Five of the six largest U.S. firms have added valuable outside perspectives.[19]  The purpose of adding outside views in those roles is to strengthen monitoring and to enhance advising to foster audit quality; this, in turn, will bolster public confidence and trust in the firm, its network, and the audit profession generally.

This year, I would like to provide my personal views on how to advance the thinking with some suggestions for U.S. firms:

  • Outside members should be strong and steadfast, independent of mind and willing to challenge each other and firm leadership constructively.
  • Each member should clearly understand their responsibilities and stake in the firm’s long-term performance in delivering quality audit services.
  • Each member should make active and substantive contributions including, for example, by providing input into setting the board’s or council’s agenda.
  • Members should provide input to the firm’s annual transparency or audit quality report (which is voluntary in the U.S.), especially regarding the board’s or council’s charter, work, and outcomes.[20]

#8.  Independent audit committees of public companies.  Audit committees of listed public companies have become well-recognized and essential in the governance of listed public companies and increasingly of entities in other countries.  In the U.S., they have financial reporting and external auditor oversight authority and responsibility.  They set the tone for the company’s financial reporting and the relationship with the external auditor.

In my experience, some of the more important drivers of audit committee effectiveness are the independence of the members, the time invested in the oversight functions, the quality of the committee’s information and communication from management and the auditors, and the committee members’ training and experience relevant to their oversight responsibilities. I encourage audit committees and their advisors to think along these dimensions to increase effectiveness. In addition, an audit committee should incorporate the audit firm’s understanding of the company’s business and audit risks into its oversight of the auditor’s expertise, incentives and, ultimately, appropriate performance in the conduct of the audit.

As relevant information for the audit committees’ oversight, I believe it is also essential for the committee members to familiarize themselves with relevant research evidence.  For example, existing academic research has not been conclusive on the relationship between an auditor’s tenure and either audit quality or auditor independence.  Some studies document that mandated rotation may worsen an auditor’s efforts to be skeptical and may mask company “opinion shopping.”  There is also some evidence suggesting that professional skepticism can, in some cases, benefit from a long-term auditor-client relationship.[21]

Audit committees work in the interest of shareholders, and they have a clear information advantage over outside shareholders.  As such, I have encouraged voluntary audit committee-related disclosures, which are increasing.  I am heartened by the momentum over the past several years, recognizing there is always more that could be done.

For example, in a survey of proxy statement disclosures by Fortune 100 companies relating to audit committees in 2018:[22]

  • sixty-two percent of companies disclosed the factors used in the audit committee’s assessment of the external auditor’s qualifications and work quality, while in 2012 the percentage was 18%, and
  • eighty-nine percent of companies disclosed that the audit committee considers non-audit fees and services when assessing auditor independence, up from 12% in 2012.

I encourage audit committee members of listed companies to continue to consider ways to make their communication with investors more useful, including communicating how the audit committee met its responsibilities.

#9.  International cooperation.  The business environment continues to reflect the extensive cross-border reach of companies and the markets they serve.  OCA is actively engaged in promoting comparability among public company financial reporting and audit activities on the global front as well.

Over the past year, I have participated in the work of the Monitoring Group.  The Monitoring Group is a group of regulatory and international financial organizations committed to advancing the public interest.[23]  The Monitoring Group’s work is done in view of promoting international audit quality in order to strengthen confidence in the audit of financial statements, in particular, those of public companies.[24]  Given the importance of international standards to the U.S. capital markets, I was honored to be appointed to serve in the roles of vice chair, now co-chair, and in a few weeks will assume the role of chair of the Monitoring Group.

The approach I have taken over the past year has been, and will continue to be collaboration with and among Monitoring Group members, including exchanging views on ways to strengthen the effectiveness of the structure and governance of setting international audit-related standards.  This collaborative spirit is also consistent with the Monitoring Group’s main mode of decision-making:  consensus, which helps incorporate each member’s view.

I have also urged continuous improvement as a parallel, current, and an ongoing responsibility of all the organizations involved in the overall structure for setting international audit-related standards, including the standard setting boards, the International Federation of Accountants (IFAC), the Public Interest Oversight Board (PIOB), and the Monitoring Group.  It is the responsibility of each organization to identify and respond to necessary changes in a timely manner, even in addition to and apart from the Monitoring Group’s ongoing effort at developing recommendations to strengthen the structure and governance of international audit-related standard setting.

Having said that, the effectiveness of standard setting also depends on the human factor.  I look forward to working with the chairs and leaders of the PIOB, IFAC, and the standard setting boards to better understand whether behaviors — at the individual, group and organizational level — are calibrated and aligned in such a way that the entire system  works smoothly and effectively.

On a separate front of international cooperation and coordination, though significant progress has been made, obstacles to the flow of information from foreign jurisdictions to U.S. regulators remain, hindering regulatory oversight of U.S.-listed companies.  Last December, Chairman Clayton, Chairman Duhnke and I communicated such concerns to the market in a statement.  We highlighted impediments to the SEC’s and PCAOB’s regulation, supervision, and enforcement resulting from restrictions on the access to books and records maintained in China, and the PCAOB’s inability to inspect the audit work of PCAOB-registered accounting firms with respect to U.S.-listed companies with operations in China.  Such limited oversight as a result of barriers to information access, combined with limited enforcement tools, could allow bad actors to hide fraud more effectively and do so without meaningful consequence, including the inability of defrauded investors to recoup losses.  This state of affairs undermines confidence in all China-based companies.[25] It is important for investors, advisors, securities analysts, index publishers, and others to be aware of the impact of limitations in this area.

As we noted in December, depending on various facts and circumstances, including company-specific considerations, if significant information barriers persist, remedial actions involving U.S.-listed companies may be necessary or appropriate.  In the past, remedial measures have included, as examples, requiring affected companies to make additional disclosures and placing additional restrictions on new securities issuances.  Companies need to consider how these circumstances could affect their initial or periodic disclosures.

#10.  Technology, data, and innovation.  Not a day goes by without illustrations of the profound effects of technology on the economy.  Technological developments are changing business and financial reporting, and consequently how effective audit approaches take advantage of technology and data.

Among other work, we engage with market participants on innovative ideas and technological developments.  As an example, we collaborate with the SEC staff’s FinHub (Strategic Hub for Innovation and Financial Technology) to help reduce regulatory barriers to innovation that benefits investors and the markets.  The Commission also has supported the expansion of the role of structured data, tagging, and related systems to provide investors with new and efficient ways to consume and analyze the information in our markets.

These are examples of changes just in the past four years, many of which were planned years ago and benefited from multiple years of development.  The changes have strengthened the structure for financial reporting.

Some Currently Observed Outcomes

The financial reporting structure is supported by clear responsibilities for and certifications from management; requirements to devise and maintain sufficient internal accounting controls; requirements to have independent, expert audit committees or others charged with governance; clear accounting and reporting standards issued by a reliable, well-resourced standard setter; strong audit firms; a well-resourced audit regulator; and timely, prevention-first (among other essential) regulatory approaches.

The following observations also buttress my belief in the current strength of the U.S. financial reporting structure:

  • While our collective work is never done and the inherent risks of financial reporting failure are always present, restatement rates in the most recent past have been at the lowest level in about two decades.[26]  A survey of investors indicates a high degree of confidence in financial reporting.[27]
  • Companies with ineffective disclosure controls (242 in 2018) have decreased for the second year in a row, after peaking in 2015 (275), with IT-specific controls being the most frequently identified deficiency.[28]
  • During 2018, there were 209 new engagements and 186 departures among the major global and national audit firms, suggesting that audit committees can and do change audit firms.[29]
  • Similar to restatements, while our collective work to reduce defect rates is never done, auditor inspection findings in the U.S. are on the decline, particularly among the largest of registered firms, both in frequency and severity.

Although these points are anecdotal, I believe they are consistent with an emphasis on maintaining a high-quality financial reporting structure, a structure that fosters investor confidence, promotes efficient capital allocation, and ultimately makes the U.S. more competitive in the global marketplace.

Aiming Toward the Future 

We should not rest on our laurels.  We must peer into the future and plan.  I will discuss two broad areas that have gone through significant changes and identify opportunities for the accounting profession.

Economic trends

As context for my perspective, the SEC oversees over $97 trillion in securities trading annually on U.S. equity markets and the activities of over 27,000 registered market participants, including investment advisers, mutual funds, exchange-traded funds (ETF), broker-dealers, municipal advisors, and transfer agents.[30]

The SEC is responsible for selectively reviewing the disclosures and financial statements of almost 8,000 reporting companies, of which approximately 4,300 are exchange listed.[31]  Of the top 100 publicly traded companies in the world, 81 are subject to the SEC’s reporting requirements.[32]

Evolution of technology

Technology is a prominent force that has been a catalyst of profound changes to business models, business process, accounting, and auditing.

The technology sector has attracted substantial amounts of capital investment and represents a significant share of the economy.  Since its invention in 1989, the World Wide Web has exponentially expanded the reach of information technology and has transformed the world and business.  For example, as of March 2019, the S&P 500 index included 68 companies belonging to the Information Technology sector,[33] representing 21% of S&P 500 companies’ total market capitalization.[34]

These statistics are significant, yet they understate the impact of technology in a sense because they do not capture the effect of technology in transforming how companies in other sectors do business.[35]  They also illustrate the pervasive and fast pace of change in technology, which also affects how investors and other users access and process financial information.

The SEC itself demonstrates the impact of technology as its IT systems provide a critical service to the markets.  On a typical day, investors and other market participants access disclosure documents through the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system 41 million times.  Again, that’s a single day!

The opportunities and benefits of technology provide also come with risks and complexities.  For example, data security and privacy concerns are coming to the fore.  How we respond to these challenges will have a profound effect on our capital markets.  As such, we need to understand these changes through the lens of our capital markets, particularly in their impact on financial reporting.  Adequately preparing the next generation of the accounting profession for such challenges will be critical to that understanding.

Investment strategies

On the investing side, retail investors are and have been critical to our capital markets.  Over the past four decades, they have been increasingly relying on financial intermediaries to help them make investment decisions.  For example, almost 45 percent of U.S. households owned funds (generally ETFs or mutual funds) in 2018, a sharp increase from about only six percent in 1980.[36]

As a result of innovative, valuable institutional services, the U.S. issuers’ equity securities markets have been increasingly intermediated, although further separating companies from their ultimate, retail investors.  For example,

  • In 1950, institutional shareholdings accounted for only 7% of total U.S. equity ownership; this percentage rose to 28% in 1979, and over 50% in 1999.[37]
  • For S&P 500 companies, the rate of institutional shareholdings increased to about 80% in 2017.[38] A change that has fueled this trend is the growing shift from actively-managed to passively-managed funds.  In every year since 2005, actively-managed U.S. domestic equity mutual funds experienced outflows, while index domestic equity mutual funds had inflows and index domestic equity ETFs had positive net share issuance.[39]

These shifts can impact how accounting and audit information serves investors.  For example, passive investors are not necessarily passive owners.  Their governance and trading decisions rely on the consumption of high-quality, consistent, comparable financial information and other metrics, in part, because it reduces their trading and monitoring costs.[40]

Also, passive investing relies on the efforts of active investors whose buying and selling activities determine share prices.  Transparent financial disclosures are essential for active investors to set informationally efficient prices.

Thus, there exists a strong demand for extensive, refined financial data for corporate managers and investment advisors, both of whom manage shareholder capital.  Opportunities go to those who identify the changes affecting the market participants and how needs for financial data used by investors might change.

Small business

Another broad economic influence is the pace of small business formation.  While attention is sometimes focused on large corporations, the growth and reporting of small businesses are vital to our economy.

I want to discuss two broad observations I have had related to small businesses.

First, auditors serve a vital role in providing candid feedback to the small businesses they audit, in either a financial statement only audit or an integrated audit.  They can and should engage in two-way communications with the companies they audit because such communications help the auditor elicit useful information from management and improve audit quality.

