Monthly Archives: December 2021

Robinhood’s Threat to Sue SEC Over Broker Dealer Regulation Unlikely to Succeed

J.W. Verret is Associate Professor at George Mason University Antonin Scalia Law School and Managing Director of Veritas Financial Analytics LLC. This post is based on his recent paper.

This paper considers a rulemaking effort underway at the Securities and Exchange Commission to regulate the conflicts of interest that result when brokers send client orders to venues that pay the broker a fee in exchange for routing to them. These payments for order flow or rebates present a distortive conflict to a broker’s duty of best execution that has troubled the SEC for over 40 years and which the SEC has tried to regulate through multiple reforms. Courts have described the broker’s duties to their client as having a fiduciary character, which has long led some to question whether PFOF and exchange rebates violate that duty. The SEC’s new Chair has indicated he will more forcefully address broker conflicts. He has even suggested that an outright ban on PFOF and exchange rebates is “on the table”. Robinhood, a popular trading app that makes most of its equity trading revenue via payment for order flow, has threatened to challenge the rule in court.

Analysis of this rule, and of the likely outcome in subsequent court challenge, shows that Robinhood is likely to lose. The four top broker recipients of payment for order flow obtained $2.5 billion in PFOF in 2020, thus they have much at stake in this reform. The three dominant stock exchange families (particularly NYSE and NASDAQ) also have a stake in this rule, given that it is likely to prohibit similar broker inducements paid by stock exchanges. Supporters of the current system argue that zero commissions, popular among retail investors, are at risk if PFOF and exchange rebates are banned. While that may be true for some business models, this article notes that it is not true for business models like Fidelity that manage to provide zero commissions without accepting PFOF. This pending rule may well be the most substantial of Chair Gensler’s term and stands to bring more significant reform to the national market system than anything since the 1975 amendments to the Exchange Act that established the national market system. Yet this analysis is of interest not merely to brokers accepting PFOF and to the wholesale brokers and stock exchanges that pay them. This challenge also offers a deeper appreciation of the administrative law environment of SEC rulemaking in the market structure context.


SEC Resets the Shareholder Proposal Process

Sanford Lewis is Director of the Shareholder Rights Group. Related research from the Program on Corporate Governance includes The Case for Increasing Shareholder Power and Letting Shareholders Set the Rules, both by Lucian Bebchuk.

On November 3, 2021, the Securities and Exchange Commission (“SEC”) Division of Corporation Finance issued Staff Legal Bulletin 14L (“SLB 14L”). From the perspective of proponents, the bulletin resets the shareholder proposal process to: (a) align with the Commission’s original principles and structure of SEC Rule 14a-8 (the “Rule”), (b) reduce subjectivity arising from determinations made by the Staff of the Division of Corporation Finance (the “Staff”), and (c) bring the process into line with the growing importance to the capital markets of environmental, social & governance (“ESG”) issues.

The need for SLB 14L is clear. A series of Staff interpretations and now-rescinded bulletins had rewritten the ordinary business exclusion to add concepts inconsistent with other exclusions. The interpretations added complexity, cost, and subjectivity to the no-action process. Moreover, by disregarding previous Commission positions and the explicit language in other exclusions in the Rule, the Staff added a high degree of unpredictability to the process.

The adopted rules of the full Commission cannot be overturned by the Staff’s intervening guidance. The new bulletin SLB 14L has appropriately revoked nonconforming administrative guidance and realigned Staff interpretation with that of the Commission [1] and the language of Rule 14a-8. The result is an approach more consistent with investor concerns, current governance practices, societal norms, and systemic risks.


SEC Risk Factor Disclosure Rules

Dean Kingsley is Principal and Matt Solomon is Manager in Enterprise Risk Management at Deloitte & Touche LLP; and Kristen Jaconi is Associate Professor of the Practice in Accounting and Director of the Risk Management Program at the University of Southern California Leventhal School of Accounting. This post is based on their Deloitte + USC Leventhal School of Accounting Risk Management Program report. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).

The level of risk and uncertainty faced by the world, its citizens, and its companies over the past two years is unprecedented in the modern era and shows no sign of abating. From multiple waves of the worst global pandemic in 100 years to large scale supply chain and labor market disruptions, social unrest and agitation for change, a quickly worsening climate crisis, crippling cyber attacks, extreme political instability, and investor activism, companies have been challenged as rarely before to predict, prepare, and respond to risk events.

It is in this unique risk management environment that the Securities and Exchange Commission (SEC) has asked registrants to reconsider their approach to risk factor disclosures in their SEC filings, to enable appropriate and thoughtful analysis by the investment community and other stakeholders. In order to understand the impact of these changes, Deloitte and the Risk Management Program at the University of Southern California’s Leventhal School of Accounting are conducting a series of analyses on the risk factor disclosures filed by the Standard & Poor’s (S&P) 500 companies.

