Yearly Archives: 2021

Securities Enforcement Quarterly

Posted by Charles J. Clark, Craig S. Warkol and Alex Wharton, Schulte Roth & Zabel LLP, on
Wednesday, November 24, 2021
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Charles J. Clark and Craig S. Warkol are partners and Alex Wharton is an associate at Schulte Roth & Zabel LLP. This post is based on their SRZ memorandum.

Introduction

While the third quarter of 2021 marked the end of the fiscal year for the U.S. Securities and Exchange Commission (“SEC” or “Commission”), it also seems to be the start of an aggressive enforcement agenda led by its new Chairman and Director of Enforcement. In this post, we discuss the latest enforcement actions and statements from regulators related to digital assets, the SEC’s innovative “shadow trading” insider trading case, and fraud claims brought against an alternative data vendor notwithstanding that it was not engaged in securities transactions. This post also describes recent enforcement actions against investment advisers and broker-dealers for deficient cybersecurity procedures aimed at protecting customer information. We conclude by summarizing enforcement cases of particular interest to this audience, many of which illustrate the enforcement themes highlighted in previous editions of SRZ’s Securities Enforcement Quarterly.

More from the SEC on Cryptocurrencies and Digital Assets

SEC Chair Gary Gensler continues to signal that the SEC will take an aggressive approach toward digital asset issuers, exchanges, and lending platforms. The SEC Chair recently characterized the cryptocurrency market as the “Wild West” and indicated his belief that it requires more federal oversight. [1] Speaking on a panel at the Aspen Security Forum in August 2021, Gensler said the crypto market, which is currently valued at over $1.5 trillion, lacked necessary and common investor protections that the SEC is tasked with providing, allowing the market to become “rife with fraud, scams and abuse.” [2] At a September 2021 appearance before the Senate Banking Committee, Gensler commented that Coinbase, the nation’s largest cryptocurrency exchange, has yet to register with the SEC “even though they have dozens of tokens that may be securities,” [3] and later stated that “hundreds or thousands” of tokens that are traded on such exchange platforms are likely securities, [4] which would require the platforms to register with the SEC or apply for an exemption.

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The Sustainability Board Report 2021

Posted by Frederik Otto, Nicolas Alexander, and Tias van Moorsel, The Sustainability Board Report, on
Tuesday, November 23, 2021
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Frederik Otto is Founder and Business Advisor, Nicolas Alexander is Policy Advisor, and Tias van Moorsel is Sustainability Advisor at the Sustainability Board Report. This post is based on The Sustainability Board Report 2021. 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 Sustainability Board Report 2021 At a Glance

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The Economics of Deferral and Clawback Requirements

Posted by Florian Hoffmann (KU Leuven), Roman Inderst (Goethe University Frankfurt), and Marcus Opp (Stockholm School of Economics), on
Tuesday, November 23, 2021
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Florian Hoffmann is Associate Professor of Finance at KU Leuven; Roman Inderst is Chair of Finance and Economics at Goethe University Frankfurt, and Marcus Opp is Associate Professor of Finance at the Stockholm School of Economics. This post is based on their recent paper, forthcoming in the Journal of Finance. Related research from the Program on Corporate Governance includes Rationalizing the Dodd-Frank Clawback by Jesse Fried (discussed on the Forum here).

The 2007-08 financial crisis put compensation practices in the financial sector on the agenda of financial regulation. On a supra-national level, the Financial Stability Board (FSB) adopted its Principles for Sound Compensation Practices in 2009 “to reduce incentives towards excessive risk taking that may arise from the structure of compensation schemes.” In particular, short-term oriented bonus schemes have been identified as a key factor contributing to excessive risk-taking by financial institutions. This triggered regulatory initiatives around the world to intervene in the timing of bankers’ incentive compensation. For example, in the United Kingdom bankers’ variable pay compensation is now subject to minimum deferral periods of 3 to 7 years, and can be clawed back upon severe underperformance for 7 to 10 years. These regulatory restrictions do not only apply to top-level executives, but a broad set of banks’ “material risk-takers:” E.g., for Barclays alone, the compensation packages of 1746 employees are currently affected by this regulation (see Barclays 2020 Pillar 3 report).

