Monthly Archives: June 2022

The SEC and Messaging Apps

William J. Stellmach and Elizabeth P. Gray are partners and Sean Sandoloski is counsel at Willkie Farr & Gallagher LLP. This post is based on a Willkie memorandum by Mr. Stellmach, Ms. Gray, Mr. Sandoloski, Amelia A. Cottrell, Randall Jackson and Michael S. Schachter.

The government’s ongoing effort to crack down on the use of ephemeral messaging platforms at financial institutions appears to have entered a new phase. According to press reports, the Securities and Exchange Commission (the “Commission” or the “SEC”) is requiring Wall Street banks to undertake an unprecedented review of dozens of their top executives’ and traders’ personal cell phones to determine the frequency with which these platforms are used to conduct bank business.

Apps like WhatsApp, Signal, and Telegram allow users to send messages using end-to-end encryption, which prohibits third parties from accessing data, allowing it to be read by no one other than the sender and recipient. Users can also send ephemeral or “self-destructing” messages that are deleted automatically after they are viewed or some set amount of time after they are sent.

These apps are very popular and in wide use, but their use to conduct securities trading-related business violates laws and regulations that require banks and broker-dealers to maintain and preserve communications—not to mention banks’ own policies. These rules enable the review of records by the Commission and other regulators (such as the Commodity Futures Trading Commission (the “CFTC”)), in the course of their examination and enforcement duties. Indeed, the Commission views these rules as “an integral part of the investor protection function of the Commission, and other securities regulators” because these “records are the primary means of monitoring compliance with applicable securities laws, including antifraud provisions and financial responsibility standards.” [1] This isn’t empty rhetoric. Informal messages have formed the backbone of many high-profile corporate enforcement actions over the years. [2] If communications are migrating to platforms where those messages are neither surveilled nor retained, it becomes materially more challenging for the government to bring all manner of cases.

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Socially Responsible Divestment

Alex Edmans is Professor of Finance at London Business School, Doron Levit is Associate Professor of Finance and Business Economics at the University of Washington, and Jan Schneemeier is an Assistant Professor of Finance at Indiana University. This post is based on their recent paper.

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); 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); and Exit vs. Voice by Eleonora Broccardo, Oliver Hart and Luigi Zingales (discussed on the Forum here).

Responsible investing is becoming increasingly mainstream. In 2006, the United Nations established the Principles for Responsible Investment (“UN PRI”), a commitment to invest responsibly, which was signed by 63 investors managing a total of $6.5 trillion. By the end of 2021, this had grown to 4,375 investors, representing $121 trillion.

Blanket exclusion of “brown” industries, such as tobacco, gambling, and fossil fuels, is often seen as the purest and most effective form of responsible investing. Divesting starves them of capital, the argument goes, preventing them from creating further harm. Accordingly, practitioners and the public hold investors accountable for their holdings of brown firms. In 2020, Extinction Rebellion protesters dug up a lawn outside Trinity College, Cambridge to protest at its investment in fossil fuel companies, and many asset owners evaluate asset managers according to whether they manage a “net zero” portfolio. Beyond climate, Morningstar’s “globe” ratings of funds are based on the Sustainalytics ESG ratings of the stocks they hold and are thus boosted by divesting from brown stocks. Those with low ratings are often accused of greenwashing.

However, this argument considers only one channel through which divestment can affect a company’s real actions—the primary markets channel, whereby divestment affects the terms at which a company raises new capital. As the survey of Bond, Edmans, and Goldstein (2012) points out, stock market trading—and thus divestment strategies—can also have real effects through a secondary markets channel. Specifically, trading leads to the stock price reflecting a manager’s real actions, thus rewarding or punishing him for taking them. Even if a firm is in an irremediably brown sector, which unavoidably produces negative externalities, the manager may be able to take corrective actions to mitigate these externalities. Blanket exclusion fails to reward such actions because the firm is divested no matter what. Thus, it may be optimal for a responsible investor to pursue a “tilting” strategy, where she tilts away from a brown industry but is willing to hold firms that are best-in-class, i.e. take corrective actions.

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Diversity, Experience, and Effectiveness in Board Composition

Merel Spierings is a Researcher at The Conference Board ESG Center. This post is based on her recent publication, which was released by The Conference Board and ESG analytics firm ESGAUGE, in collaboration with Debevoise & Plimpton, the KPMG Board Leadership Center, Russell Reynolds Associates, and The John L. Weinberg Center for Corporate Governance at the University of Delaware.