We published our initial results in March 2021, Many companies struggle to adopt spirit of amended SEC risk disclosure rules, reviewing 88 companies that had filed their annual reports by early February 2021. Now considering the risk factor disclosures of 439 S&P 500 companies that filed their annual reports between November 9, 2020 and May 15, 2021, [1] this post identifies key trends, including an analysis of disclosures across different industries and a deep dive into two specific risk domains currently being highly scrutinized by regulators, investors, and society—climate change and human capital. And we have provided recommendations for companies to consider in the 2021 reporting season to further improve the quality of their risk factor disclosures, such as an opportunity to leverage existing enterprise risk management (ERM) and emerging environmental, social, and governance (ESG) reporting practices for their risk factor disclosure process.


High-End Bargaining Problems

William W. Clayton is Associate Professor of Law at Brigham Young University Law School. This post is based on his recent paper, forthcoming in the Vanderbilt Law Review.

Traditional law and economics theory places great confidence in the ability of contracting parties to bargain for optimal contracts, and the legal rules governing business transactions reflect this confidence in many ways. In my new paper, High-End Bargaining Problems, which is forthcoming in the Vanderbilt Law Review, I question the wisdom of a formalistic faith in bargaining by identifying flaws in the bargaining process at the high end of the market, where parties have significant resources and expertise to aid them. My paper focuses on the private equity fund industry, which is widely regarded as one of the most elite contracting spaces in the market due to rigorous investor qualification laws and other distinctive features that support careful bargaining. There are few settings, if any, where contracting parties are more thoroughly vetted through legal rules to ensure sophistication. Notwithstanding these advantages, however, a close look reveals many issues. Drawing on proprietary survey data and dozens of conversations with industry participants, my paper provides a detailed analysis of bargaining problems in private equity funds.

My analysis starts with a discussion of the controversial history behind private equity fund contracting. For decades, private equity funds avoided regulatory scrutiny and operated almost entirely under the SEC’s radar. But in 2010, Congress gave the SEC authority to examine private equity fund managers across the industry for the first time. The SEC’s findings, announced in 2014, were shocking to most industry observers. Among other issues, the SEC indicated that violations of law or material weaknesses in controls relating to the payment of fees and expenses were found in over 50% of the managers that they examined, with private equity managers regularly charging hidden fees that were not adequately disclosed to investors and shifting expenses to investors without proper disclosure that those costs were being shifted. Scholarly estimates suggest that these hidden fees and expenses were quite material. The SEC emphasized various deficiencies in private equity contracts that made this misconduct possible, and ever since these initial reports, they have maintained a dedicated “Private Funds Unit” to focus exclusively on examining private funds. In effect, the Private Funds Unit has served as a full-time police presence in the industry for nearly a decade, and it has maintained a robust presence (the unit examines hundreds of private equity fund managers each year) through the Obama, Trump, and now Biden administrations.


SEC’s Transition in Enforcement Priorities

Mary Jo White, Andrew Ceresney, and Jon Tuttle are partners at Debevoise & Plimpton LLP. This post is based on a Debevoise memorandum by Ms. White, Mr. Ceresney, Mr. Tuttle, Julie Riewe, and Rob Kaplan.

On November 18, 2021, the U.S. Securities and Exchange Commission’s (the “SEC” or “Commission”) Division of Enforcement (the “Division”) announced its enforcement results for fiscal year 2021 (“FY 2021”). [1] The first partial year of the Democratic administration came with an uptick in enforcement, with the SEC bringing 434 new enforcement actions—a 7% increase from fiscal year 2020 (“FY 2020”). According to Chair Gensler, the results demonstrated the SEC’s pursuit of misconduct “wherever we find it in the financial system, holding individual companies accountable, without fear or favor, across the $100-plus trillion capital markets we oversee.” The Director of the Division of Enforcement, Gurbir Grewal, described FY 2021 as a year with “a number of critically important and first-of-their-kind enforcement actions.”

The actions that the SEC chose to highlight in its press release provide a roadmap to understanding the priorities of Chair Gensler and the likely future focus of the Commission’s enforcement efforts. In line with an emphasis expressed in published rulemaking priorities and a number of recent public statements, the Division put front and center its actions against entities in the digital asset space and Special Purpose Acquisition Companies (“SPACs”).

Although touted by the Division for exceeding last year’s metrics, the results are still relatively low by recent historical standards, reflecting the fact that many of these actions were the product of the previous administration; the lull that often results from transitions in administrations when acting heads are in place; and the ongoing challenges stemming from the COVID-19 pandemic.