The auditor has certain communications that are required to be made to the audit committee in all audits conducted under PCAOB standards, such as the communication of uncorrected and corrected misstatements[41] and significant deficiencies and material weaknesses identified during the audit[42].  In addition to these required communications, the auditor has ongoing two-way communications with management and the audit committee regarding matters about internal controls, complex accounting matters and other matters impacting the audit.  The auditor’s feedback in these areas can help the company gain a better understanding of the related audit decisions and lead to corresponding improvements.  I believe auditors can effectively serve this role within the boundaries of the independence rules.  It is essential for auditors to have processes and controls to help mitigate the occurrence of a violation of the independence rules.

Audit firms can provide both audit and permissible other services to the same public audit client and serve the public and shareholder interests of strengthening companies and their financial reporting, while also in many cases benefitting audit quality.  Relative to large and mature companies, small businesses likely have shorter history and hence less experience in building up robust internal control systems, so they may particularly benefit from objective, seasoned feedback regarding the role and consequences of useful information.

We are all better off when auditors fully embrace their role in providing audit feedback and other services, which facilitates improvement to financial reports prepared by management, and increases the effectiveness of the audit committee’s oversight.

Second, it is essential to note that mandates for disclosures always come at a cost, and such cost could be disproportionately burdensome on small businesses.  In my view, the experience with graduated disclosures or phased implementation has been positive.

As an example of graduated disclosures, public companies referred to as Emerging Growth Companies (“EGC’s”) or as Smaller Reporting Companies are permitted to present two (instead of three) years of financial statements and MD&A.  The JOBS Act also allows EGCs to elect to use private company transition dates for accounting standards.[43]

Phased effective dates have been applied recently to the PCAOB’s new auditor reporting standard – auditors of companies that are not large accelerated filers will have an additional 18 months to implement the requirements for critical audit matters.  This approach can apply to other standard-setting activities as well.  Phased implementation enables all involved in the implementation of new or revised standards to monitor the experiences of earlier adopters, including consideration of any unintended consequences.  Phased implementation can facilitate more timely and effective post-implementation reviews, and provide support for regulatory or standard setting changes, education, and coordination, where necessary.

International trends

Let me now transition to several international trends.

Today’s companies both operate and seek capital globally.  There has been extensive international cooperation to promote convergence, where possible, between domestic and international accounting and audit standards, and work against fragmented regulation.  The SEC has for decades considered accounting convergence, as an example.[44]

It is crucial to identify similarities and differences in financial reporting and auditing standards across countries and reconcile them where possible.  Differences in these standards and their applications contribute to uneven financial reporting quality and audit quality; this, in turn, manifests in additional costs that investors bear in acquiring and processing information about foreign companies relative to domestic companies and imposes significant costs on foreign companies seeking cross-listing.[45]  Overcoming such information barriers is vital for companies and their investors to realize the benefits of cross-border capital flows and a diversified investor base.[46]

Given the nature and size of our capital markets,[47] I would expect the U.S. to set a benchmark in the quality of financial reporting and audit services, in no small part due to coordinated, intensely collaborative, and informed thinking regarding the overall financial reporting structure.

I also recognize that countries around the world have different legal, governance, capital markets systems, and regulatory approaches.  For example, regarding regulating the audit market, the U.K. has recently issued several reports with varying objectives.  In my view, some recommendations have limited use in a U.S. and international context; they might, in fact, present risks to audit quality and investor interests in those contexts.

For example, one report[48] includes a recommendation that the governance regime for an audit firm’s business should include a board comprising “a majority of non-executive directors” that reports to a new regulator. Non-executive appointments should “be approved” by the new regulator. This regulator would be charged with establishing wider public interest responsibilities that run even beyond investors’ interests.[49]

An effective and efficient global capital market depends on high-quality financial information that is reliable and comparable, regardless of country of origin.  Continually advancing the goal of disclosure of information across borders requires the cooperative efforts of all participants in the capital raising and financial reporting processes, including national governments, regulators, the international business community, international financial institutions, accounting and audit standard setters, and audit firms.

I am concerned about national approaches that structurally intertwine private sector and public sector responsibilities –blurring the lines of responsibilities and accountabilities of each and adding additional undefined, and multilayered, incentives.  For example, the path of embedding within a private-sector audit firm’s chain of command a board answerable to the regulator can undermine and impair the auditor’s independence – its objectivity and impartiality – with deleterious effects on investor and public confidence in the reliability of the auditor’s report.  A regulatory process that lacks transparency and consistency can risk placing other interest well ahead of investors’ interests; it is our obligation to put investors’ interests — notably their long term interests — first.

The example, although an important one, is one of the many ideas and recommendations being considered in different national markets that relate to audit and financial reporting.  It illustrates the importance of thoroughly examining the root causes of failures in domestic markets, assumptions that underpin recommendations, and the possible consequences of proposals – both intended and unintended.  In doing so, it is crucial to understand the starting points for audit and financial reporting in the analysis – a country-level profile of the cultural, legal, and reporting environments – and the aspects in which those starting points are similar and different from other countries and international contexts.

More broadly, it illustrates the essential responsibility for all of us – policymakers, practitioners, investors, academics, in contributing to the work of problem identification, root cause analyses, and ultimately informative evidence and other comprehensive data gathering on the audit market and audit quality to inform the policy-making process.

Conclusion

My colleagues and I firmly believe a bright future beckons.  But, it is not a certainty.  Even as we advance high-quality information in the capital markets, it is critically important to understand and maintain focus on the core principles that will move us forward and to continue to act by them.

Having fair, orderly, and efficient capital markets that facilitate capital formation while protecting investors is a pillar of the U.S. economy, and the quality and performance of the U.S. economy supports and promotes many of America’s other strengths, as well as public policy initiatives.

The future belongs to those with the energy to lead and the imagination to make things better.

Thank you.

ENDNOTES

[1] See more about this office at https://www.sec.gov/oasb.

[2] See an Overview of Financial Reporting Structure at https://www.sec.gov/financial-reporting-structure.

[3] See ICI Research Perspective (Nov. 2018), available at https://www.ici.org/pdf/per24-08.pdf.

[4] See, Commission Guidance Regarding Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, noting:

“ICFR cannot provide absolute assurance due to its inherent limitations; it is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. ICFR also can be circumvented by collusion or improper management override. Because of such limitations, ICFR cannot prevent or detect all misstatements, whether unintentional errors or fraud. However, these inherent limitations are known features of the financial reporting process, therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.”

[5] See Staff Audit Practice Alert No. 14: Improper Alteration of Audit Documentation (April 21, 2016), available at https://pcaobus.org/Enforcement/Pages/enforcement-spotlight-improper-alteration-of-audit-documentation.aspx.

[8] See An Executive Summary of ​​​Internal Control — Integrated Framework (2013) available at https://www.coso.org/Documents/990025P-Executive-Summary-final-may20.pdf.

[9] See Commission Guidance Regarding Management’s Report On Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, Release No. 33-8810 (June 20, 2007) [72 FR 35323].

[10] FEI’s Committee on Corporate Reporting (“CCR”) has released two ICFR: Insights, Issues, and Practices related to the new leases standard the new current expected credit loss standard, respectively. They are available at https://www.financialexecutives.org/Influence/Committees/Corporate-Reporting/News/ICFR-Insights,-Issues,-and-Practices.aspx.

[11] See AAER numbers 4015 through 4018, in the matters of CytoDyn, Inc., Digital Turbine, Inc., Lifeway Foods, Inc., and Grupo Simec S.A.B. de C.V., respectively (January 29, 2019).  Also see AAER No. 3978 in the matter of Primoris Services Corporation (September 21, 2018).

[12] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding Certain Cyber- Related Frauds Perpetrated Against Public Companies and Related Internal Accounting Controls Requirements, Securities & Exchange Commission (Oct. 16, 2018), available at https://www.sec.gov/litigation/investreport/34-84429.pdf.

[13] Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, Release No. 33-10491 (May 2, 2018) [83 FR 20753].

[15] See Section 201 of the Sarbanes Oxley Act, which provides that “a registered public accounting firm may engage in any non-audit service, including tax services,” that is not expressly prohibited, after audit committee preapproval).

[16] See United States v. Arthur Young, 465 U.S. 805, 817-818 (1984).  The Supreme Court observed:

“By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s creditors and stockholders, as well as to [the] investing public. This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”

[18] See Wesley Bricker, Chief Accountant, SEC, Remarks before the 2018 Baruch College Financial Reporting Conference: “Working Together to Advance Financial Reporting” (May 3, 2018), available at https://www.sec.gov/news/speech/speech-bricker-040318.

[20] The Center for Audit Quality has published Audit Quality Disclosure Framework, to facilitate the consistency and comparability of these reports.  See https://www.thecaq.org/wp-content/uploads/2019/03/caq_audit_quality_disclosure_framework_2019-01.pdf.

[21] See Kendall O. Bowlin, Jessen L. Hobson, and M. David Piercey (2015) The Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality. The Accounting Review: July 2015, Vol. 90, No. 4, pp. 1363-1393.

[23] Members of the Monitoring Group are the Basel Committee on Banking Supervision, European Commission, Financial Stability Board, International Association of Insurance Supervisors, International Forum of Independent Audit Regulators, International Organization of Securities Commissions, and the World Bank. See https://www.iosco.org/about/?subsection=monitoring_group.

[24] See, for example, Monitoring Group Charter – Preamble, page 2, available at https://www.iosco.org/about/monitoring_group/pdf/monitoring_group_charter.pdf.

[25] Jay Clayton, Chairman, and Wesley Bricker, Chief Accountant, SEC, and William D. Duhnke III, Chairman, PCAOB, Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally—Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China (December 7, 2018), available at https://www.sec.gov/news/public-statement/statement-vital-role-audit-quality-and-regulatory-access-audit-and-other.

[26] See the annual data on reissuance restatements provided in “2017 Financial Restatements: A Seventeen Year Comparison” by Audit Analytics.

[27] See Center for Audit Quality, 2018 Main Street Investor Survey, available at  https://www.thecaq.org/2018-main-street-investor-survey.

[28] See “Trends in Disclosure Controls:  2010-2017” by Audit Analytics, available at https://www.auditanalytics.com/0002/view-custom-reports.php?report=e132c8eb0e2f5eb13e2ffadbe12c379c.

[29] See “Auditor Changes Roundup: 2018 Annual Summary” by Audit Analytics, available at https://www.auditanalytics.com/blog/auditor-changes-roundup-2018-annual-summary/.

[31] See Section 408 of the Sarbanes-Oxley Act of 2002.

[32] See Fiscal Year 2020 Congressional Budget Justification and Annual Performance Plan; Fiscal Year 2018 Annual Performance Report, available at https://www.sec.gov/cj.

[33] See S&P 500 Information Technology Factsheet (March 29, 2019), available at https://us.spindices.com/indices/equity/sp-500-information-technology-sector.

[34] See S&P 500 Factsheet (March 29, 2019), available at https://us.spindices.com/indices/equity/sp-500.

[35] For example, Alphabet, Facebook, Twitter, Paypal, Electronic Arts, and Activision Blizzard are currently in S&P’s Communication Services sector, not the Information Technology sector.  Similarly, Amazon and Netflix are in the Consumer Discretionary sector. See https://www.reuters.com/article/us-usa-stocks-gics-analysis/wall-streets-sector-shakeup-will-let-more-tech-stocks-shine-idUSKCN1L724T.

[36] See ICI Research Perspective (Nov. 2018), available at https://www.ici.org/pdf/per24-08.pdf.

[37] See Bennet, J. A., R. W. Sias, and L. T. Starks. 2003. Greener Pastures and the Impact of Dynamic Institutional Preferences. The Review of Financial Studies 16 (4): 1203-1238.

