SEC Office of Investor Advocate Reviews FY 2018 Activities

The SEC Office of the Investor Advocate (“OIA”) identified “problematic products or practices” and summarized steps the agency and self-regulatory organizations took to respond to investor concerns during the past year.

In a “Report on Activities,” the OIA Investor Advocate identified “potentially problematic products or practices during Fiscal Year 2018” as reported by the SEC, NASAA, FINRA and the MSRB. These include, among others: (i) initial coin offerings, cryptocurrency and blockchain; (ii) a variety of scams and schemes (related to, e.g., regulator impersonations, Ponzi schemes, natural disasters and investments in “unicorns,” binary options, oil and gas, marijuana, microcap stocks and real estate, among others); (iii) cybersecurity; (iv) investment fees and expenses; (v) suitability of wrap fee programs; (vi) registrations of third-party providers, marketers and gatekeepers; (vii) a variety of risks (e.g., trading on margin, data aggregation, disclosure, and use of credit cards); and (vii) other practices (e.g., pennying and prearranged trading in connection with primary offerings).

In the report, the OIE focused on five key policy areas: public company disclosure, equity market structure, municipal market reform, accounting and auditing, and fiduciary duty.

On some of the broader policy questions, the OIA:

  • approved of the SEC’s current approach to ICOs, including its emphasis on the responsibilities of gatekeepers and others under securities laws;
  • encouraged FINRA to publicize the “data sets, models, and rankings” it uses to evaluate broker risk to help retail investors;
  • urged the SEC to prioritize reforming “outdated transfer agent regulations”; and
  • supported the continuing publication of investor education materials regarding the use of margin debt, although the OIA did not recommend any immediate regulatory changes.

Investor Advocate Rick A. Fleming recounted specific steps the OIA took to address investor concerns. The OIA:

  • requested additional research on the impact of proposed amendments to modernize public company reporting requirements;
  • collaborated with SEC staff and several SROs to “encourage equity market structure reforms designed to enhance market resilience, efficiency, transparency, and fairness”;
  • reviewed rulemaking proposals to reform the regulation of the fixed income markets and municipal securities markets;
  • supported the SEC’s proposed amendments concerning enhanced municipal securities disclosure under Exchange Act Rule 15c2-12;
  • provided feedback in response to MSRB’s draft amendments to rules on primary offering practices;
  • continued monitoring accounting and auditing standard setters:
  • urged the FASB to return to its earlier proposal for harmonizing its definition of materiality with “the courts, the SEC, and the PCAOB” due to investor concerns;
  • encouraged the SEC’s attention to problems regarding non-GAAP financial measures;
  • monitored developments with respect to auditor attention requirements;
  • sought internal and external feedback on accounting and auditing issues;
  • assisted the SEC in researching how proposed Regulation Best Interest would affect investors; and
  • submitted a comment supporting FINRA’s proposal to amend Rule 2111.

Mr. Fleming also stated that budgetary constraints affected some 2018 initiatives, including the agency’s failure to “build out” the Ombudsman role and certain research functions.

SEC Commissioner Peirce Criticizes “Mixed Messages” on Cryptocurrency

SEC Commissioner Hester M. Peirce expressed concern over the United States’ conflicting regulatory approach to cryptocurrency, stating that U.S. regulators are sending “mixed messages” to entrepreneurs. She encouraged the SEC to be less conservative in the approval process for crypto-exchange-traded products.

In a speech before blockchain entrepreneurs in Switzerland, Ms. Peirce stated that the U.S. regulatory environment likely is not giving crypto entrepreneurs a “welcoming impression.” According to Ms. Peirce, the U.S.’s “diffused financial regulatory system” leaves entrepreneurs unclear about which laws apply to their projects. Additionally, Ms. Peirce noted that regulators are not uniform in their approach to cryptocurrencies. For example, while the CFTC has approved crypto-derivatives markets, the SEC has not approved the application of any exchange-traded products based on cryptocurrencies or crypto-derivatives, she said.

