SEC Proposes Improvements to Merger Disclosures

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.

SEC Agrees that “Tokens” to Pay for Services Are Not “Securities”

Commentary / Steven Lofchie

On the one hand, it is certainly a positive that the SEC is announcing an intellectual framework for determining whether a “digital asset” (perhaps better known as an “Initial Coin Offering” or “ICO”) is within the definition of the term “security.” On the other hand, the framework definitely casts a very broad net, which no doubt was intended.

As to the question of whether digital assets involve a “common enterprise,” the SEC simply says that “[b]ased on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchases have been linked to each other or the success of the promoter’s efforts” (at fn. 11). There is not much analysis there. One could, for example, argue that a digital newspaper subscription constitutes a digital asset because the value of the subscription is likely dependent upon the publisher’s ability to generate other subscriptions and thereby to turn out a good digital newspaper.

On the question of whether cryptocurrencies are securities, the framework says that, to fall outside of the definition, the digital asset must “actually operate as a store of value that can be saved, retried, and exchanged for something of value at a later time.” As to digital assets generally, “any economic benefit that may derived from appreciation [must be] incidental to obtaining the right to use [the asset] for its intended functionality.”

It is fairly well accepted that certain of the major cryptocurrencies are not securities. That said, it is not at all clear that any newly issued cryptocurrency would be able to meet the SEC’s conditions so as not to be a security.

Although the SEC has cast a very wide net with this analysis, it also published a no-action letter providing at least one example as to when a digital asset would not be a security. See SEC Staff Advises Turnkey Jet Tokens Are Not Securities.


The SEC provided a “framework for analysis” to help market participants evaluate whether the federal securities laws apply to the offer, sale or resale of a specific digital asset.

The framework is based on the “Howey” case, which found that a security exists where there is “[(i)] an investment of money [(ii)] in a common enterprise [(iii)] with a reasonable exception of profits [(iv)] to be derived from the efforts of others.” As to the first two elements, the SEC states that, generally, persons pay in some way for the digital asset and “in evaluating digital assets, [the SEC] has found that a ‘common enterprise’ typically exists.”

The report focuses on the third element, whether the purchaser of the asset may reasonably expect to profit from the purchase of the assets, (i.e., by having the expectation – or at least the hope – of selling the asset to someone else at a higher price); and the fourth element, whether the purchasers of the asset depend on the efforts of others (finding that they generally do, because a third party is creating and maintaining the technology).

Former CFTC Chair Urges Congress to Strengthen Regulation for Crypto-Assets

Commentary / STEVEN LOFCHIE
While the Brookings report runs some 60 pages, plus 4 pages of footnotes, it may be summarized as follows: There is stuff that could go wrong in some way with the production, trading or ownership of crypto-assets; therefore, crypto-assets ought to be regulated in some unspecified way, which would make the bad stuff less likely to happen. (The other 59 7/8th pages, plus 4 pages of footnotes, amplify on this theme.)

To be chary of Mr. Massad’s report is not to dispute that some bad things will happen as to investments in crypto-assets. It is a safe guess that a good number of retail investors will lose money. Beyond saying that “something” should be done, Mr. Massad might have offered us something more, perhaps by starting with an explanation as to why what currently exists is insufficient and how new rules will solve the problem.

As a starting matter, Mr. Massad should better define and distinguish what he means by “crypto-assets.” Presumably, he is referring to initial coin offerings (“ICOs”). (Note, he quotes SEC Chair Clayton to the effect that all ICOs are “securities” (see fn. 54 and surrounding text)). Therefore, he should explain the deficiencies in securities regulation as applied to ICOs. Unless Mr. Massad believe that there should be one scheme of regulation for securities held through DTC and another for securities in crypto-form, all he is saying is that there should be more enforcement of the securities laws as applied to ICOs. That is reasonable; but it is not clear why any more laws or rules are required. It appears that he just wants more cops on the beat.

