It boggles my mind that, almost fourteen years after the Dodd-Frank Act was enacted, we still have unfinished rulemaking directives from that legislation. For those of you who may not have been practicing fourteen years ago, the enactment of Dodd-Frank was a big deal, because at the time we were still very much hurting from an extraordinary financial crisis for which there had been little accountability. Unfortunately, instead of accountability, we got some real gems of new disclosure rules out of the Dodd-Frank Act, such as pay versus performance, CEO pay ratio, conflict minerals and resource extraction payments. But one piece of Dodd-Frank actually sought accountability through rigid limitations on incentive compensation at financial institutions, and that is the rulemaking that remains unfinished to this day.
As Meredith noted last week on The Advisors’ Blog on CompensationStandards.com, some of the financial institutions tasked with writing the incentive compensation rules recently took action to re-propose the rules, which were last proposed in June 2016. Last week, the FDIC, the Office of the Comptroller of the Currency, and the Federal Housing Finance Agency adopted a Notice of Proposed Rulemaking to address incentive-based compensation arrangements, as required under Section 956 of the Dodd-Frank Act. The National Credit Union Administration is expected to take action on the proposed rules in the near future, and the SEC has included a rulemaking to implement Section 956 on its rulemaking agenda. The Board of Governors of the Federal Reserve did not join the joint proposal of the banking regulators, with Chair Powell recently testifying: “I would like to understand the problem we’re solving, and then I would like to see a proposal that addresses that problem.”
As this Sullivan & Cromwell memo notes, the proposed rules is consistent with the 2016 proposed rule and includes the following key provisions:
– Approach to Proportionality. Covered institutions are categorized into three tiers based on average total consolidated assets, with increasingly stringent requirements applying to institutions with over $1 billion, $50 billion and $250 billion in assets (Level 3, Level 2 and Level 1 covered institutions, respectively).
– Defining Covered Persons. Additional, more stringent rules apply to incentive-based compensation paid to “senior executive officers” and “significant risk-takers” at Level 1 and Level 2 covered institutions. The proposed rule provides a list of roles that would be classified as senior executive officers and identifies significant risk-takers based on relative compensation levels or ability to commit or expose 0.5% of the covered institution’s capital.
– Limits on Incentive Opportunity & Structures. At Level 1 and Level 2 covered institutions, the maximum earned incentive for senior executive officers is limited to 125% of the target amount, and for significant risk-takers is limited to 150% of target. (There are no fixed limits on the absolute size of potential targets.) General requirements for performance determinations would apply to all covered institutions, and Level 1 and Level 2 covered institutions would face prohibitions on the use of relative or volume-driven performance measures in isolation.
– Mandatory Deferral Requirements. The proposed rule introduces longer deferral periods (up to four years after the end of the performance period) and higher minimum deferral amounts (up to 60%) for incentive-based compensation depending on whether the covered institution is Level 1 or Level 2 and whether the individual is a senior executive officer or significant risk-taker. Deferred incentive-based compensation generally may not vest faster than on a pro rata annual basis beginning on the first anniversary of the end of the performance period and must include a “substantial portion” of both equity-like instruments and deferred cash.
– Putting and Keeping Pay at Risk. All incentive-based compensation for senior executive officers and significant risk-takers at Level 1 and Level 2 covered institutions must be subject to downward adjustment, forfeiture and clawback. The proposed rule includes a list of triggering events that require a downward adjustment and forfeiture review at Level 1 and Level 2 covered institutions. In addition, it would subject incentive pay to clawback for seven years after compensation vests.
– Governance, Risk Management and Recordkeeping Requirements. New requirements would apply to board of director and compensation committee oversight and approvals. Covered institutions would be subject to annual recordkeeping and seven-year retention requirements, with records disclosed to the appropriate Agency on request. The proposed rule also contains specific risk management and control requirements.
In my view, Section 956 of the Dodd-Frank Act was flawed from the start, making this rulemaking effort particularly challenging for the financial regulators. The reactionary approach taken by Congress in Section 956 was perhaps somewhat understandable in the wake of the financial crisis, but now seems overboard given that we are over a decade and a half removed from that particular situation. Unfortunately, the financial institutions regulators are stuck with the statutory directive, making it difficult for them to adopt rules that are more reflective of where we stand today.
The SEC’s notable absence from the joint agency action on Section 956 of Dodd-Frank Act inevitably makes one wonder, where are we on SEC rulemaking? It will probably be another month or so before we see the updated Spring Reg Flex Agenda, but the overall timing now makes things interesting as we enter the throes of a Presidential election cycle. Conventional wisdom used to be that the SEC, like other government agencies, would slow down or stop its rulemaking activity as we enter the summer before a Presidential election. This approach made sense for a variety of reasons, given that agencies would not want to have controversial proposals interfere with election year politics, and agencies generally wanted to avoid going to all of the trouble of writing a rule only to have it invalidated under the Congressional Review Act, should the political winds shift against the party in power.
