Earlier this year, I blogged about the topic of “regulation by enforcement.” At the time, I noted that the SEC denies that it engages in this conduct, but I also pointed out that courts are sometimes sympathetic to defendants’ claims that due process requires them to have adequate notice that they are potentially violating the law. Claims that the SEC is attempting to regulate by enforcement have featured prominently in its high-profile litigation against crypto heavyweight Ripple Labs, with the company asserting that it had not received “fair notice” that its XRP cryptocurrency was a security.
Ripple scored a win in March when the SDNY issued an order denying the SEC’s motion to strike Ripple’s fair notice defense. This excerpt from a Reuters article on the decision summarizes the ruling:
The SEC claimed that the defendants failed to register transactions in its digital asset, XRP, as “investment contracts” under Section 5 of the Securities Act, while the defendants contended it is not sufficiently clear that the phrase “investment contract” applies to transactions in XRP and thus raised a fair notice defense. The fair notice defense arises under the U.S. Constitution’s Due Process Clause and requires that the language of any criminal statute be sufficiently clear to objectively give fair notice of what is prohibited (See F.C.C. v. Fox Television Stations, Inc., 567 U.S. 239, 253 (2012)).
The court denied the SEC’s motion to strike Ripple’s fair notice defense; its opinion represents a significant victory for the defense. This opinion will allow the defense to marshal, on summary judgment, significant and invaluable discovery from the SEC into its own views on how XRP and other digital assets should be classified.
The article also points out that the SEC was successful in its effort to strike the defense in its lawsuit against Kik Interactive. It goes on to say that the ruling is potentially a big deal, because “if future digital asset defendants may successfully bring fair notice defenses under Section 5 based on allegations regarding the SEC’s own conduct, that will open the door in discovery to, at a minimum, requests for the SEC’s notes from meetings with third parties in the digital asset space, draft speeches from SEC leaders on how various digital assets should be categorized, and documents containing the SEC’s formal positions on whether a given digital asset qualifies as a security.”
Mondays are tough enough without having to work your way through a bunch of blogs that are more somber than the PBS NewsHour. Since my first couple of blogs today were pretty serious, I wanted to be sure to close on a lighter note. When I want to do that, the first thing I look for is news on the Wu-Tang Clan that has even the most tangential ties to stuff we cover here. Fortunately, America’s most entrepreneurial hip-hop artists never let me down.
As you know, various Wu-Tang members have jumped into crypto in a big – if not always successful – way, and I’m pleased to tell you that they’re still at it. In one of our more recent check-ins with The Wu-Tang Clan, I discussed Method Man’s nascent NFT venture, which involved him launching his own comics universe. Based on more recent media reports, it looks like he’s launched his venture on the metaverse, or more accurately, the “MEFaverse.” Here’s the project’s website, which provides more details on its “About Us” page:
The MEFaverse is the first metaversal world (Wu York City) where holders get to experience a graphic novel and not simply read it. The story revolves around Method Man, founding member of the greatest Hip Hop group of all time, Wu-Tang Clan, in a world where he became a literal superhero and not just a lyrical one. The project combines all things Hip Hop, skateboarding, and comic books in a format that speaks to all ages. This is where In Real Life (IRL) meets the metaverse.
Sound good? It looks like you need to pony up .08 ETH in order to join in. I’m not sure I understand everything that Method Man’s doing here, but I do think this may be the closest I’ve come to actually understanding a crypto project.
A couple of other Wu-Tang related developments. First, if you’re looking to invest your ever-dwindling 401(k) in Wu-Tang Clan-related NFTs – and let’s face it, at this point could you do any worse than the stock market? – OpenSea has a large collection for your perusal. Second, if you’re looking to buy a home in the Milwaukee area, be sure to check out realtor Jonathan Frost, who reminds us that “Low Mortgage Rates are Temporary, but Wu-Tang is Forever.”
