SEC Commissioner Hester Peirce criticized the agency for limiting investors’ access to new types of investment products. The Commissioner described very slow progress in formalizing and standardizing the treatment of relief for exchange-traded funds (“ETFs”).

In remarks at the ETFs Global Markets Roundtable, Ms. Peirce highlighted the benefits of ETFs in general, saying that they (i) provide investors with a range of investment options, (ii) are easy to enter and exit with low transaction fees and (iii) offer lower operating expenses relative to those of comparable mutual funds. Ms. Peirce observed that the SEC exercises caution with respect to approving new types of ETFs. She noted that the SEC just authorized its first non-fully transparent actively managed ETF after eight years of thinking about it.

Ms. Peirce urged the SEC to move forward with more speed on other requests for exemptive relief for projects. She criticized SEC “indecision” in the treatment of leveraged and inverse ETFs. Ms. Peirce said that after issuing several orders granting two sponsors permissions to operate as leveraged and inverse ETFs, the agency got “cold feet” and has not issued any other permissions. Ms. Peirce added that the agency’s reluctance to permit more competitors to offer geared ETFs is another instance of its curtailing access to an investment product that would be helpful to some investors.

In addition, Ms. Peirce proposed that the Division of Investment Management explore the marketplace’s interest in acquiring exposure to bitcoin and other cryptocurrencies through a registered investment company. She noted that although there is interest from investors and sponsors, the SEC has not yet granted an exemptive application for an ETF or approved a rule permitting the operation of crypto ETFs or other exchange-traded products. She emphasized that she did not believe such ETFs were necessarily a good investment, but added that it ought to be for the market and not the regulators to decide.

LOFCHIE COMMENTARY

Commissioner Peirce highlights fundamental questions that financial regulators must confront. Where should the line be drawn between protecting investors (effectively prohibiting them from buying a variety of risky products) and allowing investors to make their own decisions? This is not a binary decision; it is a line-drawing exercise.

Regulators tend to move toward protection rather than toward allowing investors to make their own decisions based on mandated disclosures. There is a fair amount of empirical evidence to suggest that such protectionism may be a good way to go, at least in the overall and aggregate scheme of things. This is, perhaps, even more true as holders of wealth age and become less capable of making sound decisions.

Yet depriving individuals of economic freedom has aspects that are worrisome. By way of managed ETFs, for example, the government may be depriving investors of choices that might be good for them. Should regulators discourage investors from taking such risk? Should riskier investments not be funded? Is society better or worse off?

Bigger picture, if adults cannot be trusted to make economic decisions, even on the basis of full disclosure, on what basis should they be trusted to make other decisions? By what logic are people who cannot be allowed to make reasonable economic decisions to be trusted to elect political decision makers? Where the line should be drawn is debatable, but permitting failure has to be an option.

In its Semiannual Risk Perspective for Spring 2019, the OCC described the condition of banks as “strong” as far as capital, leverage and short-term performance. The regulators highlighted a number of significant big-picture risks, particularly as to AML compliance and operations and FinTech:

AML. AML-related deficiencies “stem from three primary causes: inadequate customer due diligence and enhanced due diligence, insufficient customer risk identification, and ineffective processes related to suspicious activity monitoring and reporting, including the timeliness and accuracy of Suspicious Activity Report filings. Talent acquisition and staff retention to manage [] compliance programs and associated operations present ongoing challenges, particularly at smaller regional and community banks.”
FinTech. “Rapid developments in FinTech and ‘big tech’ firms, evolving customer preferences, and the popularity of mobile technology applications have significantly changed the way banks operate and consumers conduct their banking and financial activity. . . . [T]he pace of change and the transformative nature of technology may result in a more complex operating environment. . . . Changing business models or offering new products and services can, however, elevate strategic risk when pursued without appropriate corporate governance and risk management. New products, services, or technologies can result in greater reliance on third parties by some banks and a concentration of service providers by the industry as a whole.”