Our study analyzes the positive and normative effects of such regulatory interventions in the timing dimension of bankers’ compensation packages. The punchline of our theoretical analysis is that even if bankers’ laissez-faire compensation contracts are socially suboptimal, such policy interventions do not robustly help mitigate risks in the financial sector, and, potentially, even backfire. At a very high level, the fallacy of targeting compensation packages is that “wrong” compensation contracts are merely a symptom of distortions in the financial sector, but not their root. That is, whichever distortion has led bank shareholders to write contracts incentivizing their key risk takers to take excessively risky actions in the first place, it is still present if they face regulatory constraints on compensation design. Capital regulation instead directly targets the root of the key distortion towards excessive risk tolerance in the financial sector, excessive leverage fueled by bailout expectations. Accordingly, our study suggests a “pecking order” of regulatory tools, in which compensation regulation should be considered only if capital regulation is restricted.

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2021 Annual Corporate Directors Survey

Posted by Maria Moats, Paul DeNicola, and Leah Malone, PricewaterhouseCoopers LLP, on
Tuesday, November 23, 2021
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Maria Castañón Moats is Leader, Paul DeNicola is Principal, and Leah Malone is Director at the Governance Insights Center, PricewaterhouseCoopers LLP. This post is based on their PwC memorandum.

The corporate world is never static, but the first years of this decade have presented an unusual compilation of challenges. The COVID-19 pandemic has posed a nearly unprecedented public health emergency, with lasting global implications. The stock markets have reached record highs, interest rates have fallen to record lows, and unemployment figures skyrocketed before labor markets tightened. The country weathered a divisive presidential election. At the same time, social justice concerns have taken hold. In 2020, protests for racial justice swept the country, leaving a sustained focus on how to address current inequities and past wrongs.

Against this backdrop, business now beats NGOs, governments, and the media as people’s most trusted institution, according to the Edelman Trust Barometer. Customers and consumers are looking to companies to get involved in social issues in a new way, making statements and creating policies on public concerns that wouldn’t have been top of mind before. This includes social justice issues, as well as companies’ role in dampening the acceleration and effects of climate change.

These changes have had broad impacts on companies, from their employee base to the executive suite—and up to the boardroom. Boards are historically slow to change, in part because they are relied upon as a stabilizing force for corporations. But as the world is changing, directors are driven to change their playbook as well.

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The World Targets Change

Posted by Karen Wong, State Street Global Advisors, on
Monday, November 22, 2021
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Karen Wong is Global Head of ESG at State Street Global Advisors. This post is based on her SSgA 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).

About this Study

In 2021, ESG investing has grown to $35+ trillion—over a third of the world’s professionally managed assets.

ESG is now well and truly mainstream across the globe. Soon ESG investing will be investing, or at the very least a fundamental component of all investing.

Our latest research uncovers the views of more than 300 institutional investors, revealing an industry poised for a surge in decarbonization target-setting over the next three years. Currently 20% of the most sophisticated have already set formal targets and momentum is clearly building for those yet to do so.

Where in the past risk mitigation and performance were the clear key drivers for investors, this time around investors told us that their climate strategies are equally about creating real change and driving the economic transition. Does this signal the start of a seismic shift to performance being measured not solely in terms of returns but also in terms of environmental and social impact?

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Stock Investors’ Returns are Exaggerated

Posted by Jesse M. Fried (Harvard Law School), Paul Ma (University of Minnesota), and Charles C.Y. Wang (Harvard Business School), on
Monday, November 22, 2021
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Jesse M. Fried is Dane Professor of Law at Harvard Law School; Paul Ma is Assistant Professor of Accounting at the University of Minnesota Carlson School of Management; and Charles C.Y. Wang is the Glenn and Mary Jane Creamer Associate Professor of Business Administration at Harvard Business School. This post is based on their recent paper.