Unfortunately, nothing approaching “conventional” or having to do with “wisdom” prevails in the political state as we know it today, so we have the most recent example of the last six months of the Trump Administration, when the SEC was furiously adopting rules into late December, even after the political winds had in fact shifted and the outcome of the election was known (at least to some), which seemed quite odd. Given that precedent, it is certainly possible that we could see the same scenario play out again in terms of the SEC continuing to propose and adopt rules through the remainder of this year. Remaining out there on the rulemaking agenda are some other controversial items, such as revisiting the definition of “held of record” (and thereby forcing unicorns to register under the Exchange Act) and revisiting Regulation D to address reliance on that exemption from registration by large private issuers. Only time will tell whether these proposals see the light of day.
According to a new report issued by the Shareholder Rights Group, the Staff is seeing a lot more no-action letter requests on shareholder proposals this year, and is permitting companies to exclude a significantly higher percentage of those proposals than they did last year:
Evaluation of SEC staff no action decisions on shareholder proposals from November 1, 2023 to May 1, 2024 demonstrates that the SEC has supported company requests for exclusion of proposals roughly 68% of the time. Companies sharply increased the number of requests filed with the SEC during the same period, with these two developments combining to produce a surge of exclusions.
At this time last year, the Staff permitted exclusion of 56% of the proposals for which no-action relief was sought. The report says that so far this year, the Staff has issued 259 decisions on no-action letters compared to 167 last year and has granted no-action requests for 139 proposals, compared to 76 last year. The report says that numerous climate-related proposals have been excluded in situations where companies argued they involved micromanagement, and that social-related proposals have been bounced on similar grounds.
Last week, Meredith blogged about the inevitable challenge to the FTC’s non-compete ban filed by the US Chamber of Commerce. Given the SEC’s recent experience in the federal courts, I think many of us are inclined to believe that a court will ultimately strike down or pare back the FTC’s ban. But University of Chicago Law School professors Jonathan Masur & Eric Posner say that the ban is legal, and it’s not a close call. Here’s an excerpt from their recent post on the ProMarket Blog:
The FTC’s statutory authority to issue the noncompete rule is not an edge case. Section 5 of the FTC Act of 1914 authorizes the FTC to prevent firms from engaging in “unfair methods of competition.” Congress used this phrase, which was novel at the time and deliberately broad, to encompass anticompetitive behavior that was both already covered by the antitrust laws (which prohibited firms from using “restraints of trade” and from “monopoliz[ing]” markets) as then interpreted by the courts and that reached beyond them.
Like countless other regulatory agencies before and since, the FTC was entrusted with authority to interpret the law, effectively to make policy within the law’s ambit. As a noncompete is just a restraint of trade that restricts competition, the statute plainly authorizes the FTC to issue a rule regulating noncompetes.
While the authors acknowledge that the FTC has typically used case-by-case adjudication to make policy instead of rulemaking, it’s clear that Congress also gave the agency the authority to “make rules and regulations for the purpose of carrying out the provisions of” the FTC Act in section 6(g).
This Morgan Lewis memo provides a heads up about amendments to NYSE Rule 123D that address trading halts around reverse stock splits that will go into effect on Saturday, May 11th. The amendments are being implemented to harmonize the NYSE’s rules with those of Nasdaq. This excerpt from the memo describes the amendments:
The NYSE Amendments add new subparagraph (f) to Rule 123D, which provides that the NYSE will halt trading in a security for which the NYSE is the Primary Listing Market before the end of post-market trading on other markets on the day immediately before the market effective date of a reverse stock split. Such a trading halt due to a reverse stock split will be mandatory.
In connection with a reverse stock split, the NYSE has stated that it expects to initiate the halt at 7:50 pm EST, prior to the end of post-market trading on other markets at 8:00 pm EST, on the day immediately before the market effective date of the reverse stock split. Trading in the security will resume with a Trading Halt Auction starting at 9:30 am EST on the market effective date of the reverse stock split.
The memo says that the rule change was prompted by market participants’ concerns that allowing trading on an adjusted basis during early morning trading sessions could result in system errors or problems going unnoticed for a period of time when a security that has undergone a reverse stock split opens for trading with other thousands of securities.