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A key takeaway from the OCC’s regulatory comments is that the regulators expect that there is likely to be a material reduction in the number of smaller banks. They are squeezed on the expense end from compliance costs and new technology costs, and squeezed on the revenue end from competition with FinTech firms and customers’ disinterest in traditional banking relationships.

In a comment letter, the SIFMA Asset Management Group (“SIFMA AMG”) expressed support for a proposal by the Financial Stability Oversight Council (“FSOC”) to change existing interpretive guidance to include adopting an “activities-based approach” to address systemic risk issues. Under the approach, FSOC would identify, evaluate and address potential risks to U.S. financial stability that arose from particular activities and would seek to adopt regulations applicable to those activities, rather than impose requirements on a single entity.

SIFMA AMG agreed that the proposed guidance would improve FSOC’s ability to identify and mitigate risks to U.S. financial stability. In order to better “enhance, clarify and refine the strong foundation” outlined in the proposed guidance, SIFMA AMG advised FSOC to:

– provide more details on how FSOC will conduct the “activities-based approach” process;
– confirm that any action by FSOC is triggered by a “reasonably foreseeable and likely set of facts and circumstances,” not simply by possible or potential situations or conditions;
– identify the level of scope and scale that indicates financial risks or threats to financial stability;
– strengthen the role of the primary financial regulator;
– explicitly state that it will solicit input from the industry;
– outline the “shortcomings” of the prior guidance and how the new approach will be better;
– clarify that the cost-benefit analysis requirement applies to recommendations for increased regulation and entity-based designations;
– state that it is responsible for the burden of proof in adopting any requirement;
reference existing rules or policies concerning “transmission channels” that relate to threats to U.S. financial stability;
– set more formalized procedures for the two-stage designation process and specify how it will treat confidential information;
separate functions of investigative and prosecutorial staffs and adjudicative bodies to ensure impartiality; and
– work with non-U.S. and international policymakers to harmonize rules and policies affecting the asset management industry.

LOFCHIE COMMENTARY

The FSOC move towards imposing restraints on a particular type of activity, rather on an individual entity, is extremely significant in preventing potential abuses of power. It will limit the ability of FSOC to single out a company that may be in the disfavor of the ruling political party. While this move is to the good, it would be better still if Congress would actually adopt legislation that would confine FSOC’s discretionary power rather than rely upon FSOC to police itself.

SEC Commissioner Hester M. Peirce criticized the SEC for failing to clarify how it applies the “Howey Test” (SEC v. W.J. Howey Co.) to digital assets used in initial coin offerings (“ICOs”).

Contrary to her prior concerns about the downside effects of overregulating the crypto industry, Ms. Peirce said that the SEC’s “unwillingness to take meaningful action” has actually “stifled” the industry.

In a speech at the Securities Enforcement Forum, Ms. Peirce analyzed the recent SEC guidance on digital assets, Ms. Peirce stating that its efforts to provide clarification have been generally unsuccessful. First, Ms. Peirce stated that the SEC staff’s Howey framework probably would only be understood by a “seasoned securities lawyer.” Specifically, while Howey has only four factors, the framework listed 38 considerations for determining whether a token offering is a securities offering.

Second, Ms. Peirce criticized the first token no-action letter, which gave the “false impression” that it was a “gray area of securities law.” As previously covered, the company TurnKey had been seeking to tokenize gift cards. The letter gave the impression that the securities law is more far-reaching than it is, according to Ms. Peirce, because the token was “clearly not an offer of securities.” Additionally, the letter highlighted non-dispositive factors and so, Ms. Peirce stated, “effectively imposed conditions on a non-security.”

Third, Ms. Peirce stated the SEC Division of Investment Management letter for advisers and funds on digital assets failed to provide meaningful guidance. Ms. Peirce conceded that the letter outlined certain questions that advisers should consider when buying and holding digital assets on behalf of their clients. However, she stated that it did not clarify how advisers can remain compliant with the Custody Rule.

Finally, Ms. Peirce warned that lack of regulatory clarification will push innovation into other jurisdictions.