[39] See ICI 2018 Investment Company Fact Book, available at https://www.ici.org/pdf/2018_factbook.pdf. At the end of 2017, the assets of index mutual funds and index ETFs reached $6.7 trillion, accounting for 35 percent of total net assets in long-term funds, up from 15 percent at the end of 2007. Despite the growth, index domestic equity mutual funds and ETFs remain a relatively small part of US stock markets, holding only 13 percent of the value of US stocks at the end of 2017.

[40] See Boone, Audra, and Joshua White. 2015. The effect of Institutional Ownership on Firm Transparency

and Information Production. Journal of Financial Economics 117: 508-533. They find that higher institutional ownership is associated with greater management disclosure, analyst following, and liquidity, resulting in lower information asymmetry.

[41] See AS 1301: Communications with Audit Committees.

[42] See AS 1305: Communications About Control Deficiencies in an Audit of Financial Statements; and AS 2201: An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.

[43] See more examples of graduated disclosures at https://www.sec.gov/OCA-SegmentChart-5-2-18.pdf.

[44] See, e.g., Regulation of the International Securities Markets, Release No. 33-6807 (Nov. 14, 1988); SEC Concept Release, International Accounting Standards, Release No. 33-7801 (Feb. 16, 2000), available at http://www.sec.gov/rules/concept/34-42430.htm ; Acceptance from Foreign Private Issuers of Financial Statements Prepared in Accordance with International Financial Reporting Standards without Reconciliation to U.S. GAAP, Release No. 33-8818 (July 2, 2007), available at http://www.sec.gov/rules/proposed/2007/33-8818.pdf; Concept Release on Allowing U.S. Issuers to Prepare Financial Statements in Accordance with International Financial Reporting Standards, Release No. 33-8831 (Aug. 7, 2007), available at https://www.sec.gov/rules/concept/2007/33-8831.pdf; and Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers, Release No. 33-8982 (Nov. 14, 2008), available at https://www.sec.gov/rules/proposed/2008/33-8982.pdf. See also, A U.S. Imperative: High-Quality, Globally Accepted Accounting Standards, available at https://www.sec.gov/news/statement/white-2016-01-05.html#_edn1.

[45] See https://www.iasplus.com/en/binary/iosco/ioscores0005.pdf. Overcoming such barriers has been important to International organizations. For example, IOSCO suggested that “cross-border offerings and listings would be facilitated by high quality, internationally accepted accounting standards that could be used by incoming multinational issuers in cross border offerings and listings.”

[46] The relative importance of an accounting function in a country varies directly with the stage of development of the country’s economy, its capital markets, and legal infrastructures, which influence the demand for financial disclosures, including audited financial statements. Specifically, the volume of economic and financial data demanded by investors and by governments depends largely upon the importance of corporate activities to the economy, the extent to which company ownership and management are separated; the extent of external funding needed; the channels through which external funding is acquired (e.g., private placement or  public offerings); the extent to which taxes are predicated upon economic data; and the volume of a country’s international trade flows and foreign direct investment etc. The demand for a strong audit function goes hand in hand with that for a strong accounting function; that is, audited financial statements are a means to satisfying investors’ demand for financial information.

[47] International convergence in standards does not mean global adoption of the same set of standards, which does not necessarily lead to the same financial reporting quality and auditing quality. Financial reporting and audit outcomes vary with the strengths of the local countries’ ecosystems, e.g., country-level legal environment, corporate governance, culture expectations. The U.S. differs from other countries in its heavy emphasis on investor protection, and legal and financial systems supporting public debt and equity markets.

[48] Id. See paragraph 8.20-8.22 of the final report on the statutory audit market by CMA, available at https://www.gov.uk/cma-cases/statutory-audit-market-study#final-report.

[49] See Independent Review into the Quality and Effectiveness of Audit – Call for Views, available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/794244/brydon-review-call-for-views.pdf.

These remarks were delivered by Wesley Bricker, the chief accountant of the U.S. Securities and Exchange Commission, on May 2, 2019, at the 2019 Baruch College Financial Reporting Conference in New York, New York.

Categories
Securities Regulation

Debevoise Discusses SEC Disclosure Changes for Tech, Media, and Telecom Firms

On March 20, 2019, the SEC announced the adoption of amendments to Regulation S-K intended to modernize and simplify disclosure requirements applicable to SEC reporting companies. Highlighted below are two changes of note for companies in the technology, media and telecommunications (“TMT”) sector.

Omission of Schedules to Exhibits

M&A deal activity in the TMT sector has been particularly strong in recent years. When publicly filing a merger, acquisition or similar agreement for these deals, reporting companies customarily exclude from the filing the disclosure schedules and other immaterial attachments to the agreement. While these omissions previously were permitted only for material merger, acquisition and similar agreements, under the new rules, immaterial schedules and similar attachments may be omitted from all exhibit filings, including material contracts such as credit agreements and services agreements.

This provides welcome relief to reporting companies, some of which have already been omitting such immaterial schedules and attachments from material contracts – in some cases, resulting in an SEC comment requesting that the company refile the exhibits in full. Public companies and their prospective counterparties in the TMT sector should consider how to maximize the benefits provided by the new rules when drafting and negotiating deal documentation. For example, in preparing an acquisition agreement, the deal parties can limit the amount of immaterial information ultimately made publicly available by moving this information to the schedules of the agreement to be filed. Entire agreements, such as software licenses or technology services agreements (e.g., software and maintenance support agreements, and data center and hosting arrangements), if immaterial and included as a schedule to a material contract, may also be omitted from public filings.

To benefit from the new rules, the information in the omitted schedules and attachments must be (i) not material and (ii) not otherwise disclosed in the body of the exhibit or in the base disclosure document to which the exhibit is attached. Reporting companies must file with the applicable exhibit a list briefly identifying the contents of the omitted schedules and attachments (unless that information is already included within the exhibit in a manner that conveys the subject matter of the omitted materials – e.g., in the table of contents) and should be prepared to furnish such omitted materials supplementally to the SEC upon request (although they need not undertake to do so in the filing).

While these new rules apply to SEC filings, other regulatory regimes remain unaffected and may require TMT companies to file complete copies of all agreements. For example, television broadcast licensees must continue to file material contracts with the FCC in accordance with FCC rules and regulations.

Elimination of Formal Process for Confidential Treatment Requests

TMT reporting companies often must publicly file material contracts and agreements that contain sensitive information, such as supply agreements, services agreements and technology license agreements. In these instances, the company typically submits to the SEC a confidential treatment request (“CTR”) with respect to such information on the basis that disclosure of the information would cause it substantial competitive harm. Following review of the application, which can take several weeks, the SEC issues a confidential treatment order granting or denying the CTR. This process is time consuming and potentially disruptive to a reporting company’s business. For example, the SEC will not declare a pending registration statement effective while a CTR is being reviewed.

The new rules permit reporting companies to omit confidential information from (i) material merger, acquisition and similar agreements and (ii) material contracts not made in the ordinary course of business without filing a formal CTR. Instead, companies need only make appropriate markings to the exhibit and exhibit index indicating the presence of omitted information because such information is both not material and would likely cause competitive harm to the company if publicly disclosed. Exhibits that do not fall under one of the two categories noted above (e.g., underwriting agreements and debt indentures) do not benefit from these new rules governing CTRs.

While the new rules eliminate the formality of the CTR process, the substantive requirements related to assertions of confidentiality remain intact. As stated in an announcement issued on April 1, 2019, the SEC has established a task force and procedures for reviewing registrant filings to assess whether redactions to exhibits appear to comply with the relevant rules for redacting confidential information. Reporting companies should be prepared, upon request from the SEC, to promptly provide supplemental materials similar to those currently required in a CTR including an unredacted copy of the exhibit and an analysis supporting confidential treatment of the redacted information. If the supplemental materials do not support a company’s redactions, the SEC may request that the company file an amendment to its public filing that includes some, or all, of the previously redacted information.

Other Changes and Timing

The new rules include amendments to various other disclosure requirements applicable to current and periodic reports (e.g., Forms 8-K, 10-K and 10-Q) and offering documents, including with respect to executive officer disclosure, Section 16 “insider” filings (i.e., Forms 3, 4 and 5) and the rules governing incorporation by reference. We summarize these and other selected changes in our recent client update, accessible here.

The rules governing redaction of confidential information became effective on April 2, 2019. Companies with pending CTRs may, but are not required to, withdraw the requests. Most of the remaining final rules will become effective on May 2, 2019.

This post comes to us from Debevoise & Plimpton LLP. It is based on the firm’s memorandum, “SEC Pares Back Required Content for Exhibit Filings: Takeaways for TMT,” dated April 23, 2019, and available here.

Categories
Securities Regulation

Beyond Disclosure: A New Way of Examining Securities Regulation

When it comes to the U.S. securities markets, the game has changed. Historically, the U.S. securities markets were dominated by retail investors who engaged in a buy and hold strategy: purchasing stocks as a vehicle to invest in a corporation and, if so inclined, to have a voice in a corporation’s internal governance. To that end, these investors relied heavily on corporate disclosures and filings required under the law and regulated by a number of agencies, including the Securities and Exchange Commission (the “SEC”).

Now, however, the U.S. securities markets are dominated by large institutional investors that, at last count, make up approximately 70 percent of the market activity on Wall Street. Moreover, within this group of institutional investors (including active investors such as pension funds and investment management firms) there is a smaller, but incredibly powerful subset of firms that invest by primarily using algorithmic formulas. These quantitative hedge funds (or “quants,”) do not engage in a long buy and hold strategy. They do not care about the internal governance of a corporation. In some cases, they liquidate their holdings at the end of every day.  As such, the required disclosures matter very little (if at all) to these investors.

This current trend in market activity marks a fundamental paradigm shift in trading habits. Instead of the traditional investor paradigm – the old game where an investor’s purchase of a stock is a reflection of his confidence in the market – we now have a consumer paradigm, where the purchase of stocks is not at all connected to a valuation of the company but rather to the value of the stock itself and its currency within the market. Given this transition, what is needed is a regulatory structure that takes into account this new trading framework by treating stock as a product separate from its underlying corporation. In this way, we can devise a more responsive regulatory configuration that addresses the markets as they exist today, not as they behaved in the 1930s.

As one of the principal regulators of the securities markets, the SEC generally regulates under a disclosure model.  Rather than telling corporations what to do and how to behave (something that would generally be considered anathema to our free market system) the SEC regulates by requiring corporations to disclose their activities and financials in order to allow investors to make choices themselves. As such, the SEC’s disclosure model requires a company to provide investors with a substantial amount of information regarding its operations and financial well-being in the hope that investors will use that information to make sound choices.  However, just as there is a disaggregation between the company as a company and the company as an investment vehicle, there is also a disaggregation between how people are trading in the markets and how the government is regulating the markets. Under a disclosure model, the SEC is regulating the wrong behavior. At its core, the disclosure model focuses on the fundamentals of a company when, in fact, the current securities markets have relatively little interest in those fundamentals.

In a recent book, Professor Karen Kunz and I propose a number of frameworks for regulation under this new paradigm. A central approach of a new system would be to examine who, or what, is being regulated.  Some investors are more powerful and have greater resources than others and thus have more access to and leverage in the markets. How do we maintain a regulatory structure that takes into account all of the different market participants and their ability to affect the market?

The current model emphasizes oversight of corporate disclosure, which allows for easy identification of who is being regulated, but limits oversight to a very narrow spectrum of market participants and seems to ignore what is being regulated.  To rectify that, we offer several proposals for changing the current regulatory structure, two of which are worth mentioning here.  First, we envision treating stocks as products, rather than investments, and regulating them accordingly.   If we are to treat securities as products, then stocks and bonds become just things that companies and municipalities – and yes, even the U.S. Treasury – produce, in the same way that GM produces Jeeps and Apple produces computers. In this model, corporations are, by and large, free from the onerous requirements of the disclosure framework and yet are still able to capitalize and benefit from their products through their sale in the open market.  However, as we note in our book, “a product is only as good as the system that it is designed to work within.”  As such, we also propose a whole market regulatory structure that widens the oversight from its current narrow spectrum.