The SEC continues to make headlines & honk off crypto bros by targeting industry participants for investigations and enforcement actions. Now, it turns out that the regulatory crypto crackdown may be an issue in this year’s election, at least according to a recent Harris survey of swing state voters. The poll, which was commissioned by the Digital Currency Group, surveyed 1,201 registered voters in Arizona, Michigan, Montana, Nevada, Ohio, and Pennsylvania and found that more than 1-in-5 battleground state voters consider crypto to be a key issue. Here are some of the survey’s other key findings:
– Current crypto ownership among voters is relatively low (14%), and most do not feel knowledgeable about crypto (69%). About one-fifth of voters plan to own crypto in the next six months.
– Nonetheless, nearly a third of voters have positive feelings towards crypto (Crypto-Positive). This bloc of Crypto-Positive voters is consistently more enthusiastic about crypto than voters overall; most associate crypto with positive traits like innovative (62%), promising (50%), and accessible (45%).
– Most voters do not trust elected officials to understand innovative technology like crypto, and more than half are concerned about policymakers stifling innovation via overregulation. The vast majority want policymakers to be sure they understand crypto before regulating.
– Nearly half of voters do not trust political candidates that would interfere with crypto. One-quarter say that enthusiasm towards crypto would make them trust a political candidate more. 30% would be more likely to support a political candidate that is friendly to crypto.
– Of note, crypto regulation does have broad support –the majority of voters overall and nearly half of Crypto-Positive voters are in favor of an overhaul of crypto. Similarly, about 20-25% of voters and one-third of Crypto-Positive voters want elected officials to focus on crypto regulation or protections for crypto investors.
The survey also found that Crypto-Positive voters were more likely than other voters to be young, male, and African American or Hispanic. They were less likely to have a four-year college degree than voters overall but did not show any major differences on household income and political party lean. Finally, the survey found that Ohio voters were more negative toward crypto than voters in other swing states – so hey, I feel seen.
Yesterday, the PCAOB announced that it will hold an open meeting on Monday, May 13th to consider adopting a new auditing standard, AS 1000, General Responsibilities of the Auditor in Conducting an Audit. The new auditing standard would consolidate and reorganize several existing standards, and when the PCAOB announced the proposal last year, it said that AS 1000 was intended ‘to streamline and clarify general principles and responsibilities of auditors and provide a more logical presentation, which would enhance the useability of the standards by making them easier to read, understand, and apply.”
On “The Audit Blog”, Dan Goelzer said that there was a lot more to AS 1000 than just housekeeping:
The basic idea of updating and consolidating the foundational standards is sound. Technology, audit practice, and the standards of other audit regulators have all evolved since the PCAOB adopted the existing standards, on an “interim basis,” in 2003. Twenty years down the road, it makes sense to revisit the foundational standards, and the Board deserves credit for doing so.
But, in presenting this initiative as in essence a matter of housekeeping, the PCAOB may be seriously understating its potential impact. The proposal is not merely a repackaging of existing principles. Some aspects would seem to involve changes to the auditor’s responsibilities that would be more fundamental than the release recognizes and could have far-reaching consequences.
Those concerns were echoed by industry commenters on the proposal. Here’s an excerpt from a CAQ publication summarizing the key themes raised by accounting firms in comment letters to the PCAOB:
– The proposal expands the auditor’s responsibilities despite the Board’s statement that the amendments were clarifications of existing standards.
– The proposal eliminates key concepts and principles from the extant standards
– The proposal creates confusion about the auditor’s role and will have other unintended consequences
– Accounting firms and related groups, among other commenters, oppose the clarification of the meaning of fair presentation and state it is important that the auditor’s evaluation of the presentation of the financial statements be applied within the applicable financial reporting framework.
Despite the heartburn the proposed changes are causing to the accounting profession, the CAQ acknowledged that the handful of investors who submitted comments were generally supportive of them.
Issuers of securities in private offerings are sometimes inclined to downplay the risk of paying fees to unlicensed “finders” in connection with those deals, because they view the failure to appropriately register as a broker-dealer under federal or state law as being the finder’s problem. That’s not the case, and this Dorsey blog provides a reminder of the potentially calamitous consequences to the issuer associated with paying an unlicensed finder:
The Securities and Exchange Commission (SEC) has taken the position that a person receiving a finder’s fee with respect to a purchase of securities by a U.S. investor will, in many cases, be treated as having acted as a “broker” within the meaning of federal securities laws.[1] In those cases, the unregistered finder has violated the federal securities laws. Similarly, the issuer may have violated the federal securities laws (under an agency theory, or otherwise) by having paid such fee. In many states, state regulators take similar positions under applicable state law.