In criticizing U.S. regulators’ “mixed messages,” Ms. Peirce also addressed the SEC’s recent hesitancy in approving crypto-exchange-traded products. Ms. Peirce encouraged the SEC to empower investors to make decisions about whether or not to invest in these products. Ms. Peirce urged the SEC to be more transparent, and to better explain the agency’s decision-making process for exchange-traded crypto-products.

Lofchie Comment: No doubt the SEC believes that crypto-investments are very risky and that they are saving investors, particularly retail investors, from making bad investments. If SEC Commissioners believe that the public offering of crypto-securities constitutes an “emergency” that justifies “aggressive” regulatory action, then, at a minimum, while the SEC stalls exchange-traded crypto products, it should seek legislation endorsing such authority. Presumably, if the authority were granted, it would be subject to limits and to procedural conditions, including the transparency sought by Commissioner Pierce. In the absence of such a Congressional grant of authority, the SEC should not seek to exceed its legislated powers. It is worth noting that the advantage of allowing public trading of crypto-securities is that it would facilitate short sellers coming in, which should serve to dampen prices (assuming that the short sellers agree with the SEC’s skepticism on valuations).

Senate Banking Committee Considers State of Cryptocurrency and Blockchain

The U.S. Senate Committee on Banking, Housing and Community Affairs held a hearing on the state of cryptocurrency and blockchain. The two invited witnesses were Coin Center Director of Research Peter Van Valkenburgh and NYU Professor of Economics Nouriel Roubini.

Mr. Van Valkenburgh lauded the benefits of decentralized computing (i.e., blockchain) but criticized the surrounding “hype.” According to Mr. Van Valkenburgh, the terminology used to describe blockchain is often “vague and undefined,” leading to an overall lack of public understanding. In particular, he criticized the public perception that blockchain is the “solution to any number of social, economic, organizational, or cybersecurity problems.” However, Mr. Van Valkenburgh advocated for the continued exploration of decentralized computing, and advised regulators to take a “light-touch approach” in order to allow the technology to develop “unfettered.”

Conversely, Dr. Roubini criticized cryptocurrencies as the “mother of all bubbles,” and called the underlying blockchain technology the “most over-hyped – and least useful – technology in human history . . . nothing more than a glorified spreadsheet or database.”

In a statement given at the hearing, Senator Sherrod Brown (D-OH) expressed concern about the potential for fraudulent activity in cryptocurrencies and said that the malign effects of blockchain on our society are currently more prominent than the benefits. Senator Mike Crapo (R-ID) said that the “regulatory and oversight questions still remain,” but added that he wanted to better understand the opportunities and challenges regarding blockchain in order to regulate more effectively.

 

SEC Commissioner Urges Regulators Not to Impose Their Investment Judgment on Investors

SEC Commissioner Hester Peirce asserted that commissioners should not substitute their judgment for decisions made by investors, particularly with regard to (i) the decision to invest in a company that requires its shareholders to arbitrate any shareholder claims against the company (rather than go to litigation) and (ii) investments in bitcoin or other digital assets.

In remarks at the University of Michigan Law School, Ms. Peirce stated that (i) the SEC is no better than an investor at evaluating the investor’s best interest. She pointed to the SEC’s decision not to approve the public offering of the Winklevoss Bitcoin Trust. Ms. Peirce said that regulators should have allowed investors to decide whether a new investment is worthwhile.

Likewise, she said that the SEC should reject calls for it to become a “more activist regulator” and should not attempt to stretch SEC authority to limit mandatory arbitration between a public company and its shareholders. In this regard, Ms. Peirce questioned whether prior actions of the SEC, in discouraging corporations that were going public from requiring shareholders to arbitrate disputes, were actually within the scope of the SEC’s authority. Ms. Peirce observed that the SEC is required by the Federal Arbitration Act to “respect private contracts that favor arbitration.”