Under a whole market scheme, the focus shifts from the participants to the markets. Any party (participant) that is seen as interfering with market stability can be subject to regulatory action. This is accomplished through a global view of the financial markets, with an emphasis on the quality of the products available to the public and the platforms through which they trade. Implementation of a streamlined regulatory structure with clear lines of responsibility and enforcement allows the regulators to be nimbler and more proactive. Regulators can engage in any action as appropriate in order to maintain fairness and integrity in the markets.

The securities markets are at the heart of the financial markets in the United States, which are, in turn, at the heart of American economic stability. As such, how the SEC regulates (or fails to regulate) has a direct impact on the stability of Americans. Moreover, the markets that are subject to SEC regulation are arguably undergoing an unprecedented degree of innovation that our current regulatory structure cannot keep pace with, preventing regulators from acting swiftly in the wake of a fast-acting crisis.

There is a strong need in the securities markets for a comprehensive regulatory framework that takes into account the systemic risks of the markets rather than the individual risks of public corporations. Otherwise, we may leave untreated the causes of the 2009 financial crisis. Changing our structure would require an engagement with all pieces from a thoughtful and open viewpoint. Truthfully, there have not been many instances of success with such a fundamental approach. But that doesn’t mean it should keep us out of the game.

This post comes to us from Professor Jena Martin at West Virginia University College of Law. It is based on her recent paper, “Changing the Rules of the Game: Beyond a Disclosure Framework for Securities Regulation,” available here

Categories
Securities Regulation

Insider Trading and Disclosure: The Case of Cyberattacks

The U.S. Securities and Exchange Commission (SEC) recently identified incidents in which top executives sold shares before disclosing to the public negative information about cyberattacks. For example, the former chief information officer of Equifax, Jun Ying, exercised his stock options and sold nearly $1 million in shares about a week before Equifax disclosed the hack of its database in September 2017, gaining $480,000. Equifax stock dropped over 30 percent after news of the data breach became public. Motivated by the SEC’s concerns, we examine the relation between insider trading and corporate disclosure policies around cyberattacks.

When a cyberattack with material negative consequences occurs, security regulations require companies to disclose information on the event to the public, as in other incidents with material negative effects. Executives can opportunistically sell shares (or avoid buying shares or granting stock options) before disclosing information on cyberattacks to the public. However, they are unlikely to trade on private information that the firm intends to disclose. Disclosure of the negative information will expose and label preceding sales as insider trading, and executives will not sell shares if they wish to avoid the legal ramifications of insider trading. In some cases, however, firms withhold information and do not disclose the cyberattack to investors; and if the firm chooses to withhold information on the cyberattack, insiders’ sales of shares are less likely to be identified as insider trading.

We predict that the likelihood of insider trading is higher for firms that withhold the information than for firms that voluntarily disclose it. To test this prediction, we identify companies that were attacked and distinguish between those attacked companies that disclosed information on the attack and those that withheld information on the attack, but parties outside the company later discovered the attack. For the subsample of cyberattacks that companies voluntarily disclosed between 2010 and 2015, we find no significant insider trading in the days before the disclosure. However, for cyberattacks about which information was withheld from investors, and parties outside the company later discovered them, we find insiders sold shares after the cyberattacks and before investors learned about these attacks. Moreover, we find top officers, who were more likely to be aware of the cyberattack and influence the decision regarding whether to disclose it, made the insider sales, whereas other insiders did not sell stocks.

Finally, we find insider trading after withholding information is less likely in firms incorporated in U.S. states with stricter disclosure requirements on data breaches. Certain  states require companies to disclose cyberattacks to the state attorney general. For example, companies incorporated in California must notify the California attorney general about data breaches that affect private information of more than 500 customers or individuals. We find managers are less likely to withhold information on cyberattacks and trade on the information in states that require such additional disclosure. The clear requirement to disclose a breach to state agencies marks that breach as a significant event, on which insiders are less likely to trade before its disclosure due to litigation risk. When disclosure requirements are less strict, insiders trade after withholding information on the cyberattack.

Our sample includes 192 cyberattacks involving 120 publicly traded companies between 2010 and 2015, of which 42 firms had more than one cyberattack. We divide the sample into three groups. The first group (101 cases), denoted as Disclosing, includes cyberattacks that the attacked firm disclosed before an outsider discovered it. The second group (33 cases), denoted as Withholding, are cyberattacks that the attacked firm had not disclosed for at least two days after it learned of its occurrence and a party outside the firm consequently discovered the attack. The third group (58 cases) includes Immaterial cyberattacks. Firms are not required to disclose attacks with immaterial effects, and this group includes cyberattacks that an outsider discovered, but the firm communicated that the attack caused no material damage.

Figure 1 shows daily abnormal insider trading in the 20 days before the discovery of the cyberattack. Initially, we compute, for each firm/day, Trade (t-9, t) for t = {-20, -1}. For example, for day t = -2, we compute for each firm Trade (-11, -2). Similarly, for day t = -3, we compute Trade (-12, -3). Then, we compute abnormal daily net trade:

AbnTrade (t-9, t) = Trade (t-9, t) – Trade (-120, -60).

Figure 1 presents the abnormal daily net trade for the 20 days before the attack for the three subsamples: Withholding, Disclosing, and Immaterial. As the figure shows, net trading becomes more negative for Withholding companies. Insiders in Withholding companies sell more shares as the discovery of the cyberattack approaches, whereas the pattern for Disclosing and Immaterial subsamples is stable around zero abnormal net trading.

We also examine insider sales immediately after managers became aware of the attack. As indicated above, we have the date managers learned of the attack for withholding cases. We calculate abnormal insider trading after the date managers learned of the attack, τ, relative to trading in the preceding month: AbnTrade (τ, τ +30) = Trade (τ, τ +30) – Trade (τ -30, τ -1), and find significant trading in the withholding cases.

The primary contribution of our study is that it links corporate disclosure policy to insider trading. Specifically, we demonstrate the effect of stricter disclosure rules on insider trading, and show that when managers are clearly required (by state law) to report cyberattacks, they are less likely to trade on the information before disclosing it. However, when disclosure threshold depends more on managers’ discretion, managers are inclined to trade on withheld information.

This post comes to us from professors Eli Amir and Shai Levi at Tel Aviv University’s Coller School of Management and Tsafrir Livne at the University of North Carolina’s  Kenan-Flagler Business School. It is based on their recent paper, “Insider Trading and Disclosure: The Case of Cyberattacks,” available here.

Categories
The Dodd-Frank Act

The Impact of Banking Regulation on Voluntary Disclosures

Firms disclose a variety of information to the public, some because they are required to do so by law or regulations, and others voluntarily because they want, for example, to signal their creditworthiness to potential investors. The level and effectiveness of financial institutions’ regulatory oversight have been widely debated since the onset of the financial crisis of 2007-2009. Financial and banking regulators have responded by increasing regulatory requirements and oversight, and by mandating greater disclosure of information. However, these actions do not necessarily improve the information environment of firms if they discourage voluntary disclosures of other types of information. In our paper, we investigate whether enhanced regulatory oversight and mandatory disclosure requirements affect regulated banks’ voluntary disclosures (Beyer et al. 2010). In particular, we take advantage of the artificial size-thresholds imposed by the Dodd-Frank Wall Street Reform and Customer Protection Act of 2010 (DFA) to identify large banks that are directly affected by increased mandatory disclosure and heightened regulatory oversight and compare them with unaffected banks and financial institutions that are not subject to banking regulations.

The DFA was signed into law by President Obama on July 21, 2010. It is a complex piece of legislature with more than 1,500 sections and 848 pages.[1] Its provisions affect financial institutions and other public firms, credit agencies, and regulators. One of the aims of the DFA is to reduce the risks posed by “systemically important financial institutions” (SIFIs), defined by the DFA as banks with total assets of more than $50 billion. Banks with assets between $10 billion and $50 billion are required to conduct and report internal stress tests, as are banks with total assets of $50 billion or more. Banking regulators also reserve the right to impose additional regulatory restrictions and disclosure requirements on banks that fall below the $50 billion threshold if regulators deem them to be risky or systemically important. In our study, we define banks that are directly affected by the DFA to include SIFIs and large banks that fall below the threshold but have total consolidated assets above $10 billion.

We focus on the impact of the DFA on banks’ voluntary disclosure, which, though not explicitly addressed by the DFA, is an important component of firms’ information environments and disclosure practices (Beyer et al. 2010). Theoretical predictions in this setting potentially go in opposite directions. Since the DFA increases disclosure requirements for large banks, these banks might decide to signal their characteristics by providing additional voluntary disclosures and thus distinguish themselves from other banks (i.e., maintain a separating equilibrium). For example, the DFA requires orderly resolution of failed banks and prohibits bank bailouts (potentially eliminating the implicit too-big-to-fail guarantees). Hence, large banks might want to signal to their investors and funding providers that they are stable, responsible banks with a low likelihood of default (Balasubramnian and Cyree 2014). Given the heightened mandatory disclosure expectations, large banks might also devote more resources to financial reporting and hence be more likely to provide higher quality voluntary disclosures (Ball et al. 2012). However, commitment to disclosure might be costly as banks might change their behavior ex ante to avoid the impact of the disclosure ex post and, therefore, limiting market participants’ ability to rely on disclosed information and to impose market discipline (Bond et al. 2012; Mehran 2010; Morris and Shin 2002; Goldstein and Sapra 2013). Large banks might also be reluctant to provide voluntary disclosures that might invite more regulatory oversight (Armstrong et al. 2016). Thus, theory does not give an unequivocal answer to whether SIFIs and other large banks would increase or decrease voluntary disclosures following the imposition of the DFA.

In our study, we investigate the impact of the DFA on voluntary disclosure using two sets of proxies: management forecasts and the content of management’s quarterly conference calls with analysts. Using a difference-in-differences research design, we find that following the introduction of the DFA, large banks become less likely to issue earnings forecasts containing bad news. They also reduce the frequency of earnings forecasts but increase the rate of forecasts for dividends and return on assets. We also apply textual analysis, including Latent Direlicht Allocation (LDA) topic modeling, to provide the first evidence of how the content of banks’ conference calls changed around the DFA. LDA identifies specific topics that managers present to analysts in the scripted management presentation portion of the conference call and the additional information managers provide in the Q&A portion. We think of the former as the supply of information by management and the latter as management’s response to the demand for information from analysts.

We find that, following the introduction of the DFA, affected banks increase the quality of the information provided (measured as numerical intensity, financial information intensity, and forward-looking information intensity) in the presentation section of the conference call incrementally more than do the benchmark firms. Analysts also appear to demand more information in the Q&A section of conference calls, and managers continue to provide more informative answers to analysts of affected banks. We also find that even though affected large banks reduce their disclosure of the estimates of future performance in the presentation section of the conference call, they provide more discussion about future performance in response to analysts’ requests for more information during the Q&A. The affected banks also increase their discussion of commercial banking financial performance but decrease their discussion of investment banking financial performance, loan portfolio and provisions, and securitization incrementally more than o the benchmark firms. These findings suggest that, since the DFA increased regulatory oversight, affected banks are less likely to provide additional voluntary information related to strictly regulated activities.

Overall, we are the first to document the impact of the increased mandatory disclosure requirements and regulatory oversight on various aspects of affected banks’ voluntary disclosures since the introduction of the DFA. The evidence documented in our paper is largely consistent with the finding in Ball et al. (2012) that increased mandatory disclosure leads to more and higher quality voluntary disclosures. On the other hand, to avoid further regulatory oversight, large banks decrease voluntary disclosure along certain dimensions of financial performance, such as earnings per share forecasts and discussion of regulated activities. Our findings contribute to the debate about the DFA’s impact on the information environment of financial institutions. Our results also suggest that rolling back the DFA might have a negative impact on large banks’ information environment by decreasing not only mandatory but also voluntary disclosures.

