Yesterday, the SEC announced that it was proposing amendments to Form PF, which is a confidential reporting form that certain SEC-registered investment advisers to private funds are required to file. Here’s the 298-page proposing release and here’s the more manageable 2-page fact sheet. The SEC’s press release says that the proposed amendments, which are being proposed jointly with the CFTC, “are designed to enhance the Financial Stability Oversight Council’s (FSOC) ability to assess systemic risk as well as to bolster the SEC’s regulatory oversight of private fund advisers and its investor protection efforts in light of the growth of the private fund industry.”
This isn’t the type of SEC action we typically cover. Investment adviser regulation isn’t a high-priority topic for most of our members and – more importantly – what I know about it could fit inside a thimble. So, I wasn’t planning on blogging about the proposal until Liz flagged this WSJ article for me. The article says that, if adopted, the amendments would shed light on just how much exposure to crypto hedge funds have. That makes the proposal a little more interesting. Here’s an excerpt from the WSJ piece:
The collapse in cryptocurrency prices this year has left U.S. regulators scrambling to understand the risks that digital-asset markets could pose to the broader economy. They may soon enlist hedge funds in the effort.
The Securities and Exchange Commission issued a proposal Wednesday that would require large hedge funds to report their cryptocurrency exposure through a confidential filing known as Form PF. Created after the 2008 financial crisis, Form PF was designed to help regulators spot bubbles and other potential stability risks in the otherwise opaque ecosystem of private funds that manage money for wealthy individuals and institutions.
The potential addition of cryptocurrency data to the reporting requirements for hedge funds comes as the SEC and its sibling agency, the Commodity Futures Trading Commission, weigh a broader set of updates that would expand the scope of Form PF.
The proposing release suggests that currently, some filers apparently report crypto holdings as “cash or cash equivalents,” which makes no sense to me. The proposal would amend the term “cash and cash equivalents” to direct advisers to not include any digital assets under that category. Instead, the SEC proposes to define “digital assets” and require advisers to report them separately from other types of assets. Comments are due by the later of 30 days after the proposal is published in the Federal Register or October 11, 2022.
Earlier this year, I blogged about a 7th Cir. decision rejecting a claim that an exclusive forum bylaw could be used to preclude a plaintiff from filing a lawsuit premised on violations of Section 14(a) of the Exchange Act in federal court – which, since those claims can only be brought in federal court, would essentially preclude them from being brought anywhere. Recently, the 9th Cir. reached the opposite conclusion. Here’s what I recently said about that decision over on the DealLawyers.com Blog:
In Lee v. Fisher, (9th Cir.; 5/22), the 9th Circuit upheld a prior district court ruling dismissing federal disclosure claims and state law derivative claims on the basis of an exclusive forum bylaw designating the Delaware Court of Chancery as the exclusive forum for derivative suits. The Court reached that conclusion despite the fact that as a result of the application of the bylaw, the plaintiffs’ claims under Section 14(a) of the Exchange Act – which may only be asserted in federal court – would effectively be precluded.
This Troutman Pepper memo notes that the 9th Cir.’s decision creates a conflict with the 7th Cir., which recently held in Seafarers Pension Plan v. Bradway, (7th Cir.; 1/22), that the provisions of the DGCL authorizing exclusive forum bylaws did not permit Exchange Act claims to be brought in a Delaware court, since the Exchange Act gives federal courts exclusive jurisdiction over those claims. This excerpt from the memo summarizes the implications of the circuit split:
The circuit split created by the Ninth Circuit’s and the Seventh Circuit’s divergent rulings has injected some uncertainty into a common practice among Delaware corporations in the context of derivative claims brought under the Exchange Act. The Seventh Circuit’s decision, which is friendly to derivative plaintiffs, partially upsets standard practice in corporate affairs — that is, deciding where derivative internal corporate disputes should be heard.
The Ninth Circuit’s decision, which is friendly to Delaware corporations, generates uncertainty by splitting with the Seventh Circuit. Naturally, would-be plaintiffs and defendants will likely forum shop to the extent possible and gravitate toward their respective safe harbors. This issue could become exacerbated to the extent other circuit courts contribute to the circuit split. In that event, the uncertainty would likely continue unless and until the Supreme Court has the opportunity to, and chooses to, resolve the burgeoning circuit split.