COP26 and the Role of Private Capital

Jennie Morawetz, Paul Barker, and James Dolphin are partners at Kirkland & Ellis LLP. This post is based on their Kirkland memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

On November 13, 2021, the 26th Conference of the Parties to the United Nations Framework Convention on Climate Change—“COP26”—concluded in Glasgow. COP26 sought to progress the goals of the Paris Agreement, which was adopted at COP21 in 2015, to limit global warming to well below 2ºC—and preferably to 1.5ºC—above pre-industrial levels. Since the Paris Agreement was signed, the Intergovernmental Panel on Climate Change (“IPCC”) has determined that limiting warming to 1.5ºC will require ‘net zero’ greenhouse gas emissions by 2050. The Paris Agreement has also mobilized the financial sector, manifested by initiatives such as the Task Force on Climate-related Financial Disclosures (“TCFD”). [1] In short, COP26 was held amid unprecedented public and private sector focus on achieving net zero and mitigating and adapting to the physical and transition risks of climate change.

Here, we briefly outline certain key outcomes of COP26 and their possible implications for the role of private capital in efforts to mitigate and adapt to climate change.

COP26 Outcomes

Government Policy—COP26 culminated with 197 countries agreeing to the Glasgow Climate Pact (“GCP”). Though high-level and nonbinding, the GCP calls for action on mitigation, adaptation and finance, including accelerating the energy transition, implementing carbon emissions trading rules pursuant to Article 6 of the Paris Agreement and adaptation funding. But experts say the net zero rhetoric still does not match reality; according to the International Energy Agency, governments’ emissions commitments at COP26 remain likely to lead to warming exceeding 1.5ºC. The GCP provides that governments will “revisit and strengthen the 2030 [emissions] targets” by the end of 2022. Separately, governments pledged to limit deforestation, shipping emissions and methane emissions, [2] and the U.S. and China issued a joint declaration on climate cooperation.


Bardy Diagnostics v. Hill-Rom: New Lessons on Material Adverse Effect Clauses

Robert T. Miller is Professor of Law and F. Arnold Daum Fellow in Corporate Law at the University of Iowa College of Law. This post is based on his recent paper, forthcoming in the Brooklyn Journal of Corporate, Financial and Commercial Law, and is part of the Delaware law series; links to other posts in the series are available here.

Back in July, in Bardy Diagnostics, Inc. v. Hill-Rom, Inc., 2021 WL 2886188 (Del. Ch. July 9, 2021), the Delaware Court of Chancery (Vice Chancellor Slights) once again had to apply a “Material Adverse Effect” (“MAE”) clause to determine whether an acquirer was required to close an acquisition. As has almost always happened in the past, the court concluded that there had been no Material Adverse Effect within the meaning of the agreement between the parties. As a result, the court granted the request of the target, Bardy Diagnostics, Inc. (“Bardy”), to specifically enforce the agreement and ordered the acquirer, Hill-Rom, Inc. (“Hillrom”), to close the transaction. After initially saying it might appeal to the Delaware Supreme Court, Hillrom subsequently completed the merger.

In a paper recently posed on SSRN, I identify and discuss some important ways that the opinion in Bardy develops the law of MAEs. Most important, in my view, is that Bardy significantly affects how exceptions in MAE definitions will be applied. The reason relates to the basic structure of MAE definitions. That is, such definitions typically define the capitalized term “Material Adverse Effect” to refer to an event, fact, circumstance, etc. (for short, an “event”) that has, or would reasonably be expected to have, an (uncapitalized) material adverse effect on the target. Such definitions thus refer to two separate realities that are related as cause to effect. Now, by their plain terms, exceptions in MAE definitions apply to events, not effects, but, as I have argued in a recent article in the Journal of Corporation Law that, in applying exceptions in MAE definitions, the Court of Chancery has in dicta sometimes confused the events having material adverse effects on the company and the material adverse effects themselves, making the exceptions apply to an effect rather than the event causing it. Citing another article in which I had made the same point, the Bardy court expressly acknowledges the distinction between events and effects in the context of exceptions in MAE defintions and then consistently applies the distinction throughout the opinion. This suggests that the Court of Chancery will observe the distinction in future cases. As I argued in the Journal of Corporation Law article, this will significantly affect how exceptions in MAE definitions are interpreted and applied.


SEC Issues SAB No. 120 Regarding “Spring-Loaded” Awards

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian Bebchuk and Jesse M. Fried.