REFERENCES

Armstrong, C., Guay, W.R., Mehran, H., and Weber, J., 2016. The role of financial reporting and transparency in corporate governance. FRBNY Economic Policy Review, 22(1), pp. 107-128.

Ball, R., Jayaraman, S., and Shivakumar, L., 2012. Audited financial reporting and voluntary disclosure as complements: A test of the confirmation hypothesis. Journal of Accounting and Economics, 53(1), pp. 136-166.

Balasubramnian, B., and Cyree, K. B., 2014. Has market discipline on banks improved after the Dodd-Frank Act? Journal of Banking and Finance, 41(April), pp. 155–166.

Beyer, A., Cohen, D.A., Lys, T.Z., and Walther, B.R., 2010. The financial reporting environment: Review of the recent literature. Journal of Accounting and Economics, 50(2-3), pp. 296–343.

Bond, P., Edmans, A., and Goldstein, I., 2012. The real effects of financial markets. Annual Review of Financial Economics, 4, pp. 339-360.

Goldstein, I., and Sapra, H., 2013. Should banks’ stress test results be disclosed? An analysis of the costs and benefits. Foundations and Trends in Finance, 8(1), pp. 1-54.

Mehran, H., 2010. The effect of disclosure on information production by analysts. Working paper, Federal Reserve Bank of New York.

Morris, S., and Shin, H.S., 2002. Social value of public information. American Economic Review, 92(5), pp. 1521-1534.

ENDNOTE

[1] “The Dodd-Frank Wall Street Reform and Consumer Protection Act,” Pub.L 111-203, H.R. 4173, July 21, 2010.

This post comes to us from professors Anya Kleymenova at the University of Chicago’s Booth School of Business and Li Zhang at Rutgers University. It is based on their recent article, “The Impact of Banking Regulation on Voluntary Disclosures: Evidence from the Dodd-Frank Act,” available here.

Categories
Antitrust

Disclosure Incentives When Competing Firms Have Common Ownership

Over the past three decades, there has been tremendous change in the ownership of publicly-traded firms in the U.S. Consolidation in the asset management industry and the rise in mutual fund investing have led a small number of institutional investors to become the largest shareholders in most publicly listed firms. As a result, competing firms are increasingly becoming owned, in part, by the same large institutions (henceforth, common ownership). The fraction of U.S. public firms that are commonly owned – i.e., have at least one investor that simultaneously owns a large investment stake in the firm and at least one of its competitors – has increased from below 5 percent in 1980 to approximately 65 percent in 2016. Data from Compustat suggest that BlackRock and Vanguard are among the largest five shareholders of more than 53 percent of U.S.-listed firms.

Given this significant shift toward common ownership, it is important to understand its consequences on firm behavior. Does common ownership affect the way managers behave? How does it affect investors?

Prior literature suggests that common ownership decreases competitive behavior. That is, common ownership gives managers of co-owned firms an incentive to behave in ways that increase the portfolio value of the common owners. If firms are less competitive with each other, they may be less concerned about sharing proprietary information in their disclosures – one of the primary constraints to full disclosure.

Prior studies also maintain that disclosure by one firm in an industry can be beneficial for its peers, as there are spillover effects related to liquidity and cost of capital. Thus, increased disclosure by one co-owned firm can benefit its peer firms owned by common owners, increasing the portfolio value of common owners. For these reasons, common ownership could create incentives for firms to increase disclosure.

In a recent study, my colleagues and I tested these theories with data. We looked at common ownership’s impact on firms’ disclosure of information like earnings forecasts and capital expenditures. If common ownership does affect firms’ disclosure decisions, we wanted to know how and to what extent.

In our study, we looked at firms where one of the investors simultaneously owned a stake larger than 5 percent in at least two firms in the industry. As all public companies are required to make certain minimum disclosures in the U.S. (via 10-Ks, 10-Qs, etc.), we looked at any voluntary disclosures above and beyond that minimum. We used three disclosure proxies that are all useful to the market but differ in the degree to which they reveal proprietary information: earnings forecasts, capital expenditure forecasts, and redacted disclosures. We used a sample of 54,541 U.S. public firm observations from 1999 to 2015.

Consistent with theory, we find that common ownership is positively associated with the likelihood and frequency of disclosures of earnings and capital expenditure forecasts. To be more specific, our data showed that common ownership increases disclosure of earnings forecasts by 8.8 percent and disclosure of capital expenditure forecasts by 12.9 percent. However, common ownership does not generally affect the extent to which firms redact sensitive information from contracts.

We conducted additional tests to shed light on why common ownership increases disclosure. We find that the relationship between common ownership and disclosure is greater in industries where the proportion of commonly owned companies is higher. This is consistent with greater perceived disclosure benefits as a result of reduced proprietary costs.

Interestingly, we also find that common ownership is associated with fewer redactions when industry-level common ownership is high. This suggests that when the percentage of non-commonly owned firms in an industry decreases, co-owned firms become less worried about competition and are more likely to disclose proprietary information.

In addition, we looked at whether common ownership is associated with an increase in stock liquidity, as large institutional investors – often the common owners – value liquidity due to the size and frequency of their trading. If common ownership leads to an increase in disclosure, then these additional disclosures should reduce information asymmetry and result in increased stock liquidity. Our study shows that common ownership is associated with lower bid-ask spreads and higher liquidity. Firms with common owners have approximately 2.5 percent lower spreads and 2.4 percent higher liquidity compared with firms without common owners.

Overall, our results suggest that there are significant benefits for investors from common ownership. It helps reduce transaction costs and increases stock liquidity. It also leads to greater transparency about firms’ practices, which provides investors with better insights about firms. While common ownership is supposed to be detrimental for consumers, it gives investors a reason to celebrate.

This post comes to us from Jihwon Park, a doctoral candidate at Harvard Business School; Jalal Sani, a doctoral candidate at Penn State University’s Smeal College of Business; Professor Nemit Shroff at MIT’s Sloan School of Management; and Professor Hal D. White at Penn State University. It is based on their recent paper, “Disclosure Incentives When Competing Firms Have Common Ownership,” available here.

 

Categories
Securities Regulation

SEC Chairman Delivers Remarks to the Commission’s Investor Advisory Committee

Thank you, Anne (Sheehan). Good morning everyone. It’s good to see everyone again, particularly as the last time we all met in person was in December of last year. I was glad to be able to participate with Commissioner Roisman on a call with members of the Committee last month, where among other things we talked about human capital disclosures and proxy plumbing. My prepared remarks for that call—as well as Commissioner Roisman’s—are available on our website.

Turning to the agenda for today, I look forward to the discussion on the stock exchange regulatory structure, which is an important topic for the Commission. I am also pleased that the Committee will revisit the discussion regarding disclosures on human capital. Finally, I look forward to the discussion on investment research and potential regulatory implications. Before going into detail, I note that my thoughts are my own and do not necessarily reflect the views of my fellow Commissioners or the SEC staff.

Stock Exchanges: Investor Protection Under the Modern Exchange Regulatory Structure

Earlier this month, I, together with our Director of the Division of Trading and Markets, Brett Redfearn, spoke at length about equity market structure at an event at Fordham University. I won’t repeat those remarks, but suffice it to say that market structure is a topic that is very important to me and the staff. Our markets have evolved substantially over the last ten years, driven by increasingly advanced technologies and complex practices. We need to make sure our regulatory framework reflects the markets of today and is achieving its goals.

Last year, I was pleased that the Commission adopted rules providing for increased transparency of order routing practices, rules providing for operational disclosures by alternative trading systems (“ATSs”) trading national market system (“NMS”) stocks, and a transaction fee pilot program. The Division of Trading and Markets also held roundtables on the market structure for thinly-traded securities, regulatory approaches to combating retail fraud, and market data and market access. In my speech last month, I highlighted a few initiatives arising out of those roundtables that the staff is pursuing going forward. And on today’s topic of the current exchange regulatory structure, I look forward to hearing what I hope will be an informative, balanced and constructive discussion. Let me emphasize those words—informative, balanced and constructive. This Committee’s purpose is to advise and consult with the Commission on: (i) regulatory priorities of the Commission; (ii) issues relating to the regulation of securities products, trading strategies, and fee structures, and the effectiveness of disclosure; (iii) initiatives to protect investor interest; and (iv) initiatives to promote investor confidence and the integrity of the securities marketplace. In this regard, I am pleased to see the topics on today’s agenda as they are front of mind for many of us at the Commission.

Disclosures on Human Capital

During the February 6 Committee call, I discussed my views regarding disclosures on human capital; today, I will summarize those remarks and emphasize a few points.

I look forward to hearing more about today’s recommendation from the Investor as Owner subcommittee. As I mentioned previously, I believe the Commission’s disclosure requirements and disclosure guidance must be rooted in the principles of: (1) materiality; (2) comparability; (3) flexibility; (4) efficiency; and (5) responsibility. I also believe that our disclosure requirements and guidance must evolve over time to reflect changes in markets and industry while being true to these principles, which in well-designed rules can be mutually reinforcing.

Turning to human capital, I believe that the strength of our economy and many of our public companies is due, in significant and increasing part, to human capital, and for some of those companies human capital is a mission-critical asset. Disclosure should focus on the material information that a reasonable investor needs to make informed investment and voting decisions; yet, applying this and the other principles I mentioned to human capital in the way businesses assess and disclose, and investors evaluate, for example, revenue or costs of goods sold, is not a simple task. That said, the historical approach of disclosing only the costs of compensation and benefits often is not enough to fully understand the value and impact of human capital on the performance and future prospects of an organization.

With that as context, my view is that to move our framework forward we should not attempt to impose rigid standards or metrics for human capital on all public companies. Rather, I think investors would be better served by understanding the lens through which each company looks at its human capital. In this regard, I ask: what questions do boards ask their management teams about human capital and what questions do investors—those who are making investment decisions—ask about human capital? For example, how do investors use human capital information to make relative capital allocations among similar organizations? Armed with general and sector-specific answers to these questions, we can better craft rules and guidance. I have read the draft recommendation prepared by the subcommittee and believe your views have significantly developed. Thank you for considering my prior comments.

Investment Research and Potential Regulatory Implications

Earlier this year, significant new rules relating to research (MiFID II) became effective in the European Union (EU), which changed how asset managers are permitted to pay for research in the EU. We have heard from a number of market participants regarding how these rules pose challenges for US firms and, in particular, raise questions concerning market practice and compliance among broker-dealers and asset managers in the US. In 2017, Commission staff issued temporary no-action assurances to broker-dealers that receive certain payments under MiFID II, in order to permit US firms to comply with MiFID II’s unbundling requirements without triggering registration under the Investment Advisers Act.

It is our understanding that some market solutions have developed that may make extending the no-action relief unnecessary. For example, some asset managers have addressed the MiFID II unbundling requirement by absorbing the cost of research themselves and having their funds pay their brokers for trade execution services only. Other asset managers have created Research Payment Accounts to budget and track research costs at the fund level, permitting the funds to continue to pay for research through soft dollars and reconciling those payments to ensure compliance with MiFID II.

In addition to the regulatory compliance issues, as I mentioned during the December 13, 2018 meeting, I am concerned that the broad availability of research may be reduced as a result of MiFID II. I am particularly interested in hearing from this group regarding how MiFID II has changed the dynamics of the provision of research. For example, has MiFID II reduced the supply of research overall and/or the availability of research from a variety of broker-dealers, including smaller and specialized firms? Has MiFID II reduced the quality of research overall, or in particular sectors or for particular size issuers? More particularly, are advisers encountering challenges in obtaining the coverage and quality in research that they need to support their advisory services?

Our staff remains actively engaged with market participants on this issue and we continue to invite you to submit comments.[1] For those interested in this topic and the specific types of information we are looking for from market participants, I encourage you to review the speech that Dalia Blass, the Director of our Division of Investment Management, recently gave addressing this topic.[2]

ENDNOTES

[1] See SEC Staff Encourages Continued Engagement on Impact of MiFID II Research Provisions (Dec. 21, 2018), available at https://www.sec.gov/news/press-release/2018-301.

