Monthly Archives: April 2022

SEC 2022 Examination Priorities

Ranah Esmaili is partner, Victoria Anglin is managing associate, and Marie Fang is an associate at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. Esmaili, Ms. Anglin, Ms. Fang, Chuck Daly, Laurin Blumenthal Kleiman, and Elizabeth Shea Fries.

On March 30, 2022, the U.S. Securities and Exchange Commission (SEC) Division of Enforcement (EXAMS or Division) issued its annual examination priorities. [1] Consistent with its recent rulemaking activity, in its accompanying release, the SEC highlighted private funds; Environmental, Social and Governance (ESG) investing; retail; cyber; and digital assets as key examination priorities. This post provides a concise summary of upcoming examination priorities and perennial issues registrants can anticipate in the following year’s examinations.

Fiscal Year 2021 Highlights

The SEC highlighted some key metrics from the prior fiscal year. In FY 2021, the Division completed 3,040 examinations, which represent a 3% increase from the prior year, and is on par with prepandemic fiscal year 2019. The Division examined approximately 16% of registered investment advisers (RIAs). Approximately 70% (specifically, 2,100) of all examinations resulted in deficiency letters, and approximately 6% (specifically 190) resulted in referrals to the Division of Enforcement for investigation.

Importance of Compliance Programs

The Division highlighted the importance of registrants’ improving and promoting compliance at the firms, including compliance engagement across business lines; knowledgeable chief compliance officers; commitment to compliance by firms’ principals; and resiliency of compliance programs to withstand changes in market conditions, investor demand, key personnel, services, and lines of business.


How Would Directors Make Business Decisions Under a Stakeholder Model?

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 Business Lawyer.

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); For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); 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); Stakeholder Capitalism in the Time of COVID, by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Corporate Purpose and Corporate Competition (discussed on the Forum here) by Mark J. Roe.

In a new paper forthcoming in The Business Lawyer, I ask, “How Would Directors Make Business Decisions Under a Stakeholder Model?”

I here understand the stakeholder model in the strong form first articulated by Dodd and more recently endorsed by Blair and Stout in which boards may choose to confer a benefit on a corporate constituency other than the shareholders without regard to whether their decision benefits the shareholders, even in the long run. This strong form of stakeholder theory thus differs from most ESG advocacy, which typically claims that pursuing ESG goals maximizes value for shareholders. It also differs from weak forms of stakeholder theory, which merely seek to remind directors that managing the business in the manner of an unreformed Ebenezer Scrooge is unlikely to maximize value for shareholders in the long run.

The paper makes several points about the strong form of the stakeholder model. First, contrary to what advocates of stakeholder theory often say and even more often imply, stakeholder theory does not put all corporate constituencies on a par, letting directors give equal consideration to the interests of all constituencies. Rather, stakeholder theory uniquely disadvantages shareholders. The reason is that the claims of other corporate constituencies, such as customers, employees, creditors, or suppliers, are founded in contract (or sometimes based on a statute). These legal claims against the corporation thus become floors under what a constituency receives from the corporation. There is no analogous minimum that shareholders must receive. Hence, under the stakeholder model, a non-shareholder constituency always receives at least what it is owed in contract (or under a statute), plus, perhaps, more, and whatever more a non-shareholder constituency may receive comes, not at the expense of some other non-shareholder constituency (each of which also receives at least its contractual or statutory minimum), but at the expense of the shareholders.


AI Oversight Is Becoming a Board Issue

Avi Gesser and Bill Regner are partners and Anna R. Gressel is an associate at Debevoise & Plimpton LLP. This post is based on a Debevoise & Plimpton memorandum by Mr. Gresser, Mr. Regner, Ms. Gressel, and Lily Coad.

As more businesses adopt artificial intelligence (AI), directors on many corporate boards are starting to consider their oversight obligations. Part of this interest is related to directors’ increasing focus on Environmental, Social and Governance (ESG) issues. There is a growing recognition that, for all its promise, AI can present serious risks to society, including invasion of privacy, carbon emissions and perpetuation of discrimination. But there is also a more traditional basis for the recent interest of corporate directors in AI: as algorithmic decision-making becomes part of many core business functions, it creates the kind of enterprise risks to which boards need to pay attention.

The promise of AI is evident from recent corporate spending. According to Stanford University’s 2022 AI Index Report, private investment in AI in 2021 totaled approximately $93.5 billion—more than double the previous year. But balanced against this promise are significant business risks. For example, the real estate company Zillow made headlines in 2021 when it decided to shut down its “Zillow Offers” business, and lay off 25% of its workforce, due in part to failures of its house-buying algorithm to accurately price homes. In addition, public scrutiny over facial recognition, credit algorithms, hiring tools, and other AI systems is creating substantial regulatory and reputational risk for companies, especially with respect to bias.