The filing of post-closing notices of sale with the SEC and the states disclosing such a fee may result in federal and state regulatory enforcement actions to seek injunctions, monetary penalties or criminal sanctions against the issuer and/or finder. Perhaps more importantly, the payment of the fee may provide the relevant investor(s) with a right to rescind their investment, and create uncertainty about whether and the extent to which such rights should be reflected in the issuer’s financial statements. Such disclosures may adversely affect the issuer’s ability to raise funds, and may further increase the risk of such a rescission claim or regulatory enforcement action.
The blog goes on to recount the story of a company that paid finders fees to unlicensed brokers in a series of offerings. After the SEC came knocking, the uncertainties concerning recission rights led the company’s auditors to withhold their opinion on its financial statements, which precluded it from obtaining further financing and ultimately led to its bankruptcy. Yikes!
Last month, Stanford’s Rock Center for Corporate Governance published a report addressing seven questions about the proxy advisor industry. One of them involves a topic that’s been discussed quite a bit over the years among boards, management teams and their advisors: “Are these folks really independent?” The report says that the jury’s still out on that one:
Institutional investors rely on proxy advisors to provide an independent assessment of proposed corporate and shareholder actions. However, whether proxy advisory firms are independent is an unresolved question. Some proxy advisors receive consulting fees from the same companies whose governance and ESG practices they evaluate, and the potential exists that they alter their voting recommendations to gain or retain business. Ma and Xiong (2021) show, using a theoretical model, that conflicts of interest can bias voting recommendations and decrease firm value.
Some evidence suggests this might be occurring. Li (2018) examines voting recommendations and finds that ISS shifts its positions to make them more favorable to the preferred position of the client company when Glass Lewis initiates coverage of that company. He concludes “conflicts of interest are a real concern.”
The report goes on to discuss possible policy responses to these concerns about proxy advisor independence. However, given the current regulatory climate and the outcome of recent litigation involving the SEC’s efforts to regulate the industry, it doesn’t look like there’s much inclination among policy makers to dig much deeper into this issue.
If you’re interested in reading more about the questions raised by the Rock Center about the proxy advisor industry and the implications of its report, check out Cydney Posner’s recent blog, which takes a deep dive into these issues.
When I was in practice, I was proud of the way that my old flyover state law firm managed to more than hold its own when it came to capital markets transactions. My colleagues and I were involved in some pretty complex offerings and knew our way around a bunch of different financing structures. That being said, whenever I worked on a “modern” convert deal, I felt like a complete rube. One reason for my discomfort was that I cut my teeth on traditional converts back in the 80s and 90s, and those straightforward deals bear little resemblance to the masterpieces of financial engineering that converts have morphed into over the past couple of decades.
If you feel the same discomfort with these deals that I did, this Latham memo on “Demystifying Modern Converts” may be helpful to you. Here’s an excerpt from the memo’s discussion of one of the more complex features of a modern convert – the fundamental change make-whole provision:
Make-whole fundamental changes include the classic example of a cash merger, but they also include other events, such as the delisting of the underlying common stock, which reduces time value by decreasing liquidity and, accordingly, the ability to quickly sell the stock at fair value. As described below, calling the notes for redemption can also trigger make-whole fundamental change provisions. Importantly, a business combination event pursuant to which the notes become convertible into consideration 90% or more of which consists of listed stock of another issuer is usually excluded from the definition of make-whole fundamental change.
The theory behind this exclusion is that the convertible notes will continue to have meaningful time value following the business combination because a substantial part of the consideration due upon conversion will be based on the value of a price-volatile asset — listed stock. This is rough justice, obviously, since the new underlying security could be significantly more or less volatile than the original underlying security. Nonetheless, this is the current market compromise on the issue.
The temporary increase to the conversion rate is usually designed to result in the consideration due upon conversion having a value that, except as described below, approximates the theoretical value of the notes immediately before the make-whole fundamental change. Accordingly, converting noteholders that are entitled to the increased conversion rate will, in theory, be “made whole” for the loss of time value resulting from the make-whole fundamental change. The amount of the increase is determined by reference to a table and is based on the effective date of the make-whole fundamental change and a measure of the value of the underlying common stock as of that effective date.
The memo goes on to describe how the pricing information in the “make-whole table” is determined. I triple-dog dare you to read that discussion once and tell me with a straight face that you understand it. If you can’t do that, don’t feel bad, because my experiences with make-whole tables were what made me realize that I wasn’t the only rube on the deal team. For instance, we once priced a deal right after the market closed and then waited until almost 10:00 pm for the pricing term sheet to be completed, because none of the Wall Street bankers on the deal could figure out the make-whole table either.