[2] Dalia Blass, Keynote Address: ICI Mutual Funds and Investment Management Conference (March 18, 2019) available at https://www.sec.gov/news/speech/speech-blass-031819.

These remarks were delivered by Jay Clayton, chairman of the U.S. Securities and Exchange Commission, on March 28, 2019, to the SEC Investor Advisory Committee.

Categories
Securities Regulation

SEC Commissioner Jackson Discusses FAST Act Adopting Release

I want to begin by conveying my thanks to the staff in the Division of Corporation Finance for their hard work in developing today’s adopting release. I am especially grateful to Charles Kwon and Dan Greenspan, as well as Director Bill Hinman, for the time you spent with me and my office throughout this process.

Following up on a detailed report our staff sent to Congress under the Fixing America’s Surface Transportation (FAST) Act,[1] the Securities and Exchange Commission today adopts a final rule on information investors receive about the increasingly complex companies in our markets.[2] The rule reverses our staff’s recommendation that firms disclose a clear identifier of their corporate entities. The rule also removes our staff’s role as gatekeepers when companies redact information from disclosures—despite evidence that redactions already deprive investors of important information. For these two reasons, I respectfully dissent.

*          *          *          *

First, the financial crisis taught regulators that firms’ complex structures made it impossible to identify the corporate entities responsible for risk-taking. For more than a generation the market tried—and failed—to come up with a single identifier on its own.[3] The reason, of course, is the standard collective-action problem that our securities laws were written to solve. The few firms who tried to create a market-wide standard bore all of the costs of those efforts, giving individual firms no incentive to make the investments necessary to create a single, standard identifier across the marketplace.

That’s why investors, market participants, and regulators around the world support a single legal entity identifier (LEI), a 20–character code that identifies entities engaged in financial transactions. To encourage the use of LEIs, the Commission, the staff, and our own Investor Advisory Committee have long supported rules requiring firms that adopt LEIs to disclose them.[4] Today’s majority abandons those requirements, with little evidence or reasoning to support the change.

The majority seems to share industry’s intuition[5] that disclosing LEIs will be costly. Of course, the costs of disclosing a 20-character code are unlikely to be meaningful. The market might impose a penalty upon companies that do not obtain an LEI and then disclose that fact. But giving investors information they need to price decisions like that is a benefit, not a cost, of our securities laws.[6] Instead, the majority leaves investors wondering what the absence of an LEI disclosure means.

Second, the rule’s treatment of redactions from confidential filings is even more troubling. Historically, we’ve required firms to work with our staff when sensitive information is redacted from exhibits to registration statements. There are often good reasons for our staff to permit redactions. But recent research shows that redactions already include information that insiders or the market deems material—showing how important careful review of these requests can be for investors.[7]

Today’s rule removes both the requirement that firms seek staff review before redacting their filings and the requirement that companies give our staff the materials they intend to redact. The release doesn’t grapple with the effects of that decision for the marketplace. But one thing is clear: In a world where redactions already rob the market of information investors need, firms will now feel more free to redact as they wish. And investors, without the assurance that redactions have been reviewed by our staff, will face more uncertainty.

Both of these decisions reflect a troubling trend in our rulemaking: ignoring facts in favor of belief that the SEC can deliver a free lunch in finance. Students of markets know there’s no such thing. If more firms choose not to obtain LEIs, knowing that this choice will not be disclosed to investors, LEIs will become less useful, and the resulting risks will raise the costs of capital for all companies. If more firms redact their disclosures, knowing that our staff cannot intervene, investors will demand compensation for additional money they’ll spend to understand the risks they’re taking. Evidence from the market tells us that these redactions often include important information. And markets, not commissioners, are in the best position to say what information is important to investors.[8]

I am grateful to the staff for the hard work and long hours that this release reflects. But because the final rule prizes faith over facts, I respectfully dissent.

ENDNOTES

[1]See Staff of the U.S. Securities and Exchange Commission, Report on Modernization and Simplification of Regulation S-K (Nov. 23, 2016); see also Fixing America’s Surface Transportation (FAST) Act, Pub. L. No. 114-94, §§ 72001-03, 129 Stat. 1311, 1784-85 (2015).

[2]  It is well-documented that the structure of our equity and credit markets, and the law governing both, give firms strong incentives to adopt increasingly complex organizational structures. For a classic and compelling debate about the implications of those incentives for social welfare, compare Richard Squire, Strategic Liability in the Corporate Group, 78 U. Chi. L. Rev. 605 (2011) with Richard A. Posner, The Rights of Creditors of Affiliated Corporations, 43 U. Chi. L. Rev. 499 (1976).

[3]  Of course, some have managed, through decades of effort and investment, to create crucial reference points for market participants. Most famously, to address the slow settlement of securities transactions in the 1960s, at regulators’ urging Wall Street formed the Committee on Uniform Securities Identification Procedures (CUSIP), which today still provides the single securities identifier the market needs to function smoothly. CUSIP Global Services, About CGS (describing the 1964 genesis of that standard). Dun & Bradstreet’s Data Universal Numbering System is today “used to maintain up-to-date and timely information on more than 300 million global businesses,” Dun & Bradstreet, What is a D-U-N-S Number?, and the Markit Red Code helps the market avoid the need for “manual[] confirm[ation of] CDS reference data,” IHS Markit, RED for CDS. But each of these systems comes with its own costs—in particular, proprietary systems require subscription fees and that users limit the distribution of the data—which is why the market failed for decades to come up with a single, uniform identifier.

[4] Staff of U.S. Securities and Exchange Commission, supra note 1; see also U.S. Securities and Exchange Commission Investor Advisory Committee, Letter to Chair Mary Jo White (June 15, 2016); U.S. Securities and Exchange Commission, SEC Adopts Rules to Increase Transparency in Security-Based Swap Market (Jan. 14, 2015).

[5] The final rule offers no actual empirical evidence that disclosing LEIs imposes meaningful costs. At the proposal stage, our staff pointed out that “[m]any commenters supported requiring disclosure of LEIs, with most of them recommending that we require both the registrant and its subsidiaries to obtain and disclose LEIs.” Securities Act Rel. No. 10425 at fn. 216 (Oct. 11, 2017). Today, on the basis of a few evidence-free industry letters, the majority concludes that the file is now “mixed.” See Securities Act Rel. No. 10618 at Section II.C.2 (Mar. 20, 2019).

[6]  To the degree that the market might react negatively to the news that a firm did not obtain an LEI, rules requiring disclosure of that fact would simply induce firms to internalize investors’ preferences regarding LEIs when deciding whether or not to obtain one. Negative market reactions to a company’s decisions aren’t costs of disclosure rules; they convey the benefit of giving the company and its management reason to pursue investor preferences.

[7] See Anne Thompson, Oktay Urcan & Hayoung Yoon, What Information Do Firms Hide in Confidential SEC Filings? (working paper 2018) (also pointing out the troubling fact that redacted positive information is associated with insider purchases of stock).

[8] It might be argued that market forces will give registrants economic incentives not to redact excessively. That, of course, is a case against mandatory disclosure more generally; for a famous economic analysis of the flaws of that premise, see Merritt Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice is Not Investor Empowerment, 85 Va. L. Rev. 1335 (1999) (explaining why a voluntary disclosure regime cannot be expected to yield socially optimal information production). Consistent with that analysis, the evidence makes clear that firms often redact important information, see Thompson et al., supra note 6.

This post comes to us from Robert J. Jackson, Jr., a commissioner of the U.S. Securities and Exchange Commission.

Categories
Securities Regulation

SEC’s Corporate Finance Director Discusses Disclosing Risks

Today, I would like to discuss [1] how the U.S. securities disclosure requirements, which are largely principles-based, apply in areas where the disclosure topics may be complex, associated with uncertain risks and rapidly evolving. Sounds like Brexit might fit that description, and I don’t think I could come to London this week without spending some time discussing it. I realize that you all may be worn out on the subject, and the U.S. regulatory perspective on this topic may seem of secondary or tertiary interest to those of you living through these events. However, I would note that over half of the world’s largest companies[2] have their primary listing in the U.S. and a larger proportion trade and report in compliance with our requirements. Given that these companies typically have extensive international operations, including in the U.K. and EU, we have a keen interest in the quality of disclosure that is being provided by the many issuers for which Brexit may have a material impact.

As you know, our disclosure requirements are intended to provide investors with the material information they need about companies and their securities offerings to make informed investment and voting decisions. Robust disclosure decreases information asymmetries and is the foundation of reliable price discovery. When investors have confidence that they are receiving full and transparent disclosure, markets operate more efficiently and the cost of capital is reduced. I think the strength the U.S. markets have displayed over time shows that there is much that is right about our disclosure system and the information it generates and on which market participants rely.

Our disclosure regime emphasizes materiality. Information is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote or make an investment decision.[3] Principles-based disclosure requirements articulate an objective and look to management to exercise judgment in satisfying that objective by providing appropriate disclosure when necessary. Management’s Discussion and Analysis (MD&A)[4] and Risk Factors[5] are examples of such disclosure requirements and are well-suited to elicit disclosure about complex and evolving areas. Ideally, MD&A allows investors to see a company’s results and prospects through the eyes of management. A well written MD&A allows investors to understand how management is positioning the company in the face of uncertainties, like those associated with rapidly evolving topics such as Brexit. Risk factor disclosure should address the most significant things that make an investment in a company and its securities subject to uncertainties or risk. Concise and focused disclosure explaining how each risk affects the company is most useful for investors. Companies should take care not to bury the reader in generic boilerplate or laundry lists of risks that might apply to any company. In addition, companies need to keep in mind that Commission rules also require them to disclose any further material information necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.[6] The flexibility of our principles-based disclosure requirements should result in disclosure that keeps pace with emerging issues, like Brexit or sustainability matters, without the need to for the Commission to continuously add to or update the underlying disclosure rules as new issues arise.

Brexit Disclosure

For several months, Chairman Clayton[7] and I have highlighted the need for more robust public company disclosure about how companies are considering Brexit and its possible impact on their business and operations. Today, I would like to focus on the Brexit-related disclosures that we’ve seen to date, explain how our principles-based disclosure requirements can be applied to Brexit and share with you the types of issues the Division of Corporation Finance may consider when evaluating Brexit-related disclosure in periodic reports in the coming months.

We frequently conduct cross-industry surveys to evaluate the quality of disclosures on complex and evolving topics to inform our filing review process, and I thought Brexit disclosure was an appropriate topic for us to examine. So what did we find? We saw a wide range of disclosures, even within the same industry. Some companies provided generic disclosure, merely stating that Brexit presents a risk, that the outcome is uncertain and that it could materially and adversely impact the business and its operations. In my opinion, this type of disclosure does little to explain to investors the potential specific impact of Brexit on a company’s business and operations and is insufficient to guide investors in a meaningful manner.

On a positive note, we’ve also seen some thoughtful and appropriately detailed disclosures of how Brexit may impact companies. Not surprisingly, we have seen foreign private issuers[8] – companies likely impacted most directly – provide tailored disclosure at a higher rate than U.S. domestic registrants. This suggests that many of you in the audience have done a commendable job advising your clients. And of course, it may reflect the higher expected impacts of Brexit among the community of non-U.S. issuers. That said, we anticipate that there will be international effects that non-U.K. and non-EU issuers will not escape. As Brexit becomes more imminent, and perhaps in response to our public requests for more robust disclosure, we are encouraged to observe that a higher percentage of companies appear to be including tailored Brexit disclosures in their 2018 annual reports. While this is encouraging, we believe there is room for continued improvement.