Where AI Overlaps with ESG

Both AI and ESG encompass a wide breadth of corporate issues, with considerable overlap, including:


Litigation Risks Posed by “Greenwashing” Claims for ESG Funds

Amy Roy and Robert Skinner are partners, William T. Davison is counsel, and Brooke Cohen and Rachel Scholz-Bright are associates at Ropes & Gray LLP. This post is based on their Ropes & Gray memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian Bebchuk and Roberto Tallarita (discusseded on the Forum here); and 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; and Exit vs. Voice by Eleonora Broccardo, Oliver Hart, and Luigi Zingales (discusseded on the Forum here).


The massive flow of assets into ESG-focused funds reflects the intense and growing demand for investment products that enable investors to put their values into action while pursuing strong financial returns in their portfolios. The dramatic growth of the ESG funds sector has predictably attracted the attention of regulators, commentators and the private plaintiffs’ bar. The SEC’s Division of Enforcement last year formed a Climate and ESG Task Force to, among other things, “analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies” and ESG related issues have moved to the forefront of exams conducted of registered investment advisers. States have similarly demonstrated an increased focus on ESG regulations: a dozen state attorneys general, including those of California and New York, sent a letter to the SEC last year that called for increased ESG-related disclosures for climate-related financial risks by “all SEC-regulated firms.” Notably, foreign regulators have been ahead of their U.S. counterparts in focusing on ESG disclosures; in particular, the Sustainable Finance Disclosure Regulation (SFDR) in the European Union will require disclosure of ESG considerations by all funds. The head of the SEC’s Climate and ESG Task Force has emphasized that its review of ESG fund disclosures and marketing materials will be guided by “long-standing principles of materiality and disclosure” in assessing potential violations of the securities laws or advisers’ fiduciary duties.

The growing ESG fund sector has also been the subject of recent public criticism from various quarters, particularly claims of greenwashing leveled against climate-focused funds, from media outlets including Time, USA Today, The Economist, Reclaim Finance, and Responsible Investor. According to the sponsors of a number of published studies, like As You Sow, InfluenceMap, and Morningstar, many funds with a sustainable or “green” investment thesis are not living up to their names and promises, because their portfolio holdings are not sufficiently aligned with specified standards for addressing climate change. Indeed, SEC Chair Gary Gensler published a video on March 1, 2022 in which he expressed skepticism about whether many ESG-focused funds live up to their names, asserting that the investing public does not have sufficient information to evaluate ESG funds. In his video, Mr. Gensler asserts that the process for selecting an ESG fund should be as straightforward as purchasing a carton of milk labelled fat-free and suggests that he would cause the SEC to pursue new disclosure rules for ESG-focused funds.


Do Startups Benefit from Their Investors’ Reputation? Evidence from a Randomized Field Experiment

Ting Xu is Assistant Professor of Finance at the University of Virginia Darden School of Business; Shai Bernstein is the Marvin Bower Associate Professor of Business Administration at Harvard Business School; and Richard Townsend is Associate Professor of Finance at the University of California San Diego, Rady School of Management. This post is based on their recent paper. Related research from the Program on the Corporate Governance includes Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups by Brian Broughman and Jesse Fried (discuss on the Forum here); Agency Costs of Venture Capitalist Control in Startups by Jesse Fried and Mira Ganor (discuss on the Forum here); Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley by Jesse Fried and Brian Broughman (discussed on the Forum here).

It is widely believed that venture capitalists (VCs) actively add value to startups beyond providing funding. For example, VCs may provide advice, connect startups to their networks, or help startups professionalize. However, it is also possible that VCs add value passively as well, simply by attaching their names to startups. Reputable VCs may attract important resources to their portfolio companies, like talent, customers, suppliers, or strategic partners. This helps startups overcome the “cold start” problem, namely convincing stakeholders to work with a firm that has little to no track record. While the potential for such passive value adding by VCs has long been discussed, there is scant empirical evidence on whether it actually occurs or is important in practice.

In a recent working paper, we test for passive value adding by VCs using a field experiment. Specifically, we focus on the labor market and study whether reputable VCs can passively attract talented employees to their portfolio companies. We analyze a field experiment conducted by AngelList Talent, the largest online search platform for startup jobs. Startups with job openings can post them on the site, and those interested in working for a startup can search these postings and apply. Beginning in February 2020, AngelList Talent began adding “badges” to their job search results. One badge highlighted whether a job was associated with a startup that was funded by a top-tier VC. A separate badge highlighted whether a job was associated with a startup that recently closed on a round of VC funding. The visibility of each type of badge was randomly enabled at the user level. Thus, a user with the top investor (recently funded) badge feature enabled would see the badge for all startups that merited it, while a user with the feature disabled would never see it.