[On Nov. 29, 2021], the staff of the SEC’s Office of the Chief Accountant and Corp Fin released Staff Accounting Bulletin No. 120, which provides guidance about proper recognition and disclosure of compensation cost for “spring-loaded” awards made to executives. According to the SEC press release, “[s]pring-loaded awards are share-based compensation arrangements where a company grants stock options or other awards shortly before it announces market-moving information such as an earnings release with better-than-expected results or the disclosure of a significant transaction.” When these grants are not routine, according to the staff, they “merit particular scrutiny.” Notably, the staff advises that, in measuring compensation actually paid to executives, companies “must consider the impact that the material nonpublic information will have upon release. In other words, companies should not grant spring-loaded awards under any mistaken belief that they do not have to reflect any of the additional value conveyed to the recipients from the anticipated announcement of material information when recognizing compensation cost for the awards.”

More specifically, the staff adds new guidance (and rescinds other guidance) to help companies estimate the fair value of share-based payment transactions under Topic 718 with respect to the determination of the current price of the underlying shares and the estimation of the expected price volatility when the company grants awards that are “spring-loaded.” When companies grant awards while in possession of positive MNPI, the staff believes that companies estimating fair value should consider making adjustments to the current price of the underlying share or the expected volatility of the price of the underlying share for the expected term of the award.


Corporate Implications from COP26

Lee Anne Hagel is a Director and Kilian Moote is a Managing Director at Georgeson and Harry Etra is Founder and Chief Executive Officer of HXE Partners LLC. This post is based on a Georgeson/HXE memorandum by Ms. Hagel, Mr. Moote, Mr. Etra, Hannah Orowitz, Emily Wei and Alejandro Delmar. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

The 26th meeting of the UN Conference of the Parties (COP26) led to several newsworthy developments, with companies, countries, and coalitions announcing various initiatives and pledges throughout the thirteen-day meeting. We found the two below especially significant:

  1. The announcement of interim targets from the Net Zero Asset Managers Initiative (NZAM), and
  2. The formation of the International Sustainability Standards Board (ISSB), and the subsequent consolidation of the Value Reporting Foundation (VRF) and the Climate Disclosure Standards Board (CDSB).

In this post, we highlight the potential impacts these developments might have on the broader corporate landscape. Generally speaking, we expect consolidation of standard-setters and heightened focus from asset managers will raise the bar for companies both as it relates to data disclosure and target setting.

NZAM Disclosed Initial Targets

The Net Zero Asset Managers initiative is composed of 220 signatories, representing over $57 trillion in asset under management (AUM) globally, who have committed to supporting the goal of net zero greenhouse gas emissions by 2050 or sooner. As part of this initiative, asset managers must disclose:

  1. The initial percentage of their assets under management that will be managed in line with net zero, and
  2. The “fair-share” interim targets for the AUM that will be managed in line with net zero and target date.

NZAM’s 2021 Progress Report, issued during COP26, disclosed interim targets for 43 signatories. The report details the first disclosures for NZAM, as signatories are required to disclose interim targets within twelve months of signing onto the initiative. The targets commit approximately $4.3 trillion in AUM out of a total $11.9 trillion AUM across the 43 signatories to be managed in line with net zero. This translates to approximately 35% of AUM already being managed in-line with net zero across the 43 signatories.


The Lasting, Positive Impact of Sarbanes-Oxley

Michael W. Peregrine is a partner at McDermott Will & Emery LLP. This post is based on his McDermott Will & Emery memorandum.

Next year will mark the 20th anniversary of the passage of the Sarbanes-Oxley Act, federal legislation that has had an enormous—and mostly positive—impact on the integrity and reliability of companies, their financial statements, leadership and advisors. It sparked the corporate responsibility movement, which continues to impact corporate and leadership ethics and compliance with law. It remains one of the most consequential governance developments in history and serves as an important lesson for corporate officers, directors and their professional advisors.

The act was developed in response to the sweeping instability of commerce and the financial markets following the collapse of several major U.S. corporations in 2000 and 2001 because of financial reporting irregularities, fraud and other contributing factors.
For example, when Enron—once the country’s largest energy trading firm—filed for Chapter 11 protection in December 2001, it became the largest bankruptcy in U.S. history at that time. It was soon surpassed in such ignominy by the July 2002 bankruptcy of the telecommunications firm WorldCom. Several other large corporations met similar fates.

Sarbanes-Oxley was developed in response to the loss of consumer confidence in the capital markets and corporate financial statements arising from these scandals. Congressional hearings identified a series of causes that contributed to the harm, including lax oversight of auditors, the absence of auditor independence, insufficient corporate governance practices, conflicts of interest of stock analysts, limited disclosure obligations and “grossly inadequate” funding of the SEC and its enforcement capabilities.


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