As you all know too well, there is tremendous uncertainty associated with Brexit, including whether it will be delayed beyond March 29, 2019 to permit further negotiations, or whether it will be reversed or sharply modified through a second referendum or other arrangements. In addition, there is a lack of clarity on what the actual effects of Brexit will be on companies, their investors and on global financial markets. Despite this uncertainty, the reality for many companies is that Brexit is already here. I would think that management and boards have not thrown up their hands in light of the uncertainties and declared that “nothing can be done” – they have been preparing for the variety of outcomes well in advance of March 29. Businesses have not been able to take a wait-and-see approach. Rather, they’ve had to prepare for a range of outcomes. Your clients likely have made a number of important decisions to mitigate the risk of whatever outcome they may face and investors should know not only the nature and extent of those risks, but also what companies have done to prepare.

As we review disclosures in this area, we appreciate that each company has its own considerations. For example, the Brexit-related disclosure for a large international bank will be different than a multi-national automobile manufacturer, and largely unlike that of a pharmaceutical or life sciences company. Given the differences across industries and companies, there is no one specific data point or prescriptive piece of information that all companies could provide to disclose material information relating to their Brexit-related risks.

Rather, investors are better served by understanding the lens through which each company’s management looks at its exposure. How does management assess and analyze Brexit-related risks and the potential impacts on the company and its operations? What is management doing to mitigate and manage these risks? What is the nature of the board’s role in overseeing the management of these risks? Depending on the facts and circumstances of each company, the answers to these questions should provide material information to investors seeking to understand the risks attendant to Brexit for that company. One analytical tool to evaluate disclosure in this context is to consider how management discusses Brexit-related risks with its board of directors. Obviously not all discussions between management and the board are appropriate for disclosure in public filings, but there should not be material gaps between how the board is briefed and how shareholders are informed. For those of you involved in crafting disclosure documents, you can ask yourself a straightforward question: would these disclosures satisfy the curiosity of a thoughtful, deliberative board member considering the potential impact of Brexit on the company’s business, operations and strategic plans?

I would like to share some observations of disclosure topics that companies may consider in this context. These are the types of questions that I expect we will have in mind when evaluating Brexit-related disclosures in 2018 annual reports. This list is by no means exhaustive, and the materiality and usefulness of Brexit-related disclosure will always depend on the particular facts and circumstances of the company.

  1. Is the business exposed to new regulatory risk given the uncertainty of which set of laws and regulations will apply and whether transition agreements will be in place? We have seen useful, tailored disclosure by some financial institutions that addresses the regulatory risks associated with the potential loss of passporting arrangements that currently permit U.K. entities to provide services to businesses and customers throughout the EU. Similarly, some firms have provided disclosure explaining specific efforts undertaken to re-locate their U.K. operations, or to merge with or acquire EU subsidiaries, to mitigate the regulatory risks of Brexit. Banking and financial services are obviously not the only industries subject to regulatory risk in light of Brexit. Biopharmaceutical companies with substantial U.K. operations face risks concerning how their products and clinical trials will be regulated. Airlines face risks that potential restrictions on flying rights or changes in administration of antitrust laws may negatively impact their joint ventures. For companies in these industries and others affected by regulatory risk, we would expect tailored disclosure explaining these risks where appropriate.
  2. Are there significant supply chain risks due to the potential disruption to the U.K.’s access to free trade agreements with other nations and any resulting changes in tariffs on exports and imports? Will potential changes to customs administrations and delays materially impact a company’s business, particularly if the business relies on just-in-time supply chains? We believe that companies are actively considering the potential impact of these matters on their business, and we look forward to seeing disclosures that provide insight as to how management is assessing and mitigating these risks.
  3. Does the company face a material risk of losing customers, a decrease in sales or revenues or an increase in costs due to tariffs or other factors? Is demand for the company’s products especially sensitive to exchange rates or changes in tariffs? Discussion and analysis of these types of questions regarding known trends, demands, commitments, events and uncertainties are critical for investors to understand the extent to which a company’s reported financial information is indicative of future results. To the extent management sees the potential impact of Brexit in terms of anticipated costs, reductions in forecasted sales or changes in working capital, it may be appropriate in some cases to include estimates or ranges of quantitative changes, as well as qualitative disclosures.
  4. Does the company have exposure to currency devaluation, foreign currency exchange rate risk or other market risk? Given the potential for heightened foreign exchange volatility, we are aware of reports that companies are increasing their hedging activities. We will look at quantitative and qualitative disclosures about market risk to better understand each company’s approach to market risk management in this area.
  5. What is the company’s exposure to contractual risk in the face of Brexit? Has the company undertaken a review of its existing contracts with counterparties in the U.K. or the EU to determine whether renegotiation or termination is necessary in light of contractual obligations? To the extent these discussions involve material contracts, we would expect disclosure to reflect these discussions.
  6. Do Brexit-related issues affect financial statement recognition, measurement or disclosure items, such as inventory write-downs, long-lived asset impairments, collectability of receivables, assumptions underlying fair value measurements, foreign currency matters, hedge accounting or income taxes? We expect that boards and audit committees are considering these reporting implications and that these considerations will be discussed in company disclosures, as appropriate.

These are just examples, and how these risks will affect a company’s business and how management seeks to mitigate the risks will vary greatly across companies. We have even seen some companies disclose the absence of any actual or anticipated material impact of Brexit on their business. We therefore expect to see a wide range of disclosures about Brexit. However, to the extent material, each company’s Brexit disclosure should provide tailored insight into how management views the risks posed to the business and operations and what actions they are taking to address these risks.

Sustainability Disclosure

Another set of issues that illustrates the utility and importance of flexible, principles-based disclosure requirements is the array of issues under the umbrella of environmental, social, and governance, or sustainability, issues. Sustainability disclosure continues to be of interest to investors and other market participants, and the very breadth of these issues illustrates the importance of a flexible disclosure regime designed to elicit material, decision-useful information on a company-specific basis. We understand that investors continue to engage with companies on sustainability topics and that market participants across the globe are giving significant thought to the types of sustainability disclosures the market is seeking as it strives to efficiently allocate capital.

We recognize that market participants have raised questions about the sufficiency of sustainability disclosures, and I think this is a complicated issue. While many market participants have expressed a desire for more specific sustainability disclosure requirements, others have concerns that specific sustainability disclosure requirements could result in disclosure that might not be considered material to a reasonable investor. In addition, market participants who do support additional sustainability disclosure requirements do not themselves uniformly recommend additional disclosure on the same sustainability issues. We hear differing views on whether disclosure requirements should be principles-based or prescriptive, and whether they should utilize a specific set of reporting standards to enhance comparability.

So it appears to me that the market is still evaluating what, if any, additional disclosure on these topics would provide consistently material and useful information. The marketplace evolution of sustainability disclosures is ongoing – companies certainly provide more sustainability information than they did ten years ago – and allowing this evolution to continue should provide market participants with a continued opportunity to sort out the types of information they find useful. Had we leapt into action and issued prescriptive sustainability disclosure requirements when people first began calling for them, I believe we would have stymied that evolution and stifled efforts to develop useful disclosure frameworks. Substituting regulatory prescriptions for market-driven solutions, especially while those solutions are evolving, in my view, is something we need to manage with utmost care. In the meantime, we are watching carefully as market-led approaches develop in this area, and we actively compare the information companies voluntarily provide – typically outside of their SEC filings – with the disclosure we see filed with us.

As we approach this or other disclosure topics, I am always cognizant that imposing specific bright-line requirements can increase the costs associated with being a public company and yet not deliver the relevant and material information that market participants are seeking. Adding requirements to the disclosure regime that do not deliver benefits that justify their costs decreases the attractiveness of our public markets, which in turn can reduce the number of public investment options available to all investors.

As I’ve mentioned, an important objective of our disclosure framework is to allow investors to see the company through the eyes of management. I encourage companies to consider their disclosure on all emerging issues, including risks that may affect their long-term sustainability. And as they do so I would suggest they ask themselves whether their disclosure is sufficiently detailed to provide insight as to how management plans to mitigate material risks and how their decisions in the area of risk could be material to the business and their investors. Again, this is a process where I believe it is helpful to think about how management engages with board members on the topic.

Let me spend a couple of minutes discussing climate-related disclosures more specifically. Extreme weather events and the continued interest of investors and other market participants in climate-related disclosures have led to a lot of discussion about what companies should disclose about climate or weather-related matters. The Commission published an interpretive release in 2010 that discussed how our existing disclosure requirements may apply to climate-related issues and reminded companies of the need to regularly assess their disclosure obligations as they pertain to climate-related issues.[9] That guidance remains a relevant and useful tool for companies when evaluating their disclosure obligations concerning climate change matters. For example, the guidance discusses how companies with businesses that may be vulnerable to severe weather or climate-related events should consider disclosing material risks of, or consequences from, these events. This remains true today. As another example, it notes that if a company determines that its physical plants and facilities are exposed to extreme weather risks and it is making significant business decisions about relocation or insurance, then, when these matters are material, companies should provide disclosure.

One item the 2010 guidance does not touch upon is the board’s risk management role in this area. Item 407(h) of Regulation S-K[10] and Item 7 of Schedule 14A[11] require a company to disclose the extent of its board’s role in the risk oversight of the company, such as how the board administers its oversight function and the effect this has on the board’s leadership structure. The Commission has previously highlighted that this should provide investors with important information about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company.[12] To the extent a matter presents a material risk to a company’s business, the company’s disclosure should discuss the nature of the board’s role in overseeing the management of that risk. The Commission last noted this in the context of cybersecurity, when it stated that disclosure about a company’s risk management program and how the board engages with the company on cybersecurity risk management allows investors to better assess how the board is discharging its risk oversight function.[13] Parallels may be drawn to other areas where companies face emerging or uncertain risks, so companies may find this guidance useful when preparing disclosures about the ways in which the board manages risks, such as those related to sustainability or other matters.

Conclusion

I appreciate the opportunity to share my thoughts on how our principles-based requirements can be applied to complex, evolving disclosure topics and I hope you enjoy the remainder of the conference.

ENDNOTES

[1] The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners or other members of the staff.

[2] PricewaterhouseCoopers, Global Top 100 Companies by Market Capitalisation (March 2018), available at https://www.pwc.com/gx/en/audit-services/assets/pdf/global-top-100-companies-2018-report.pdf.

[3] TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

[4] Item 303 of Regulation S-K [17 CFR 229.303].

[5] Item 503(c) of Regulation S-K [17 CFR 229.503(c)].

[6] Rule 408 of the Securities Act [17 CFR 230.408]; Rule 12b-20 of the Exchange Act [17 CFR 240.12b-20].

[7] Chairman Jay Clayton, SEC Rulemaking Over the Past Year, the Road Ahead and Challenges Posed by Brexit, LIBOR Transition and Cybersecurity Risks (Dec. 6, 2018), available at https://www.sec.gov/news/speech/speech-clayton-120618.

[8] Rule 405 of the Securities Act [17 CFR 230.405]; Rule 3b-4 of the Exchange Act [17 CFR 240.3b-4].

[9] Commission Guidance Regarding Disclosure Related to Climate Change, Release No. 33-9106 (Feb. 8, 2010) [75 FR 6290].

[10] Item 407(h) of Regulation S-K [17 CFR 229.407(h)].

[11] Item 7 of Schedule 14A [17 CFR 240.14a-101].

[12] See Proxy Disclosure Enhancements, Release No. 33-9089 (Dec. 16, 2009) [74 FR 68334] (“[D]isclosure about the board’s involvement in the oversight of the risk management process should provide important information to investors about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company.”).

[13] Commission Statement and Guidance on Public Company Cybersecurity Disclosures, Release No. 33-10459 (Feb. 21, 2018) [83 FR 8166].

These remarks were delivered by William Hinman, director of the Division of Corporate Finance of the U.S. Securities and Exchange Commission, on March 15, 2019, at the 18th Annual Institute on Securities Regulation in Europe, in London, England.