In the course of his recent blog about Staff comments on the war in Ukraine, Dave also noted that the Staff has been seeking additional disclosure on inflation & supply chain issues. Yesterday, Olga Usvyatsky tipped us off via Twitter that the SEC released a number of comment letters addressing those topics. Most of the comments focused on disclosure in the Risk Factors & MD&A sections of the filings. Here are excerpts from some of those letters that should give you a flavor of the general nature of the Staff’s comments:
“We note your risk factor indicating that inflation could affect your margin performance and financial results. Please update this risk factor if recent inflationary pressures have materially impacted your operations. In this regard, identify the types of inflationary pressures you are facing and how your business has been affected.”
“We note your discussion here and on page 26 of your April 3, 2022 Form 10-Q related to inflation that it could affect your prices, demand for your products, your profit margins. We further note your disclosure that your test and industrial automation businesses will be impacted by supply constraints, which are in turn impacted by inflation. Please update this risk factor in future filings if recent inflationary pressures have materially impacted your operations. In this regard, identify the types of inflationary pressures you are facing and how your business has been affected.”
“We note your risk factor here and throughout the filing related to supply constraints. We further note from your Form 8-K dated April 27, 2022 that you continue to encounter material constraints in most product areas and that you provide wider than normal Q2 guidance range reflects those supply challenges. Specify in future filings and in more detail whether these challenges have materially impacted your results of operations or capital resources and quantify, to the extent possible, how your sales, profits, and/or liquidity have been impacted.”
“Please consider including disclosures in future filings to discuss known trends or uncertainties resulting from mitigation efforts undertaken, if any, from your supply chain disruptions. Explain whether any mitigation efforts introduce new material risks, including those related to product quality, reliability, or regulatory approval of products.”
“Please discuss in future filings whether supply chain disruptions or inflation have materially affected your outlook or business goals. Specify whether these challenges have materially impacted your results of operations or capital resources and quantify, to the extent possible, how your sales, profits, and/or liquidity have been impacted. Revise also to discuss in future filings any known trends or uncertainties resulting from mitigation efforts undertaken, if any. Explain whether any mitigation efforts introduce new material risks, including those related to product quality, reliability, or regulatory approval of products.”
A few common themes emerge from these comments. First, the Staff is focusing the need to keep risk factor disclosure up to date, and companies would be well advised to consider whether updates are necessary in order to avoid falling into the hypothetical risk factor trap. Second, the Staff wants more detail in disclosures about how a company’s business is being affected by inflation or supply chain disruptions. Finally, MD&A disclosure about these issues needs to address not only their current impact, but also any “known trends or uncertainties” that may result from them or from the company’s mitigation efforts.
At its last meeting, FASB proposed several changes that would impact segment reporting. These include requiring disclosure of the title & position of its chief operating decision maker and enhanced disclosure of significant expenses. This excerpt from a WSJ article on the proposal summarizes the proposed changes to expense disclosure:
U.S. public companies would have to start breaking out big-ticket expenses incurred by their business divisions under a new proposal from the U.S. accounting standards-setter aimed at helping investors get a clearer view of financial performance. Companies usually split their operations into segments by business line or geography. They are required to disclose a measure of their profits or losses by operating segment in financial statements, but don’t have to go into much more detail.
Under a proposal from the Financial Accounting Standards Board, companies would have to disclose significant expenses in those divisions, which could cover things like labor, technology fees, rent or cost of goods sold.
In addition, FASB proposes to permit companies to report multiple measures of a segment’s profit or loss, so long as at least one of those measures is one that is most consistent with those used in measuring the corresponding amounts in the consolidated financial statements. FASB’s staff is drafting a proposed Accounting Standards Update and interested parties will have 75 days to comment on the proposal.
The front office of my favorite MLB team has a reputation for the effective use of analytics. Like most jaded Cleveland fans, I’ve often thought they’ve opted for that approach because the club has no money & data scientists are a lot cheaper than power hitters. Nevertheless, I give the Guardians’ brain trust a lot of credit for doing things like extracting some real value in exchange for an un-signable star like Francisco Lindor. Oh, and I also give them a lot of credit for not being the Browns brain trust. Don’t even get me started on those freakin’ guys. . .