If by crypto-assets Mr. Massad means cryptocurrencies, he should say so, and explain how cryptocurrencies should be regulated. If he wants them prohibited, he should say that. Rather, he argues that Bitcoin mining is so “highly energy intensive” is so bad, that – by comparison – he would “long for a return of Lehman Brothers” (at 11). That statement certainly suggests that he favors prohibition. If that is the case, then recommending the imposition of a recordkeeping regulation is somewhat beside the point.

Finally, if by crypto-assets Mr. Massad means assets that give a person a “right to use . . . some sort of blockchain based application or service” (at page 29), he owes us an explanation as to what type of regulation he imagines the SEC or CFTC imposing and to what purpose, and what will be the anticipated effect on blockchain businesses.

Mr. Massad’s suggestion that the Financial Stability Oversight Council (“FSOC”) direct the production of a report for the regulation of crypto-assets, albeit in some unknown way and to an undefined end, demonstrates a potential for abuse by FSOC of its all-too-ambiguous powers. FSOC was supposed to be focused on “gaps in regulation that could pose risks to the financial stability of the United States.” There is zero evidence that crypto does that. The purpose of FSOC is not supposed to be to evade the “formal notice and comment process used for rule making.” FSOC has neither expertise with respect to crypto-assets nor any focus on most of the potential problems raised by Mr. Massad; e.g., energy usage by Bitcoin miners or suitability issues. That Mr. Massad thinks FSOC should be used as a device for rushing through regulations without “formal notice and comment process” is probably a better argument for eliminating FSOC (what exactly has it accomplished to date?) than it is for regulating crypto.

Ten years of experience with Dodd-Frank, much of which is still not implemented because it was neither practical nor useful, should offer some lessons. Throwing out a laundry list of issues, and then demanding regulation with no consideration of specifics, is unlikely to get you where you want to go. It may even take you in the wrong direction. “Too-big-to-fail” was, by way of example, supposedly a cause of the financial crisis. Yet following on Dodd-Frank, increases in regulation and resulting cost have likely only increased concentration.

To advance the discussion of the regulation of crypto-assets, Mr Massad has to define: (i) what are the assets or transactions that he wants to regulate; (ii) does he favor a single scheme of regulation that would cover all cryptocurrencies, ICOs, and assets that create a right of use; (iii) what is the specific problem he is trying to solve (is it energy usage or suitability or just the absence of governmental control); (iv) what are the requirements (whether imposed by statute or rule) for which he advocates; and (v) what does he predict is the likely effect of imposing those requirements (meaning why would it solve the problem, and at what cost)? He should address whether he is trying to regulate or trying to prohibit. It’s fair to demand such specificity of a former senior regulator.

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In a Brookings Institute working paper, former CFTC Chair Timothy Massad urged Congress to bolster regulation of crypto-assets.

Mr. Massad pointed out that new crypto exchanges and trading platforms are not held to the same standards required of securities and derivatives market intermediaries, resulting in weak investor protection. In part, this has allowed crypto-assets to be used to circumvent sanctions, and to facilitate payment for illegal activities.

Mr. Massad argued against deferring to state law with respect to regulating crypto-assets. He recommended that Congress:

pass legislation giving the SEC or the CFTC “authority to regulate the offering, distribution and trading of crypto-assets”;

provide more resources to the SEC and the CFTC to regulate crypto-assets;

adopt legislation around “core principles,” which address, among other things: (i) protection of customer assets, (ii) governance standards, (iii) conflicts of interest, (iv) recordkeeping and reporting, (v) trade execution and settlement, (vi) pre- and post-trade transparency obligations, (vii) anti-fraud prohibitions, (viii) disclosures to customers regarding fees, order types and execution practices, (ix) risk management, business continuity and cybersecurity, (x) capital, and (xi) AML and KYC requirements;

direct the relevant agencies to establish regulations to implement the core principles;

grant the relevant agencies authority to determine whether non-U.S. platforms that provide access to U.S. investors should be required to meet U.S. standards, comply with comparable standards or disclose that they do not meet U.S. standards; and

direct the relevant agencies to decide whether there should be alternative ways for centralized and decentralized platforms to comply with the core principles.