The SEC’s Proposed Rules for P4P Disclosures

Mike Kesner is partner, Ira T. Kay is a managing partner/founder, and John Ellerman is partner at Pay Governance LLC. This post is based on their Pay Governance memorandum. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance (discussed on the Forum here); and Pay without Performance: The Unfulfilled Promise of Executive Compensation both by Lucian Bebchuk and Jesse M. Fried.


In 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). One of the important provisions of the Dodd-Frank legislation was the requirement that companies registered with the Securities and Exchange Commission (SEC) disclose how the executive compensation actually paid (CAP) by the registrant company relates to the company’s financial performance in both tabular and narrative disclosures. This disclosure mandate is referred to in Dodd-Frank and by the SEC as “Pay versus Performance,” although we prefer to describe it as pay-for-performance (P4P), as it more accurately describes one of the primary objectives of companies’ compensation programs.

In 2015, the SEC released its initial proposal for meeting the Dodd-Frank P4P disclosure requirement. However, 6 years passed without resolution regarding the initial SEC proposal. On January 27, 2022, the SEC released a supplemental proposal adding additional financial disclosures to the P4P proposal. At that time, the SEC announced that it was reopening the initial release of 2015 for public comment as well as inviting comment to the 2022 supplemental release. The SEC extended a 30-day comment period for written comments to be submitted to both the 2015 and 2022 proposed disclosure rules.


SPACs Remain in the SEC’s Crosshairs

Derek Dostal, Pedro J. Bermeo, and Lee Hochbaum, are partners at Davis Polk & Wardwell LLP. This post is based on a Davis Polk memorandum by Mr. Dostal, Mr. Bermeo, Mr. Hochbaum, Michael Kaplan, W. Soren Kreider IV, and Richard D. Truesdell. Related research from the Program on Corporate Governance includes SPAC Law and Myths by John C. Coates (discussed on the Forum here).

SPACs remain in the SEC’s crosshairs with this comprehensive rule proposal that expands the scope of underwriter liability, amends the scope of a safe harbor for financial projections and adopts a new safe harbor under the Investment Company Act of 1940. If adopted, the proposal would represent the most expansive regulatory consequences to SPAC business combination transactions since their creation in the early 1990s, and will likely chill SPAC activity.

After an unprecedented run of initial public offerings by special purpose acquisition companies that raised nearly a quarter trillion dollars in the last two years, on March 30th the SEC proposed a sweeping set of rules in a 3-1 vote that the majority indicated would ensure “greater transparency and more robust investor protections” that “could assist investors in evaluating and making investment, voting, and redemption decisions with respect to these transactions.” In contrast, the lone dissenting Commissioner indicated that the proposal “seems designed to stop SPACs in their tracks,” noting that while there are legitimate disclosure concerns, she would have supported “sensible disclosures around SPACs and de-SPACs.” We tend to agree with the dissent that if the rules are adopted as proposed, SPAC activity will be significantly reduced. This proposal is consistent with a number of recent SEC proposals on stock and option transactions involving companies and their “insiders”climate change disclosures and cybersecurity disclosures where the SEC is effectively seeking to act as a merit regulator and prohibit certain activity, an expansion of its historical mission of investor protection through disclosure requirements.


California Court Finds California Board Diversity Law Unconstitutional

David A. Bell, Dean Kristy, and Dawn Belt are partners at Fenwick & West LLP. This post is based on a Fenwick memorandum by Mr. Bell, Mr. Kristy, Ms. Belt, Jennifer J. Hitchcock, and Ron C. Llewellyn. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite by Alma Cohen, Moshe Hazan, and David Weiss (discussed on the Forum here); Will Nasdaq’s Diversity Rules Harm Investors? by Jesse M. Fried (discussed on the Forum here); and Duty and Diversity by Chris Brummer and Leo E. Strine, Jr. (discussed on the Forum here).

On April 1, 2022, the Superior Court of California, County of Los Angeles granted the plaintiffs’ motion for summary judgment in a case challenging the legality of AB 979 under the California Constitution. AB 979 required California-headquartered companies to have a specified minimum number of ethnically and racially diverse or LGBT members on their boards of directors. The court’s decision effectively strikes down AB 979, a law that had been championed as an effective means for remedying the lack of diversity on the boards of directors of California-based companies.