Geez, where was I going with this – oh yeah, SEC Enforcement! Anyway, this Holland & Knight blog picks up on Liz’s recent blog about the trio of insider trading enforcement actions that the SEC brought late last month and details the role that data analysis tools may have played in each of those cases. If you read that blog, it’s hard not to conclude that when Big Brother has access to Big Data, insider trading is even dumber than it used to be.
Section 404 of the Sarbanes-Oxley Act requires companies to review their internal control over financial reporting and report whether or not it is effective. Non-accelerated filers are required to provide management’s assessment of the effectiveness of their ICFR, while larger companies are required to accompany that assessment with an attestation from their outside auditors.
Audit Analytics recently issued its annual report on the most recent round of auditor attestations & management-only assessments of ICFR. This recent blog reviews the results of the past 18 years of experience under SOX 404, and makes several interesting observations:
– In FY 2021, 5.8% of SOX 404(b) auditor attestations disclosed ineffective internal controls. In contrast, 23.7% of management reports and 41.9% of management-only reports disclosed ineffective controls. These percentages represent increases from the levels seen in FY 2020, across all three report types.
– The report includes a thorough breakdown of the control and accounting issues contributing to an ineffective control assessment. Notably, in FY 2021, a recurring control issue cited in adverse SOX 404 reports related to a lack of qualified accounting personnel. Other issues stem from this lack of highly trained company accounting professionals. This includes the inability to enforce a “segregation of duties” within the accounting function.
The blog notes that the significantly higher percentage of management-only reports disclosing ineffective controls reflect the demographics of companies required to file these reports. Large companies must file auditor attestations along with management reports on ICFR, while smaller companies are permitted to file management-only reports.
The recurring references to the lack of qualified accounting personnel are particularly troubling. Over the past few years, there have been numerous media reports about a potential shortage of accountants. It looks like the chickens have come home to roost on this issue this year, and that the shortage will continue to place stress on companies’ internal controls in the future.
A recent 2nd Circuit decision pared back the scope of the claims for which compensation may be received under Dodd Frank’s whistleblower provisions. Here’s the intro from this Sheppard Mullin blog on the decision:
In Hong v. SEC, No. 21-529 (2d Cir. July 21, 2022), the Court held that a person who provides the Securities and Exchange Commission (“SEC”) with information about potential securities laws violations is entitled to receive a whistleblower award under Section 21F of the Securities Exchange Act (15 U.S.C. § 78u-6) if the SEC itself brings a qualifying action, but not when the SEC shares the whistleblower’s information to other agencies who then bring an action in partial reliance upon it.
In this case, the whistleblower tipped the SEC off to some alleged shenanigans involving his employer bank’s portfolio of residential mortgage-backed securities. The SEC didn’t take action but shared his information with the DOJ & the Federal Housing Finance Agency. Ultimately, the bank settled with the agencies for $10 billion, so you can understand why this guy was hoping for a big payday.
However, the SEC contended that it wasn’t on the hook for whistleblower claims resulting from actions by other agencies. It said that in order for actions by other agencies to qualify as “related actions” under Section 21F, there must also be an underlying SEC action. The 2nd Circuit applied Chevron deference to the SEC’s interpretation of the scope of Dodd-Frank’s whistleblower provisions & ultimately ruled in the agency’s favor.
The blog says that the decision sets definitive limits on the reach of the Dodd-Frank Act’s whistleblower incentives and may also affect an individual’s assessment of whether to risk their career to come forward with information on potential wrongdoing.
We continue to receive questions from members in our Q&A Forum (see Topic #11109) and via email about when the SEC will announce the inflation adjustment to the emerging growth company revenue cap that the JOBS Act requires it to issue every five years. Unfortunately, we’ve not heard anything on this front, so to our knowledge, it’s still on the agency’s “to do” list as it was the last time that we blogged about it.
Yesterday, the Senate passed the 755-page Inflation Reduction Act of 2022. Among its other provisions, the legislation imposes an excise tax equal to 1% of the fair market value of any stock that a company repurchases during its fiscal year (see p. 31). I remember a tax prof in law school saying something like excise taxes are always simple, because the government just takes a slice off the top, which probably explains why this part of the statute is only about 6 pages long. This excerpt from a Congressional Research Service report provides an overview of the excise tax provision:
A provision in H.R. 5376 would impose a 1% excise tax on the repurchase of stock by a publicly traded corporation. The amount subject to tax would be reduced by any new issues to the public or stock issued to employees. The tax would not apply if repurchases were less than $1 million or if contributed to an employee pension plan, an employee stock ownership plan, or other similar plans.