I blogged earlier this week about a shareholder proposal that urged a company to impose additional restrictions on Rule 10b5-1 plans, which largely mirror the conditions in the SEC’s proposed changes to Rule 10b5-1. The shareholder proposal didn’t pass, but nearly 49% of shareholders voted in favor of it.
A member emailed this note in response:
It occurred to me that not enough attention has been paid to the issue surrounding the legal framework for insider trading violations and the SEC’s proposal to restrict the 10b5-1 affirmative defenses. It is one thing for a company to adopt a policy limiting the use of the 10b5-1 safe harbor, even in response to a shareholder proposal, but it is another for the SEC to seek to limit defenses to insider trading violations that is inconsistent with the legal requirements for insider trading liability.
The member noted that the ABA comment letter to the SEC on the Rule 10b5-1 proposal raises this concern. The ABA comment letters always draw a strong team of participants, and this one includes heavy hitters Stan Keller and John Huber, among other very accomplished members of the securities law community (if you have been practicing in this space for more than a few years, you will probably recognize all of the names on this particular letter). Here’s an excerpt:
Moreover, we are concerned that adding the proposed conditions to the affirmative defenses in Rule 10b5-1 as it is now constructed would be inconsistent with insider trading law. In our letter dated May 8, 2000 commenting on the proposal to adopt Rule 10b5-1, we expressed our concern about whether the enumerated affirmative defenses fully reflected insider trading law and suggested that they be designated as non-exclusive safe harbors or that a catch-all affirmative defense be added. The Commission chose not to take our suggestions in adopting Rule 10b5-1.
However, that was not particularly problematic because the affirmative defenses in the rule as adopted were closely aligned with insider trading law. That would not be the case though if the Commission were to adopt the proposed amendments because of the substantial limitations that would be imposed on the affirmative defenses. Accordingly, we are concerned that the proposal, if adopted, would depart from established insider trading law. To illustrate: under current Rule 10b5-1 a person who does not have material non-public information could grant discretionary authority to sell shares to a third party; that third party can then sell at a time it does not have material nonpublic information even if the person granting the authority, who may not even know about the sale at the time it is made, then has material nonpublic information.
If the Rule 10b5-1 affirmative defenses are unavailable because one or more of the conditions that would be added by the proposal (such as a cooling-off period) have not been met, the person who granted the discretionary authority in the foregoing circumstances still may not be violating Rule 10b-5 even though it is not relying directly on Rule 10b5-1 as amended.
We therefore recommend that the Commission reconsider its approach in light of these concerns and either:
(i) If there are demonstrable abuses in how Rule 10b5-1 is currently being used, the Commission should address them directly. For example, if terminating a plan in order to take advantage of material nonpublic information is considered an abuse, the Commission could make clear that such a termination would violate the good faith requirement of Rule 10b5-1 and the plan would not be a defense to liability as provided in Rule 10b5-1(c)(1)(ii). This targeted approach would address an abuse but not interfere with other terminations for good reason that are not abusive; or
(ii) If additional requirements to the availability of the affirmative defenses along the lines of those proposed are adopted, the rule should expressly recognize that it provides non-exclusive safe harbors so that Rule 10b5-1 as amended is consistent with insider trading law. Recognition of safe harbors would encourage adoption of practices consistent with the safe harbors, but to be effective the safe harbors should reflect prevailing practices, such as those we describe below, adopted by companies designed to ensure compliance and prevent abuses.
On his D&O Diary blog, Kevin LaCroix has been tracking securities lawsuits and D&O claims that stemmed from sexual misconduct allegations. Last week, he analyzed the recent news that CBS had agreed to settle a securities class action lawsuit that was filed when news of inappropriate behavior by the company’s former CEO surfaced, and was followed by a 6% decline in company stock price. Kevin notes:
In their amended complaint (here), the plaintiffs alleged that the defendants had on numerous occasions stated that the company maintained the highest standards for ethics and appropriate business actions, and that the company had a zero tolerance policy for sexual harassment, while in fact the company had a pervasive culture of sexual misconduct; that the company’s culture created an undisclosed risk that Moonves would have to leave the company; and that after the #MeToo story first began to emerge the defendants – and Moonves in particular—made a number of reassuring statements about the company and its practices, which the plaintiffs allege were misleading. The complaint further alleges that a number of CBS executives, including Moonves, sold millions of dollars’ worth of their personal holding in company stock in advance of the revelations about Moonves.