Mr. Massad called on the Financial Stability Oversight Council or the U.S. Treasury Department to provide a report recommending Congress to enhance regulation in the crypto-assets sector. He also encouraged the industry to continue developing its own self-regulatory standards.

Senate Committee on Banking Considers Bills on Capital Formation and Corporate Governance

The U.S. Senate Committee on Banking, Housing and Urban Affairs (the “Senate Banking Committee”) considered legislative proposals on capital formation and corporate governance.

Chair Senator Mike Crapo (R-IA) stated that the Banking Committee has held three hearings in 2018 on legislative proposals – (i) the Helping Angels Lead Our Startups Act, (ii) the Fair Investment Opportunities for Professional Experts Act and (iii) the JOBS and Investors Confidence Act of 2018 – with respect to capital formation, corporate governance and the proxy process. Mr. Crapo said the purpose of the hearing is to address these bills again “in the context of identifying areas where we can find bipartisan consensus in the new Congress.” Mr. Crapo described the importance of unified legislative action, and added that it is “time to re-examine the standards of inclusion” for proposals that pursue environmental, social or political agendas.

In a separate statement, Senator Sherrod Brown (D-OH) touched on the importance of putting workers before Wall Street when considering these bills. He criticized the notion that it was a necessity for bills that facilitate capital formation, stating that time is better spent making sure that workers at companies such as Uber are receiving the wages and benefits they have earned, rather than “letting companies cut corners on their accounting controls.” Mr. Brown emphasized the importance of protecting ordinary American investors, noting that support for American companies should put employees first.

Lofchie Comment: It is disappointing that Senator Brown thinks it productive to attack the supposed “shortsighted obsession” of Wall Street. If he believes that the private sector is particularly cursed by an inability to think into the future, he should suggest a cure, rather than merely rehearse a cliché. Or is he suggesting that everything would be better if only elected officials made decisions as to capital allocation? That seems unlikely on its face, but if he believes it to be so, he should try to make the case for it. To what government – federal, state, or city – would he point as a model of long range investment planning?

New York Fed Officer Urges Firms to Prepare for LIBOR Transition

Executive Vice President and General Counsel of the Federal Reserve Bank of New York (“New York Fed”) Michael Held urged firms to prepare for the transition from LIBOR to an alternate interest rate. He cautioned that the transition from LIBOR has been identified by the Financial Stability Oversight Council as a financial stability risk. Mr. Held stated that “[t]he gross notional value of all financial products tied to U.S. dollar LIBOR is approximately $200 trillion – about 10 times U.S. GDP.” He further reported that approximately 95 percent of LIBOR exposure is in derivatives contracts.

In remarks at the SIFMA Compliance and Legal Society luncheon, Mr. Held stated that market participants with LIBOR exposure must undertake two tasks: (i) begin using the Secured Overnight Financing Rate (“SOFR”) or another robust alternative to LIBOR (or make sure that new contracts have workable fallback language) and (ii) deal with the “trillions of dollars of existing contracts that extend past 2021” which don’t currently have a sufficient fallback. According to Mr. Held, understanding the scope of an institution’s exposure to LIBOR-based products, and the contractual impact on those products when LIBOR is no longer available, is an important risk management assessment that should be completed as soon as possible.

UK and U.S. Swaps Regulators Agree to Maintain Existing Arrangements Post-Brexit

In a Joint Statement, the Bank of England (“BoE”), the Financial Conduct Authority (“FCA”) and the CFTC said that the United Kingdom’s withdrawal from the European Union would not serve to disrupt existing agreements as to the regulation, or exemptions from regulation, of firms engaged in the trading or clearing of derivatives.

The parties said that:

  • by the end of March 2019, the BoE, FCA and CFTC will put in place “information-sharing and cooperative arrangements to support the effective cross-border oversight of derivatives markets and participants and to promote market orderliness, confidence and financial stability”;
  • post-Brexit, U.S. trading venues, firms and central counterparties may continue to operate in the United Kingdom on the same basis that they do today; and
  • post-Brexit, the CFTC intends to issue new no-action letters and orders to permit UK firms to continue to operate in the United States on the same basis that they do today.