The tax would not apply if repurchases were treated as a dividend. It would not apply to repurchases by regulated investment companies (RICs) or real estate investment trusts (REITs). It also would not apply to purchases by a dealer in securities in the ordinary course of business. The excise tax would apply to purchases of corporation stock by a subsidiary of the corporation (i.e., a corporation or partnership that is more than 50% owned by the parent corporation). The tax would also apply to purchases by a U.S. subsidiary of a foreign-parented firm. It would apply to newly inverted (after September 20, 2021) or surrogate firms (i.e., firms that merged to create a foreign parent with the former U.S. shareholders owning more than 60% of shares).
In general, excise taxes can be deducted to determine profits subject to the corporate tax, so that the tax is reduced by the corporate tax rate (21%). That is, for a profitable corporation each dollar of excise tax reduces profits taxes by 21 cents. The language specifies that this tax would not be deductible, so there would be no corporate profits tax offset.
You probably noticed that this summary describes the House version of the bill, but the Senate version appears to be the same. The rationale for the excise tax – beyond the horse trading required to get Senator Krysten Sinema (D – Ariz.) to support the legislation – is that dividends and repurchases should have similar tax consequences. This excerpt from the Center on Budget Policy and Priorities’ statement on the legislation summarizes that position:
Dividends are generally taxable when shareholders receive them. Under a stock buyback, in contrast, shareholders who sell their shares to the corporation at a gain owe capital gains tax but shareholders who don’t sell their shares — typically the overwhelming proportion — see the value of their shares rise but don’t pay tax on the gain until they sell. Their wealth increases but their taxes don’t. By imposing a 1 percent excise tax on share buybacks, this provision is designed to correct this tax policy inefficiency.
The legislation now goes back to the House, where it is expected to pass and subsequently be signed into law by President Biden. Check out this resource for more technical details on the legislative process.
While companies and stockholders are extremely fond of stock buybacks, many other people don’t think as highly of them. In fact, a lot of commentators are vehemently opposed to them. For instance, this excerpt from a 2020 HBR article essentially says that they’re something that only a Bond villain could love:
With the majority of their compensation coming from stock options and stock awards, senior corporate executives have used open-market repurchases to manipulate their companies’ stock prices to their own benefit and that of others who are in the business of timing the buying and selling of publicly listed shares. Buybacks enrich these opportunistic share sellers — investment bankers and hedge-fund managers as well as senior corporate executives — at the expense of employees, as well as continuing shareholders.
Critiques like these have gotten some traction, and to a certain extent are reflected in the SEC’s recent proposals for additional disclosure on buybacks. While I doubt that Ernst Blofeld would oppose a buyback of SPECTRE’s stock, a couple of recent studies have popped up suggesting that buybacks aren’t bad, just mostly misunderstood. The first study, from three finance profs, says that critics who side with the views expressed in the HBR article have it all wrong. Here’s an excerpt from the abstract:
Repurchases account for a tiny fraction of the trading volume in a typical stock, making their price impact too small to facilitate short term price manipulation. Price appreciation following repurchases is modest and does not reverse on average, suggesting prices increase due to repurchases signaling firms’ good prospects. Also, we find no evidence that CEOs of repurchasing firms are paid excessively or that repurchases crowd out valuable investment opportunities.
The second study, from the Bipartisan Policy Center, says that greater attention should be paid to the good things that buybacks enable companies to accomplish, and that repurchases should be evaluated under a dynamic approach that takes into consideration the best ways to ensure the most efficacious use of capital in the U.S. economy:
When one looks at repurchases through a dynamic, instead of a static, approach, the benefits appear to have a much broader impact on society. Repurchases provide investors, including those beneficiaries with 401ks and pensions that are invested market wide, with additional financial resources that they otherwise would not have had. These additional resources may in turn be reinvested or saved, which can provide needed capital for small companies and others to facilitate innovation and growth.