As detailed here, on January 15, 2020, in a lengthy and detailed opinion, Southern District of New York Judge Valerie Caproni largely granted the defendants’ motion to dismiss the lawsuit. Although she largely rejected the plaintiffs’ claims, Judge Caproni did find one statement that Moonves himself had made at a November 29, 2017 industry event to be false and misleading. Moonves had said that the #MeToo movement was a “watershed event,” adding that “It’s important that a company’s culture will not allow for this. And that’s the thing that is far-reaching. There’s a lot we’re learning. There’s a lot we didn’t know.”
Judge Caproni found, taking the allegations in the light most favorable to the plaintiffs, that this statement was — “just barely” — false and misleading, as it implied that Moonves was just learning for the first time about these kinds of allegations when he was at the time actively seeking to conceal his own misconduct. The statement also falsely implied that he was not personally at risk himself.
Kevin explains that the plaintiffs ended up with a $14.75 million settlement payable by the company or its insurers – not record-breaking, but nothing to sneeze at. Meanwhile, Kevin also blogged that a court dismissed a securities fraud suit against Activision Blizzard.
Results here are decidedly mixed, as Kevin notes. But because lawsuits are distracting, attract negative attention and do sometimes result in significant payouts, boards will need to continue to pay attention to corporate culture risks and executive misbehavior. We have a checklist for members on this topic, which we recently updated to reflect legal restrictions on mandatory arbitration provisions. This checklist provides step-by-step considerations for risk assessments and more. If you aren’t already a member, sign up today to get access – you can become a member online, by calling 1-800-737-1271, or by emailing sales@ccrcorp.com. Our “100 Day Promise” means there’s no risk to signing up!
In what is no doubt the biggest news of the week for our judicial branch (kidding), the “Courthouse Ethics & Transparency Act” has been presented to the President for signature. Congress approved the bill last week. Here’s a summary:
The Courthouse Ethics and Transparency Act would require that federal judges’ financial disclosure reports be made publicly available online and require federal judges to submit periodic transaction reports of securities transactions in line with other federal officials under the STOCK Act. The bill, which passed the Senate unanimously in February, would amend the Ethics in Government Act of 1978 to:
• Require the Administrative Office of the U.S. Courts to create a searchable online database of judicial financial disclosure forms and post those forms within 90 days of being filed, and
• Subject federal judges to the STOCK Act’s requirement of filing periodic transaction reports within 45 days of securities transactions over $1,000.
Importantly, the bill also preserves the existing ability of judges to request redactions of personal information on financial disclosure reports due to a security concern.
As we’ve noted in this blog before, the STOCK Act hasn’t exactly been known for its sweeping effectiveness. That did not deter the sponsors of the bill, who pointed to its importance in maintaining the independence of the judiciary. The WSJ reported last year that 131 judges had failed to recuse themselves from lawsuits involving companies in which they or their families held shares.
Here’s something that Lawrence just blogged about on PracticalESG.com:
Last week, the SEC’s Climate & ESG Task Force – which sits in the Commission’s Division of Enforcement and has a mandate to identify material gaps or misstatements in issuers’ ESG disclosures – announced that it had charged a Brazilian mining company with making false & misleading claims about dam safety that resulted in a collapse that killed 270 people, caused environmental & social harm, and allegedly led to a loss of more than $4 billion in the company’s market cap. The announcement explains:
According to the SEC’s complaint, beginning in 2016, Vale manipulated multiple dam safety audits; obtained numerous fraudulent stability certificates; and regularly misled local governments, communities, and investors about the safety of the Brumadinho dam through its environmental, social, and governance (ESG) disclosures.