LOFCHIE COMMENTARY

Commissioner Peirce continues to challenge the SEC’s lack of clarity on the application of the Howey test to ICOs. While it is true that the SEC did issue a position paper on the Howey Test and ICOs (SEC Publishes “Framework” for Determining if Digital Assets Are “Securities”), the purpose of the position paper seems largely to assert broad jurisdiction (lest the SEC be subject to the retrospective accusation of having missed something). In particular, the SEC in that position paper failed even to attempt to define the most important legal question under Howey; i.e., what constitutes a “common enterprise.”

At the same time that the SEC issued its position paper, the SEC staff issued a no-action letter holding that a particular crypto offering was not a “security.” See Subject to Strict Conditions, SEC Agrees that “Tokens” to Pay for Services Are Not “Securities”. This no-action letter did little to resolve the jurisdictional question as the tokens that were the subject of the letter very clearly fall into the class of “stable coins” that are completely linked to the value of the dollar on a one-for-one basis, and so there is no opportunity whatsoever for investment gain. In short, the SEC’s no-action letter simply addressed the most obvious possible case for admitting that it did not have jurisdiction, and failed to address any area of uncertainty.

The SEC voted to propose rule amendments intended to improve the information disclosed regarding acquisitions and dispositions of businesses. The proposal is designed to facilitate access to capital in a more timely manner and to reduce the compliance burden of financial disclosures.

The proposed changes would, among other things:

– clarify the required determination of “significance” under the rule by revising the investment test and the income test, expanding the use of pro forma financial information in measuring significance, and conforming the significance threshold and tests for a disposed business;
– require the financial statements of the acquired business to cover up to the two most recent fiscal years rather than up to the three most recent fiscal years;
allow disclosure of financial statements that omit “certain expenses for certain acquisitions of a component of an entity”;
– provide guidance on when financial statements and pro forma financial information are required;
– authorize the use of, or reconciliation to, International Financial Reporting Standards;
– remove the separate acquired business financial statements requirement for businesses that have been included in the registrant’s post-acquisition financial statements for a complete fiscal year; and
– improve the content of the pro forma financial information requirements to reflect “reasonably estimable synergies and transaction effects.”

Specifically, the proposal would: (i) amend Rule 3-14 to align with Rule 3-05 where no unique industry considerations exist; ​(ii) clarify elements of Rule 3-14, including the “determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements”; (iii) codify smaller reporting company requirements in Article 8 of Regulation S-X; (iv) adopt a new Rule 6-11 and amend Form N-14 to include financial reporting for fund acquisitions by investment companies and business development companies; and (v) amend the definition of “significant subsidiary” for investment companies.

SEC Commissioner Robert J. Jackson Jr. voted to request public comment on the proposal, but urged commentators to propose improvements to the rules that would empower investors to hold executives more accountable for merger and acquisition disclosure. Commissioner Jackson cited “longstanding evidence” that corporate insiders use mergers to promote private interest over that of long-term investors. According to Mr. Jackson, the proposed rule amendments ignore this evidence and could lead to less disclosure about acquisitions by companies whose market value is significantly different from their book value. Additionally, Commissioner Jackson expressed concern that the economic analysis in the release ignores “the other half of [the] well-known equation: that acquiring companies’ stocks tend to take a hit upon the announcement of a merger.”

Comments must be submitted within 60 days of publication in the Federal Register.

LOFCHIE VIEW:

Judging by his statement, Commissioner Jackson appears to distrust corporate managers (i) when they keep profits within a company and use it to acquire another company and also (ii) when they disburse profits by buying back stock. See, e.g., SEC Commissioner Calls for Revision of Stock Buyback Rules. In general, a company that has more money than it can reasonably use for internal expansion must either use the money to buy something else or return it to shareholders. Here, Commissioner Jackson argues that “many mergers are not in investors’ long-term interests.” If the Commissioner is convinced of that, then there is inconsistency in his resistance to allowing issuers to give money back to their shareholders through stock buybacks. Even if a company can’t be too thin, it can be too (cash) rich.