Lofchie Comment: Commissioner Peirce has become the voice of “liberalism” (in the very, very old-fashioned sense of the word): belief in limited government, government respecting the rights and abilities of individuals to make decisions, and government agencies not stretching the bounds of their authority to accomplish what officials decide is “good policy.” Note Commissioner Peirce’s views (and wit) in Motherhood and Humble Pie: Remarks before the Cato Institute’s FinTech Unbound Conference (summarized here). At a time when so many call for the government to expand its authority over private persons, Commissioner Peirce’s defense of the individual (including the individual’s right to screw up) is welcome.

SEC Director of Investment Management Outlines Policy Initiatives

In testimony before the U.S. House Committee on Financial Services, SEC Division of Investment Management (the “Division”) Director Dalia Blass outlined the following underlying aims of the Division: (i) improve the retail investor experience; (ii) modernize the regulatory framework and engagement; and (iii) utilize resources efficiently. The Division is working on the following rule proposals or potential rulemaking areas:

  • propose Regulation Best Interest;
  • modernize fund disclosure both by reviewing the content of disclosures and by allowing funds to provide shareholder reports online;
  • improve disclosure as to variable annuities;
  • finalize a rule for the issuance of exchange-traded funds (“ETFs”), so that the SEC exemptive process can more efficiently process exemptive relief requests for ETFs not within the scope of the rule;
  • reduce obstacles to publishing research on investment funds in compliance with the Fair Access to Investment Research Act of 2017;
  • harmonize and improve registration and reporting requirements for business development companies and closed-end registered investment companies (“RICs”);
  • regulate the use of derivatives by RICs;
  • publish guidance regarding valuation procedures;
  • update investment adviser marketing rules;
  • improve investment company liquidity disclosures;
  • support fund innovation as to cryptocurrency-related holdings; and
  • review the proxy process.

Lofchie Comment: While the SEC talks the talk as to facilitating innovation, walking the walk is far more difficult. ETFs, for example, have become a significant product in the financial markets, and yet the SEC is only now considering a rule to routinize their issuance. As to cryptocurrency funds, one really has to question whether the SEC wants them to go forward, or is hoping that interest in the product is a bubble that will pop before the SEC is pushed to act. Compare SEC Rejects Another Nine Proposed Bitcoin ETFs with SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking.

Federal District Court Confirms that Cryptocurrencies are “Commodities” under CFTC Jurisdiction

The U.S. District Court for the District of Massachusetts ruled that cryptocurrencies fall within the definition of a “commodity” under the Commodity Exchange Act.

In a Motion to Dismiss, defendants argued that an allegedly fraudulent cryptocurrency, My Big Coin, is not a “commodity” since it does not deal in “contracts for future delivery” and thus is not within the CFTC’s jurisdiction over commodities. The plaintiff responded that there is future trading in cryptocurrencies and, as a result, My Big Coin falls under CFTC jurisdiction.

The Court denied the Motion to Dismiss and held that Congress defines a commodity by focusing on categories (e.g., cryptocurrency), not specific items (e.g., My Big Coin).

SEC Staff Comment on Suspension of Trading of Virtual Currency Tracking Certificates

The SEC Division of Trading and Markets and Division of Corporation Finance (the “Divisions”) commented on the SEC’s September 9th Order temporarily suspending trading of certain bitcoin and ether tracking certificates. The Divisions asserted that the lack of accurate and consistent information pertaining to Bitcoin Tracker One and Ether Tracker One (together, the “certificates”) led to confusion amongst market participants. The Divisions cautioned market participants that seek to quote, trade, or facilitate transactions in the certificates to examine the legal and regulatory implications of doing so. The SEC staff is currently working with the CFTC staff in connection with the regulatory considerations relevant to the certificates under the Commodity Exchange Act.