AB 979

As described in our previous post, AB 979, which was signed into law on September 30, 2020, by Governor Gavin Newsom, required California-headquartered public companies to have at least one director on their boards who is from an underrepresented community, defined as “an individual who self‑identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self‑identifies as gay, lesbian, bisexual, or transgender” by the end of 2021. The required number of directors from underrepresented communities would increase by the end of 2022 to two directors for boards with more than four but fewer than nine directors and to three directors for boards with at least nine directors. Under AB 979, the California Secretary of State must report annually on companies’ compliance with the law and may impose fines of $100,000 for an initial violation and $300,000 for each subsequent violation.


Liability for Non-Disclosure in Equity Financing

Albert H. Choi is Paul G. Kauper Professor of Law at the University of Michigan and Kathryn E. Spier is Domenico De Sole Professor of Law at Harvard Law School. This post is based on their recent paper.

Under the current US securities laws, when a company raises capital by selling securities to outside investors, the company must disclose material information it possesses to the prospective investors. In case the company fails to do so, the investors can bring suit against the company to recover compensatory damages. Presumably, such a liability regime deters companies from withholding material information and ensures that the outside investors will receive necessary material information from the company so as to make an informed decision as to whether to purchase the offered security. At the same time, though, critics have argued that the private enforcement regime, especially the class action system, is too costly and encourages indiscriminate lawsuits against even innocent companies. To what extent do such a liability regime induce the company to disclose all material information to the investors? Is such a private liability regime necessary in the first place? If so, in what form? Should the investors be allowed to bring class actions or be required to bring suit on an individual basis, as some advocates have argued? What is the role of the plaintiff class action lawyers? In a recent paper, we attempt to answer some of these questions with the help of game theory.

The paper presents a model in which a firm, initially owned by an entrepreneur, sells stock to the outside investors while deciding whether to disclose certain material information the firm (and the entrepreneur) possesses to the prospective investors. The investors make rational inferences based on the firm’s decision to disclose and, in case it is revealed that the firm hid material information, the investors can bring suit against the firm to recover damages. Notably, the damage payment received by the outside investors is offset in part by the reduced value of their equity stake. When the entrepreneur must commit enough of her own resources to the venture, the entrepreneur (and the firm) will disclose material information to the outside investors even without any liability system. In case the entrepreneur does not need to expend sufficient resources, holding the firm liable is necessary to deter the firm (and the entrepreneur) from withholding bad news. The equilibrium probability of non-disclosure depends on the frequency with which the entrepreneur is privately informed (the degree of adverse selection) and the level of liability. Full deterrence may require damages that are supra-compensatory in the sense that that the damage payments exceed the overcharge to the investors, in part, to offset the insufficient deterrence that stems from the reduced share price that the investors suffer.


SEC Rules Would Make SPAC Process More Burdensome than Traditional IPOs

Gail Weinstein is senior counsel, and Philip Richter and Brian Hecht are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Richter, Mr. Hecht, Joshua Wechsler, Daniel J. Bursky, and Ashar Qureshi. Related research from the Program on Corporate Governance includes SPAC Law and Myths by John C. Coates (discussed on the Forum here).

On March 30, 2022, the Securities and Exchange Commission proposed new rules that would eliminate many of the current benefits for a private company in going public through a merger with a SPAC (in a so-called “de-SPAC” transaction) rather than through a traditional initial public offering (IPO) process. The proposed rules are more far-reaching than was expected and would transform the SPAC process, making it lengthier, more costly, and more complex, and imposing a greater risk of liability for the entities involved. Even before issuance of the proposal, the SPAC market has been receding due to increased regulatory, judicial and investor scrutiny and skepticism. Market changes underway over the past year or so have made SPACs less attractive as compared to traditional IPOs than they had been (as discussed below)—and the proposed rules, if adopted, would accelerate this trend.

According to the SEC, the proposed changes are motivated by the SEC’s view that “a private operating company’s method of becoming a public company should not negatively impact investor protection.” The proposed rules “are intended to provide investors with disclosures and liability protections comparable to those that would be present if a private operating company were to conduct a traditional firm commitment initial public offering,” the SEC stated. We would observe that, arguably, the proposed rules are in fact more burdensome than those applicable to a traditional IPO—in light of the requirements relating to the SPAC making a fairness determination with respect to the de-SPAC and the significantly expanded potential liability for financial advisors and others with respect to de-SPACs (as discussed below).

In this post, we note the key proposed changes and their likely impact; explain the SPAC structure; provide a brief background; summarize the proposed new rules; and reach conclusions, noting open issues arising from the proposal.


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