The notes to the document provide a “non-exhaustive list” of existing cooperation documents among the BoE, FCA and CFTC that will require amendment or reaffirmation post-Brexit.

 

SEC Proposes Greater Flexibility on Communications with Institutional Investors

The SEC proposed a new rule and related amendments that would allow issuers to communicate with certain potential investors to determine whether such investors might be interested in a “contemplated registered securities offering.” Under the proposed rule, such communications would be exempt from restrictions imposed by Securities Act Section 5.

The proposal is intended to give more flexibility to issuers regarding their communications with institutional investors. According to the SEC, the proposal would expand the “test-the-waters” accommodation to all issuers, including investment company issuers. The accommodation is currently only available to emerging growth companies. Under the proposal:

  • there would be no filing or legending obligations;
  • “test-the-water” communications must not be at odds with material information in the related registration statement; and
  • issuers that are subject to Regulation FD would be obligated to consider whether any information in a “test-the-water” communication would lead to disclosure obligations under Regulation FD.

Comments must be received by the SEC no later than 60 days after the date of publication of the proposal in the Federal Register.

CFTC Commissioners Urge Bank Regulators to Change to Leverage Ratio Treatment of Cleared Derivatives

Four Commissioners of the CFTC urged U.S. banking regulators to amend the calculation of the supplementary leverage ratio in order to recognize client-posted initial margin in cleared derivatives. The Commissioners’ comments came in response to a rule proposal by the banking regulators to update the calculation of derivative contract exposure amounts under the regulatory capital rules, previously covered here.

In a comment letter, CFTC Commissioners Dan Berkovitz, Rostin Behnam and Brian Quintenz said that the banking regulators (the Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency) neglected to acknowledge the “risk-reducing impact” of client initial margin that the clearing member banking organization holds on behalf of clients. The Commissioners contended that a supplementary leverage ratio (“SLR”) calculation that permits initial margin to offset potential future exposures would eliminate an unnecessary impediment to banks offering client clearing services.

According to the Commissioners, the adoption of the standardized approach for counterparty credit risk (SA-CCR) without offset will:

  • “maintain or increase the clearing members’ SLRs by more than 30 basis points on average”;
  • continue to “disincentivize clearing members” from supplying clearing services; and
  • limit access to clearing in “contravention of G20 mandates and Dodd-Frank.”

Commissioner Dawn Stump recused herself from providing commentary on the proposed rule.

OFAC Imposes Additional Venezuelan Sanctions

The U.S. Treasury (“Treasury”) Department Office of Foreign Assets Control (“OFAC”) designated five officials affiliated with “illegitimate former” Venezuelan President Nicolas Maduro, pursuant to Executive Order 13692. According to OFAC, these five individuals “continue to repress democracy and democratic actors in Venezuela and engage in significant corruption and fraud against the people of Venezuela.” The individuals include Manuel Salvador Quevedo Fernandez, the “illegitimate President” of Venezuela’s state-owned oil company, Petróleos de Venezuela, S.A.

Treasury stated that it may continue to sanction officials “who have helped the illegitimate Maduro regime repress the Venezuelan people.” As a result of OFAC’s action, all property and interests in property of the designated individuals subject to U.S. jurisdiction are now blocked, and U.S. persons generally are prohibited from engaging in any dealings with them.

OCC Proposes Amending Company-Run Stress Testing Requirements

The Office of the Comptroller of the Currency (“OCC”) proposed amending the OCC’s company-run stress testing requirements for national banks and federal savings associations. The proposal is consistent with section 401 of the Economic Growth, Regulatory Relief and Consumer Protection Act. Comments on the proposal must be submitted by March 14, 2019.

The proposal would, among other things:

  • increase the minimum threshold for national banks and federal savings associations to conduct stress tests from $10 billion to $250 billion;
  • reduce the frequency with which certain banks would be obligated to conduct stress tests; and
  • cut the number of required stress testing scenarios from three to two.