Categories
M & A Securities Regulation

The Effect of SEC Comment Letters on M&A Outcomes

Recent research on the effectiveness of the SEC’s filing review and comment letter process has focused almost exclusively on reviews of Forms 10-K and other periodic filings. Reviews of filings involving transactions such as mergers and acquisitions (M&A) have received little attention, even though (1) they are a top priority of the SEC and the executives and officers of the filing companies and (2) the SEC scrutinizes every transactional filing of this nature, in contrast to periodic filings, which are reviewed selectively. In our paper, SEC Comment Letters and M&A Outcomes, we examine the impact of one transaction-specific type of SEC comment letter, Form S-4 reviews, on short- and long-term M&A outcomes.

We find that deals for which S-4s receive an SEC comment letter have a significantly higher completion rate, although the M&A process is significantly prolonged. These results provide evidence on the immediate costs and benefits of the SEC’s S-4 filing review process on M&A outcomes. We also find that S-4s that receive an SEC comment letter are less likely to have a goodwill impairment or a restatement in the year after the deal is completed. These results suggest that the SEC’s S-4 filing review process improves the accounting quality of the entities involved in M&A deals. In cross-sectional tests, we find that the main results are stronger for S-4 comment letters with higher word counts and M&A specific comments. Our findings have important implications for regulators and others involved in the U.S. M&A market, as they provide evidence on the costs and benefits of the SEC’s disclosure regulation of M&A.

When a deal involves the combination of two public entities and when at least some stock is exchanged as consideration, the newly issued securities of the combined entity are required to be registered with the SEC on Form S-4, which is subject to mandatory review. As part of its review, the SEC may issue a comment letter if it finds potential deficiencies in the firms’ accounting choices, non-compliance with the S-4 disclosure requirements, or disclosures that could be clarified or improved.

The SEC staff screens all registration statements related to M&A for potential issues that would require further review. This mandatory review process is distinct from the periodic filing review process, which is done selectively. Since the SEC reviews only certain periodic filings and  issues a comment letter only when it finds issues with a company’s accounting and disclosure choices, absent a comment letter, researchers are unable to distinguish between periodic filings that are reviewed but do not receive comments and periodic filings that are not reviewed. As a result, it is difficult to cleanly isolate the effect of SEC comment letters. In contrast, since all S-4 filings are required to be reviewed, if the filing does not receive a comment letter, we can infer that the filing underwent SEC scrutiny without any issues being raised. Consequently, we can cleanly isolate the effect of SEC comment letters without the confounding effect of whether or not there was a review.

The Form S-4 review and comment process are particularly important in our setting, as the Form S-4 acts as both a registration statement and a proxy filing. The newly issued securities for the combined firm are required to be registered with the SEC to comply with Section 5 of the Securities Act, similar to those in an IPO, as the stock consideration offered in the M&A deal is considered a public offering. The filing also must comply with the rules regarding soliciting proxies to approve an action that requires shareholder approval. Both sets of shareholders involved in the deal are typically required to vote on it. Therefore, the S-4 is intended to provide a comprehensive set of disclosures for all acquirer and target shareholders prior to voting on whether to approve the merger.

To examine the short- and long-term consequences of S-4 comment letters on M&A outcomes, we first explore how the completion rate of deals differs between those that do and those do not receive an SEC comment. If the comment letter process delays the S-4 from being declared effective, it could also slow completion of the deal or even kill it. Alternatively, SEC comment letters could improve the transparency of the S-4 disclosures, allowing the legacy target and acquirer investors to more clearly value the deal, leading to a higher likelihood of completion.

Next, for completed deals, we examine the influence of S-4 comment letters on the duration of the M&A process from initial announcement to completion. This is an important issue because any benefits from the comment letter process may be accompanied by additional time or other obstacles to getting the deal done. It also sheds light on the sometimes competing missions of the SEC to protect investors and facilitate capital formation.

With regard to long-term consequences of SEC comment letters, we examine two measures of accounting quality related to the M&A deal: goodwill impairments and restatements. The SEC’s aims to help the company remedy any potential disclosure deficiencies at the time the S-4 is registered to avoid future issues regarding accounting quality. If the S-4 review process is effective, it should alleviate mispricing of goodwill and resolve accounting or estimation issues before they rise to the level of a restatement. This would predict a negative association between the receipt of a comment letter and the likelihood of future goodwill impairment and restatements. However, the receipt of a comment letter alone could signal poor accounting quality that could have a persistent effect. This would predict a positive association between the receipt of a comment letter and the likelihood of future goodwill impairment and restatements.

Using all S-4 filings between August 1, 2004 and December 31, 2015, we find that S-4s that receive an SEC comment letter have a significantly higher completion rate (4.3 percent more likely to be completed), but that the M&A process is significantly prolonged (20.4 percent or 34 days longer on  average between the initial announcement and completion date). These results provide evidence on the immediate costs and benefits of the SEC’s S-4 filing review process on M&A outcomes. Regarding long-term accounting quality, we find that S-4s that receive an SEC comment letter are less likely to have a goodwill impairment or a restatement in the year after the deal is completed. These results suggest that the SEC’s S-4 filing review process is effective in improving the accounting quality of the entities involved in M&A.

Finally, we examine the nature and extent of S-4 comment letters to shed light on the regulatory mechanisms that contribute to the M&A outcomes. We look at how the overall effects vary with the number and complexity of S-4 comments, for which we use as a proxy the average word count of the SEC comment letters. We also test what types of comments contribute to the overall effects, particularly goodwill, pro forma financial statements, and other M&A-specific comments. We find that the documented effects (higher completion and duration and lower goodwill impairments and restatements) are stronger for S-4 comment letters with higher word counts and M&A specific comments (i.e. comments on goodwill, pro forma financial statements, or other M&A-specific comments). These cross-sectional results help to make our main findings clearer and more credible.

Our study contributes to the academic literature on the effectiveness of the SEC’s filing review process. Our findings have implications for regulators and others involved in the U.S. M&A market, as they provide important evidence on the costs and benefits of the SEC’s disclosure regulation of M&A. Another practical implication is that investors can view an S-4 comment letter as a positive sign that the deal is more likely to be completed and have better future accounting quality.

This post comes to us from Professor Bret A. Johnson at George Mason University, Professor Ling Lei Lisic at Virginia Tech, Joon Seok Moon, who is a doctoral student at George Washington University, and Mengmeng Wang, who is a doctoral student at SUNY Buffalo. It is based on their recent paper, “SEC Comment Letters and M&A Outcomes,” available here.

Categories
Uncategorized

Does Public Ownership and Accountability Increase Diversity?

For two generations, U.S. companies, regulators, and activists have grappled with how to increase employment diversity in large firms. Quotas and other explicit hiring targets have tended to fare poorly in the courts. Instead, diversity policies have come to focus on processes rather than outcomes. If a firm can demonstrate that it used fair and objective practices when hiring, evaluating, and rewarding employees, the argument goes, then that firm should not be thought of as discriminatory, even if its resulting workforce does not represent the wider labor market.

This focus on confirming or denying discriminatory intent can obscure the original question. An ultimate goal of the Civil Rights Act and supporting legislation is to remove racial and sexual discrimination in U.S. workplaces. An implication is that, if discrimination were ended, we would see more racially integrated workplaces. Yet there is relatively little research on which employer policies actually increase racial or gender diversity. The importance of policies’ effect on actual workforce composition should be underlined. For if the prevailing approach is to assume employers have fulfilled all of their obligations by adopting policies that do not increase diversity, then the prevailing approach does not live up to the intentions of the act.

In a new working paper, we compare workforce composition across two populations of privately held and publicly traded companies. Public companies are often seen as having the potential to be more diverse, for a variety of reasons. Almost all work on employment diversity stresses that formal rules and objective employment procedures that limit the discretion of potentially biased employers or managers will help women and minority workers. Public firms tend to be larger, older, and more bureaucratic than privately held firms. SEC rules and other reporting requirements force public firms to disclose more and different types of information to the government and the public, meaning they have to be more aware of the implications of their own practices. Additionally, because publicly traded companies must provide information to shareholders, and because problems with a public company’s reputation can affect its bottom line through its share price, many activists think that there are more ways to influence such firms.

At the same time, we know that public companies tend to be more profitable and to offer their employees more secure and varied careers than many privately held ones. For these reasons, jobs with these firms are highly valued, and the historically white, male employees who hold them might fight to keep them more tenaciously. More fundamentally, since we do not know exactly which employment practices produce more diverse workforces, we do know whether greater bureaucracy around HR practices in public firms translates into greater diversity.

The problem with studying this question lies in the comparison group. Which private and public firms should we compare? The decision to offer equity on the public markets is not random, and we have every reason to expect that public firms differ systematically from private ones, in size, profitability, the industries in which they operate, and more. Any of these characteristics might be related to what the firm’s workforce looks like. How might we isolate the effect of being publicly traded?

Our approach is to look at firms that file an intent to make an initial public offering (through filing as S-1 with the SEC) and then to compare the firms that went through with their IPO with the firms that withdrew their initial filing and remained private. These two groups of firms are all but indistinguishable when they make those initial filings, allowing us to control for unobserved differences between public and private firms.

We gathered data on all S-1 filings, withdrawn and successful, between 1985 and 2014. We then tried to match each company with data on their workforce composition gathered from EEO-1 establishment surveys filed with the Equal Employment Opportunity Commission. Any firm with more than 100 employees must complete an EEO-1 survey each year, detailing (for each establishment it operates, across nine occupational categories) the numbers of employees it has, broken out by race and gender. Thus, for more than 2,000 firms, we were able to track their workforce numbers for multiple years before and after their S-1 filing and directly compare diversity in firms with successful IPOs to diversity in those that withdrew.

Of course, a firm’s decision to withdraw an IPO filing is not itself random. Were a firm to suddenly record losses, or to find itself in regulatory trouble, it would be more likely to withdraw, but it would also be more likely to lay off employees or make other changes that could affect the composition of its workforce. To get around this issue, we predict whether or not a company followed through with its IPO based on how the markets did in the first two months after the company’s initial filing, and then compare employment outcomes across the two predicted populations. The procedure works for two reasons. First, swings in the markets are very predictive of whether firms withdraw IPO filings—virtually no one wants make an initial public offering into a bear market. Second, while such short-term swings can lower a firm’s valuation, they tend not to affect the firm’s performance—its products and services are unchanged. Thus, the broader market performance does not affect firm performance, except insofar as it affects whether the firm ultimately goes public. With this research design in place, we can isolate the effect of being publicly traded.

Anyone who is hoping that publicly traded firms have, on average, more diverse workforces will find our results distressing. We find no evidence that going public increases employment diversity. We examined proportions of female and non-white employees, as well as female and non-white managers. In no category did public firms outperform private ones.

It is important to understand that this does not mean that diversity was flat over time in these companies. The percentage of female workers has been fairly constant in public companies over the last 30 years (albeit at more than 40 percent in most firms), but the shares of non-white workers and all female and minority managers have grown steadily. Yet they have grown at the same rates, from the same starting points, as in privately held firms. Public ownership, by itself, seems to have had zero effect.

Given our findings, we think the most important question to ask is why so many people assume that public firms will be better managed or more diverse than their private counterparts. We argue that there is a general problem that affects this type of research on organizations. Firms vary in how willing and able they are to cooperate with researchers. They also vary in how willing they are to diversify their workforces, and how able they are to use internal data to do so. Most existing research on employment diversity uses samples of firms that agreed to share data with researchers. Yet if such cooperating firms are also the firms most committed to changing what their workforces look like, then we will tend to over-estimate the effect of different types of structures and policies. Our work demonstrates that we should not be optimistic about the indirect effects of formalizing employment practices on diversity. Even a comparatively large change in the governance structure, like that associated with going public, seems to have little effect. For those firms, regulators, and activists who want to increase diversity, the answers lie elsewhere.

This post comes to us from professors Rembrand Koning at Harvard Business School and John-Paul Ferguson at McGill University. It is based on their recent article, “Does Public Ownership and Accountability Increase Diversity?: Evidence From IPOs,” available here.