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).

Investor and regulator focus on board composition and practices has evolved significantly over the past 20 years. In the wake of the Enron and WorldCom collapses, these stakeholders initially focused on strengthening board independence and oversight. [1] After the financial crisis of 2008, that gave way to a greater focus on whether boards have the right mix of skills and experience to guide business strategy—as well as mechanisms for shareholders to hold boards accountable for business performance. [2] More recently, the focus on board diversity has not only accelerated, but also expanded to the broader question of how boards are overseeing environmental, social, and governance (ESG) matters. For example, in early 2022, investors raised the bar for board diversity, [3] and the US Securities and Exchange Commission (SEC) proposed rules seeking greater disclosure of the board’s role in climate change and cybersecurity, with rules on human capital management to come.

These trends have significant implications for board composition, size, and education. Companies need boards with directors who have a diversity of backgrounds, as well as the skills and experience to oversee the expanding list of priorities. They also need boards of sufficient size to accommodate these individuals, as well as to populate the (new) board committees that address ESG topics. And they need to have more robust onboarding programs for these new directors, as well as ongoing board education programs to ensure the entire board is not relying on the expertise of a few directors but is fluent in the growing list of issues that boards are expected to oversee.

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California Bill Would Prohibit Settlement Agreements Keeping Certain Information Secret

Jason Russell is Partner and Hillary Hamilton and Candace Ross Phoenix are Associates at Skadden, Arps, Slate, Meagher & Flom LLP.  This post is based on their Skadden memorandum.

The California Senate will soon consider a bill prohibiting settlement agreements that prevent disclosing information about defective products or environmental hazards.

The Public Right To Know Act of 2022, SB 1149, would impact actions involving a “defective product or environmental hazard that poses a danger to public health or safety.” The bill would, if passed, prohibit both settlement agreements that restrict the disclosure of factual information and court orders that do not allow public disclosure of the covered information.

The bill allows any person, including a news media representative, “for whom it is reasonably foreseeable that the person will be substantially affected by a” violation of the act to challenge such a provision, agreement or order by filing a motion in the action or bringing a separate action for declaratory relief.

The act does not apply to certain categories of information: (1) medical or personal identifying information regarding an injured person; (2) the settlement amount; (3) a current customer list or trade secret if a party moves for an order of nondisclosure in good faith and demonstrates that the presumption is “clearly outweighed by a specific and substantial overriding confidentiality interest”; and (4) the citizenship or immigration status of any individual.

Under the bill, an attorney’s failure to comply could be grounds for professional discipline and a potential investigation by the State Bar of California. Violations under the act include: (1) requesting a settlement provision preventing disclosure of factual information; (2) advising a client to sign an agreement including such a provision; and (3) moving for an order of nondisclosure without good faith.

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Boards Are Tying Goals to ESG Metrics

Molly Stutzman is Analyst of Corporate Research, Laura Thornton is Junior Analyst, and Matthew Nestler is Senior Manager of Workplace Policies Research at JUST Capital. This post is based on their JUST Capital memorandum. Related research from the Program on Corporate Governance includes The Perils and Questionable Promise of ESG-Based Compensation by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); and Paying for Long-Term Performance by Lucian A. Bebchuk and Jesse Fried (discussed on the Forum here).

Key Findings

Customers, employees, shareholders, and other stakeholders, are increasingly expecting companies to tackle environmental, social, and governance (ESG) issues. That includes the American public. In our 2021 survey of the People’s Priorities, “The board of directors holds executives accountable to the interests of its workers, customers, communities, and the environment, as well as shareholders,” emerged as the third-most important Issue to the public, representing over 10% of our Rankings model.

And, as pressure has increased, so have corporate disclosures showing board oversight of ESG efforts. Our analysis of three data points on board oversight of ESG issues, covered under the Shareholders and Governance stakeholder, has led to two key findings. First, disclosure on these data points is steadily increasing. Almost a fifth of companies in the Russell 1000 Index report all three ESG governance data points we measure in 2022—up from around a tenth in 2020. Second, the Oil & Gas, Utilities, Energy Equipment & Services, and Chemicals industries have a much larger percentage of companies disclosing on all three ESG governance data points than other industries.