The SEC’s complaint also alleges that, for years, Vale knew that the Brumadinho dam, which was built to contain potentially toxic byproducts from mining operations, did not meet internationally-recognized standards for dam safety. However, Vale’s public Sustainability Reports and other public filings fraudulently assured investors that the company adhered to the “strictest international practices” in evaluating dam safety and that 100 percent of its dams were certified to be in stable condition.
‘Many investors rely on ESG disclosures like those contained in Vale’s annual Sustainability Reports and other public filings to make informed investment decisions,’ said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement. ‘By allegedly manipulating those disclosures, Vale compounded the social and environmental harm caused by the Brumadinho dam’s tragic collapse and undermined investors’ ability to evaluate the risks posed by Vale’s securities.
Although Vale is a Brazilian company, they have American Depositary Receipts (ADRs) and file reports with the US SEC, which gives the SEC jurisdiction to enforce US securities regulations/laws against the company. The 76 page complaint contains a number of allegations about third party auditor conflict of interest, bias and fraud in dam safety audit work conducted in conjunction with engineering assessments. There is also a significant element of corporate governance failures related to the audits. This Cooley blog has more details on the 76-page complaint.
The action is the first I know of that directly connects safety audits to “violating antifraud and reporting provisions of the federal securities laws,” potentially setting a precedent significantly increasing liability of ESG auditors. It appears to be the first action brought by the ESG Task Force since its formation in March of last year.
What This Means
The Climate and ESG Task Force was established specifically to enforce against material gaps or misstatements in issuers’ ESG disclosures. ESG data and the audits producing such data are now a securities law risk. Companies that use auditors to collect or validate environmental, safety, sustainability and similar data should ensure professional standards for audit practices and impairment identification/management are fully implemented.
Non-financial EHS auditors may see this as unfortunate timing given that the SEC climate proposal includes an attestation report for emissions inventory disclosures and certain related disclosures about the service provider. The proposal language states that the attestation service provider would not have to be a registered public accounting firm and the attestation report would not need to cover the effectiveness of internal control over GHG emissions disclosure (i.e., ICFR). However, questions 144 – 153 of the proposal request input on matters related to whether the use of non-financial auditors is appropriate. The Vale action may create doubt that doing so is a good idea.
We’re posting memos about this development in our “ESG” Practice Area on TheCorporateCounsel.net – and diving into even greater detail in the “Enforcement” Subject Area on PracticalESG.com.
Board advisors will need to stay on their toes as we greet the “Brave New World” of ESG litigation – and this is one of the timely topics that we’ll cover October 11th at our “1st Annual Practical ESG Conference.” Join us virtually to hear from litigators doing this work – Morrison & Foerster’s Jina Choi, Beveridge & Diamond’s John Cruden, and Baker McKenzie’s Peter Tomczak. This session – “ESG Litigation & Investigations – Are You at Risk?” – also features Doug Parker of environmental data firm Ecolumix, who previously served as a Special Agent & Director of the EPA’s Criminal Investigation Division, where he oversaw maters including the investigation into the Deepwater Horizon disaster and the Volkswagen emissions scandal. It’s sure to be a fascinating and practical conversation.
Here’s the full agenda for the event. Sign up online or email sales@ccrcorp.com to register – get in before June 10th to take advantage of the “Early Bird” discount.
Wachtell Lipton recently published an updated version of its longstanding “Audit Committee Guide.” The 2022 edition weighs in at 210 pages. This introductory note explains how the guide can be used:
To assist those who serve on the audit committee with their special role, this Guide provides an overview of the key rules applicable to audit committees of NYSE- and Nasdaq-listed companies and describes some of the best practices that audit committees should consider. In addition, attached as exhibits are a Model Audit Committee Charter for NYSE-listed companies, a Model Audit Committee Charter for Nasdaq-listed companies, a Model Audit Committee Responsibilities Checklist, a Model Audit Committee Member Financial Expertise and Independence Questionnaire, a Model Audit Committee Pre-approval Policy, Model Policies and Procedures with respect to Related Person Transactions, Model Whistleblower Procedures and a Model Audit Committee Self-Evaluation Checklist. These models are just that—models that can and should be adapted by a company to fit its own circumstances.