Long-run buy-and-hold stock market returns with dividend reinvestment (“total shareholder returns” or “TSR”) are significantly higher than risk-free returns, leading to an annual equity risk premium of about 6%. Stocks are thus pitched as a key component of wealth accumulation strategies and have become an important savings vehicle for American families. The high equity premium has also led policymakers to consider investing Social Security funds in the stock market.

In a paper recently posted on SSRN, Stock Investors’ Returns are Exaggerated, we explain that the stock market generates much less wealth for investors as a group than it appears. While individual investors who hold stock and reinvest dividends (“TSR investors”) earn the equity premium, investors as a group cannot. The main reason: TSR requires dividend reinvestment in shares previously held by other investors, which is by construction impossible for all investors to achieve. As a group, investors cannot plow dividends back into public firms, and must invest them in lower-yielding assets. Thus, every TSR investor who earns the equity premium necessarily involves another investor not earning that premium. The same holds for cash distributed via net repurchases (stock buybacks less issuances), which now exceed dividends. In addition, TSR is boosted by well-timed repurchases and equity issuances that merely transfer value from trading to continuing stockholders. The returns for stock investors collectively therefore must be lower than that implied by TSR, as public firms distribute considerable amounts of cash and engage in market-timed equity transactions with their own shareholders.

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Regulated Funds

Posted by John J. Mahon and Shaina L. Maldonado, Schulte Roth & Zabel LLP, on
Monday, November 22, 2021
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John J. Mahon is partner and Shaina L. Maldonado is an associate at Schulte Roth & Zabel LLP. This post is based on their SRZ memorandum.

On Sept. 29, 2021, the Securities and Exchange Commission proposed Rule 14Ad‑1 and amendments to Form N-PX (collectively, “Proposal”) under the Investment Company Act of 1940, as amended (“1940 Act”), that, if adopted, would require more comprehensive information from mutual funds, exchange-traded funds and certain other investment companies registered under the 1940 Act that currently file reports on Form N-PX annually regarding their proxy votes, and would make that information provided easier to analyze. In addition, the Proposal would require all fund managers that are 13F filers [1] to disclose their proxy votes on executive compensation matters, otherwise called “say-on-pay” votes, annually on Form N-PX, regardless of whether or not they manage a registered investment company. The Proposal is intended to implement Section 951 of Dodd-Frank, which relates to managers’ reporting requirements. [2]

Below are some of the key proposals related to the amended Form N-PX that would be applicable to registered investment companies and their managers if the Proposal is adopted.

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How GPs Can Compete for Capital Through ESG

Posted by Addison Holmes, Pickering Energy Partners, on
Sunday, November 21, 2021
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Addison Holmes is an Associate in ESG Strategy & Integration at Pickering Energy Partners. This post is based on her Pickering Energy Partners memorandum. 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).