SEC Commissioner Peirce Calls on SEC to Embrace Innovation and Allow Cryptocurrency Risk-Taking

SEC Commissioner Hester M. Peirce urged the SEC to embrace FinTech innovation and permit more risk-taking by investors in cryptocurrencies.

In remarks before the Cato Institute’s FinTech Unbound Conference, Ms. Peirce elaborated on her dissent from the SEC’s rejection of an exchange-traded product (“ETP”) that was designed to give investors exposure to bitcoin. Ms. Peirce explained her disagreement with the SEC’s decision to deny an exchange’s bid to list shares of the Winklevoss Bitcoin Trust (see previous coverage), asserting that “it seemed to turn on the Commission’s assessment of bitcoin rather than on the exchange’s plans for trading the [ETP].” She went on to state:

“The focus on the lack of regulation of cryptocurrencies particularly troubled me. What authority do we have to require that assets underlying securities be regulated as if they were securities? Even if we had this authority, private markets can and do regulate themselves.”

Ms. Peirce urged the SEC to:

  • avoid the temptation to replace the market’s product testing with the agency’s own and allow investors to determine the value of these innovations for themselves;
  • create a space for innovation to occur in SEC-regulated markets or accept that investors will seek out innovations in less regulated markets;
  • establish an environment in which investors can openly communicate with the SEC and its staff; and
  • reaffirm the agency’s commitment to expanding investor access, including through innovative technologies.

Lofchie Comment: Ms. Peirce’s speech is witty and thoughtful.

SEC Chair Summarizes Recent Efforts to Promote Capital Formation

In a speech at the Nashville 36|86 Entrepreneurship Festival, SEC Chair Jay Clayton outlined recent agency efforts to encourage capital formation for public companies and companies that are considering going public.

Mr. Clayton highlighted three specific categories of SEC actions: (i) a scaled disclosure framework for smaller companies (including adjusting the thresholds for companies deemed to be “smaller reporting companies” and eligible to provide more limited “scaled disclosures”), (ii) disclosure modernization and simplification (i.e., revising GAAP and S-K disclosure requirements to minimize duplication) and (iii) staff guidance to facilitate the initial public offering (“IPO”) process.

Mr. Clayton suggested that the SEC undertake a review of the current framework for exempt offerings. In particular, he stated that the SEC should:

  • examine the “complexity” of the current exemption framework for issuers and investors, and decide on changes to streamline it;
  • consider whether rules regarding who can invest in certain offerings should be expanded to focus on criteria such as the sophistication of the investor and the specific amount of the investment; and
  • permit issuers to transition more readily from one exemption to another, or to a public offering.

Mr. Clayton also discussed the SEC’s approach to distributed ledger technology, digital assets and initial coin offerings. He asserted that efforts in those particular areas reflect the two abiding principles of the SEC: (i) embrace new technologies that reduce costs while also offering new investment opportunities and (ii) require that retail investors have access to necessary information to make sound investment decisions.

SEC Rejects Another Nine Proposed Bitcoin ETFs

The SEC Division of Trading and Markets rejected applications for nine exchange-traded funds (“ETFs”) tied to bitcoin futures markets from three separate companies – ProShares, Direxion, and GraniteShares – on the grounds that they lacked adequate means of preventing “fraudulent and manipulative acts and practices.” In each case, the rejections were subsequently stayed pending review by the SEC Commissioners.

The SEC affirmed its position that bitcoin futures markets necessitate stringent market manipulation and fraud prevention procedures since they are reliant upon a single exchange to determine the value of the bitcoin ETF. According to the SEC, the companies stated in their applications that they would use the Chicago Board Options Exchange (“CBOE”) and Chicago Mercantile Exchange (“CME”) futures market to establish the value of their ETFs. However, the SEC determined that the CBOE and CME bitcoin futures markets are not “markets of significant size.” Furthermore, the SEC did not agree that the companies’ existing surveillance procedures and capacity to share surveillance information with U.S. futures exchanges were sufficient to prevent market manipulation and fraud.