In today’s financial and enhanced regulatory enforcement climate, the audit committee must be vigilant not only in monitoring financial reporting and compliance, but also in following appropriate procedures in performing its duties. It is incumbent upon every audit committee to ensure that its policies and procedures are “state of the art.” We hope that this Guide will assist audit committees in doing so.
Members can access this guide along with heaps of other helpful resources in our “Audit Committees” Practice Area. If you aren’t already a member of TheCorporateCounsel.net, sign up now and take advantage of our “100-Day Promise” – During the first 100 days as an activated member, you may cancel for any reason and receive a full refund!
On the heels of its March proposal on enhanced cybersecurity disclosure, the SEC announced earlier this week that it is allocating 20 additional positions to its newly renamed “Crypto Assets & Cyber Unit” (formerly known as the “Cyber Unit”).
This group sits in the Division of Enforcement and will grow to 50 dedicated positions with the new allocation – nearly double its current size! In addition to its expanded role of protecting investors in crypto markets, the announcement suggests that the unit will continue to investigate companies for:
Failing to maintain adequate cybersecurity controls and for failing to appropriately disclose cyber-related risks and incidents. The Crypto Assets and Cyber Unit will continue to tackle the omnipresent cyber-related threats to the nation’s markets.
To the extent that your company hasn’t already gotten serious about cybersecurity oversight and disclosure, the SEC is sending strong signals that now is the time to do so. This 17-page memo from Tapestry Networks recaps recent discussions among sophisticated audit committee chairs and cyber experts about the steps companies are taking. Here are some takeaways:
– The role of the Chief Information Security Officer is continuing to evolve, and their reporting structure sends a signal. It’s critical for CISOs to feel like they can be candid with the board.
– Directors employ a range of tools to understand companies’ cyber capabilities – maintaining open lines of communication is extremely important in the current heightened risk environment. Dashboards, KPIs, executive sessions with the CISO, and third-party assessments are methods that some boards use to stay informed.
– Boards are assessing how to best provide & structure cyber oversight – many are searching for a unicorn “cyber expert” who also has well-rounded business expertise, and more companies are creating stand-alone technology committees (but it’s still a minority practice). In 2021, 68% of Fortune 100 companies continued to assign primary responsibility for cybersecurity oversight to the audit committee.
See the full write-up for more color on all these points, along with sample cyber-related questions for audit chairs to consider. We’ve posted a number of memos about the board’s role in cybersecurity oversight in our “Cybersecurity” Practice Area.
We continue to worry for the people of Ukraine and the various consequences of the Russian invasion. We know the Staff at the SEC is also considering the disclosure implications – John blogged a few weeks ago about a comment letter exchange, and he shared a prediction that other companies could receive similar comments. Yesterday, Corp Fin posted this sample letter to companies regarding the business impact of the invasion. The Staff identified several topics for which companies should provide detailed disclosure, to the extent material or otherwise required:
(1) direct or indirect exposure to Russia, Belarus, or Ukraine through their operations, employee base, investments in Russia, Belarus, or Ukraine, securities traded in Russia, sanctions against Russian or Belarusian individuals or entities, or legal or regulatory uncertainty associated with operating in or exiting Russia or Belarus,
(2) direct or indirect reliance on goods or services sourced in Russia or Ukraine or, in some cases, in countries supportive of Russia,
(3) actual or potential disruptions in the company’s supply chain, or
(4) business relationships, connections to, or assets in, Russia, Belarus, or Ukraine. The financial statements may also need to reflect and disclose the impairment of assets, changes in inventory valuation, deferred tax asset valuation allowance, disposal or exiting of a business, de-consolidation, changes in exchange rates, and changes in contracts with customers or the ability to collect contract considerations.
In addition, since Russia’s invasion of Ukraine, many companies have experienced heightened cybersecurity risks, increased or ongoing supply chain challenges, and volatility related to the trading prices of commodities regardless of whether they have operations in Russia, Belarus, or Ukraine that warrant disclosure.