Executive Summary

  • The Pickering Energy Partners ESG Consulting team ran an analysis of the 100 private equity firms most active in Energy deals over the last 5 years. [1]
  • In analyzing those 100 firms and scoring them on their ESG disclosure, we saw that the competitive bell-curve based on disclosure completeness displays a positive skew. This indicates most firms are just beginning their ESG journey and there exists a great opportunity to establish a competitive advantage.
    • 33% had no ESG integration at all
    • 12% were in the “Crawl” phase, with either an ESG website or general ESG statement
    • 20% were in the “Walk” stage, developing ESG policies that outline a firm’s approach to ESG evaluation and integration into the investment process
    • 35% were in the “Run” stage, with a strong reporting infrastructure in place to monitor ESG-related KPIs among portfolio companies, aggregate this data, and report to stakeholders at a regular cadence
  • Of the 100 firms analyzed, 45 were PRI signatories.
    • However, only 28 had an ESG report. This implies many firms are not compliant with the current PRI requirements.
    • Only 16 are actively considering TCFD, indicating that many GPs do not understand the requirements of being a PRI signatory will likely be non-compliant in the future.
  • Firms that participate in more energy deals and which have higher committed capital tend to also have higher ESG reporting quality because they have more LPs that are requesting this data. That said, high quality reporting opens larger pools of capital and supports fundraising efforts.
    • Of those firms with the highest ESG reporting quality, 80% are PRI signatories and 80% consider TCFD, and 70% consider GRI.
  • High quality ESG reporting comes in the form of regular reports (including an annual ESG report), qualitative commentary supported by quantitative data, and disclosing data points that are common across frameworks, material to the businesses of portfolio companies, and influential for LPs.
    • Low quality ESG reporting, on the other hand, comes at the risk of lost deals and increasing LP frustration.
  • In conclusion, we recommend that GPs control the narrative by:
    • Formally incorporating ESG-related considerations within the broader strategic considerations and directives of the firm
    • Identifying material ESG data points relevant to the economic reality of portfolio companies and monitor these data points on a consistent basis to identify risks and opportunities in the portfolio
    • Establishing and conveying an ESG narrative that highlights a distinct set of value drivers and is supplemented by data

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2022 Glass Lewis Policy Guidelines: United States

Posted by Eric Shostal, Glass, Lewis & Co., on
Sunday, November 21, 2021
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Eric Shostal is Senior Vice President of Research and Engagement at Glass, Lewis & Co. This post is based on a Glass Lewis memorandum by Mr. Shostal, Kern McPherson, Courteney Keatinge, and Brianna Castro.

Summary of Changes for 2022

Glass Lewis evaluates these guidelines on an ongoing basis and formally updates them on an annual basis. This year we’ve made noteworthy revisions in the following areas, which are summarized below but discussed in greater detail in the relevant section of this document:

Board Gender Diversity

We have expanded our policy on board gender diversity. Beginning in 2022, we will generally recommend voting against the chair of the nominating committee of a board with fewer than two gender diverse directors, or the entire nominating committee of a board with no gender diverse directors, at companies within the Russell 3000 index. For companies outside of the Russell 3000 index, and all boards with six or fewer total directors, our existing policy requiring a minimum of one gender diverse director will remain in place.

Our voting recommendations in 2022 will be based on the above requirements for the number of gender diverse board members. However, beginning with shareholder meetings held after January 1, 2023, we will transition from a fixed numerical approach to a percentage-based approach and will generally recommend voting against the nominating committee chair of a board that is not at least 30 percent gender diverse at companies within the Russell 3000 index.

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ESG Global Study 2021

Posted by Jessica Ground, Capital Group, on
Saturday, November 20, 2021
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Jessica Ground is Global Head of ESG at the Capital Group. This post is based on her Capital Group memorandum. 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).

Global investors strongly prefer an active approach to ESG. Threequarters use active funds to integrate environmental, social and governance (ESG) issues — more than double the proportion using passive funds and trackers. Rather than investing in funds that merely screen out unethical sectors, investors want managers to identify and manage ESG risks and opportunities through bottom-up security selection and fundamental analysis.

Further underlining the preference for active management, nearly half of investors point to exercising voting rights and having regular meetings with senior executives at companies as key engagement tools. Investors appear to be looking for a holistic approach to ESG that encompasses all stages of the investment process.

The importance attached to qualitative analysis reflects a need for better ESG data and information. Investors point to a lack of robust data as a top barrier to greater ESG adoption. Issues with the quality and consistency of data pose particular problems throughout the investment journey. Investors say the uncertainty around the reliability of ESG scores is the greatest hurdle when incorporating ESG data, ratings and research. And one-fifth of respondents identify lack of consistency among different rating provider scores as the top implementation challenge.

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