Companies also should consider how these matters affect management’s evaluation of disclosure controls and procedures, management’s assessment of the effectiveness of internal control over financial reporting, and the role of the board of directors in risk oversight of any action or inaction related to Russia’s invasion of Ukraine, including consideration of whether to continue or to halt operations or investments in Russia and/or Belarus.
This is a rapidly evolving area. Corp Fin’s sample comment letter follows a rulemaking petition last week that asked the SEC to require disclosure about business dealings in and with Russia and Belarus. For guidance on the financial statement impacts that may warrant disclosure, check out Dave’s blog last week. In our “Ukraine Crisis” Practice Area, we’re posting lots of resources for members who are navigating these issues.
The shareholders rejected a shareholder proposal that Abbott’s Board of Directors adopt a policy on Rule 10b5-1 plans with certain restrictions and disclosure requirements, with 48.76 percent of the votes cast voting “For” the proposal.
The proposal was submitted by the NYC Comptroller and called for a policy for Rule 10b5-1 plans that would require:
1. A “Cooling Off Period” of at least 120 days between Plan adoption and initial trading under the Plan.
2. An “Overlapping Plan Prohibition” preventing an individual/entity from having multiple Plans simultaneously.
3. Named Executive Officers and Directors to disclose on the Company’s proxy statement the number of shares subject to a Plan.
4. Whenever a Section 16 corporate officer or director adopts, modifies, or cancels a Plan, a Form 8-K disclosure indicating the name of the affected individual, the number of shares covered, and the date of adoption, modification, or cancellation of the Plan.
5. Disclosure on Form 4 of whether a trade was made under a Plan, and the Plan’s adoption or modification date.
It’s a big deal when the first iteration of a shareholder proposal comes close to passing, even if it doesn’t make it quite all the way there. This one is particularly notable because it was based on the recommendations of the Commission’s Investor Advisory Committee and it includes several features that ended up being part of the SEC’s rule proposal – e.g., a 120-day cooling-off period, a prohibition on overlapping plans, and additional disclosure. ISS and Glass Lewis both recommended voting for the proposal.
Abbott’s board did not support the proposal, saying that they already have policies and limitations in place to guard against insider trading (30-day cooling off period, pre clearance, no trades during blackouts, Form 4 footnotes, etc.) and that the proposal would disadvantage the company by having it go well beyond current market practices for trading plans and, in some ways, beyond the SEC’s pending rule proposal.
Abbott’s statement of opposition doesn’t directly say whether the company supports the SEC’s proposal. But it cautions against over-burdening parameters for trading plans, and that is not out of step with general corporate sentiment – through comment letters on the rule proposal, dozens of other companies & corporate advisors have indicated that aspects of the proposal would be overly burdensome and actually make insiders less likely to adopt & use Rule 10b5-1 plans. The implied consequence to that is diminished predictability & transparency, compared to what we have today.
This Rule 14a-8 proposal shows that shareholders have more than one way to push for changes to insider trading policies & practices. The voting outcome might also reinforce messaging to the SEC that investors support adopting the Rule 10b5-1 amendments substantially as proposed. On the other hand, more than half of Abbott’s shareholders did not support this proposal! And it’s unclear whether adding cumbersome conditions to the affirmative defense will deliver the enhanced transparency & protections that shareholders say they want.
We’ve been posting tons of memos about the SEC’s proposal – along with other resources – in our “Rule 10b5-1″ Practice Area. Members should also make sure to visit the transcript from our webcast about the proposal – Skadden’s Brian Breheny, Davis Polk’s Ning Chiu, WilmerHale’s Meredith Cross, Broadridge’s Keir Gumbs and Morrison & Foerster’s Dave Lynn were kind enough to share their many practical insights about what it will mean if adopted. Also check out this blog contributed by Orrick’s JT Ho, Carolyn Frantz and Soo Hwang about steps companies should consider before the SEC adopts a final rule.