Board Oversight of ESG from 2020-2022: Unpacking the Rise in Disclosure

As proxy season kicked off last month, Mastercard made headlines with a decision to link ESG goals with bonus calculations for employees at all levels. The company had previously tied these metrics to compensation for senior-level executives, incentivizing leaders to be accountable to all their stakeholders and not merely shareholders. And while this remains a growing trend as median CEO pay sees another record-setting year, this latest move marks a deeper degree of incorporating ESG into how the company operates. Mastercard’s shift also comes as corporate America faces challenges from investors over policies and practices related to climate change, racial equity, political contributions, and other ESG issues.

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Holding Foreign Insiders Accountable

Robert J. Jackson, Jr. is the Pierrepont Family Professor of Law, Co-Director of the Institute for Corporate Governance and Finance at NYU School of Law, and a former Commissioner at the U.S. Securities and Exchange Commission; Daniel Taylor is Associate Professor of Accounting at the Wharton School of the University of Pennsylvania; and Bradford Lynch is a PhD student at The Wharton School of the University of Pennsylvania. This post is based on their recent paper.

Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation by Jesse Fried (discussed on the Forum here); and China and the Rise of Law-Proof Insiders by Jesse M. Fried and Ehud Kamar (discussed on the Forum here).

1. Introduction

In October 2020, Ant Group, an affiliate of the Nasdaq-listed Chinese firm Alibaba, was preparing for its initial public offering (IPO). But on October 24, Alibaba CEO Jack Ma publicly criticized Chinese regulators and Communist Party officials (Zhai et al., 2020). Chinese leaders responded forcefully, and on November 3 the Ant IPO was suddenly suspended, leading Alibaba shares to fall more than 8% (Yang & Ng, 2020). Unbeknownst to most investors, however, the day before that announcement Skyscraper Limited, an entity controlled by Alibaba insiders, sold more than $150 million in Alibaba shares, avoiding millions in losses (McMorrow et al., 2021). Disclosure of that transaction was provided not in the widely-watched form that U.S. insiders must provide (Jackson, 2012) but rather on a little-known paper filing stored in file cabinets in the SEC’s reference room known as Form 144 (see e.g., Figure 1).

Figure 1. Form 144 Paper Filing by Foreign Insiders.

Below is an image of a paper filing on Form 144 associated with the sale by Sky Scraper Enterprises of over $155 million worth of shares in Alibaba, a foreign firm with American Depository Shares traded on Nasdaq. There is no corresponding Form 4. The day after this filing, shares of Alibaba fell more than 8%.

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What Boards Should Know About Digital Assets

Tim Davis is a Principal, Robert Massey is a Partner, and Carey Oven is a National Managing Partner at Deloitte LLP.  This post is based on their Deloitte memorandum.

The proliferation of digital assets has accelerated rapidly, generating a level of market interest sufficient to influence strategy at many major financial institutions and other corporations. Digital assets are disrupting the entire financial market, driving changes in the financial ecosystem. Blockchain, the underlying distributed ledger technology (DLT) for managing digital assets, is also gaining considerable traction, providing companies with the ability to transform some aspects of how they do business.

Digital assets—including cryptocurrencies, stablecoins, tokens, and non-fungible tokens (NFTs)—are items of value that exist only in digital form. Using cryptographic technology, digital assets are secured, exchanged, and verified in decentralized digital ledgers.

Cryptocurrencies roughly quadrupled in value from the end of 2020 to late 2021, when the market was worth more than $3 trillion. [1] In early April 2022, market capitalization for the thousands of cryptocurrencies tracked by CoinGecko was valued at $2.26 trillion. [2] Thousands of major companies have begun accepting cryptocurrencies as payments and are using crypto for a variety of investment, operational, and transactional purposes.

According to Deloitte’s 2021 Global Blockchain Survey, leaders at financial services institutions globally regard digital assets and blockchain technologies as a strategic priority. Nearly 80% of survey respondents said digital assets will be very or somewhat important to their respective industries in the coming two years. [3] More than three-quarters of respondents (76%) said they believe digital assets will serve as a strong alternative to or replacement for fiat currencies in the next five to 10 years. [4]

Explosive growth in digital assets prompted President Biden to sign an executive order on March 9, 2022, to establish a national policy for digital assets, focused on priorities such as consumer and investor protection, financial stability, financial inclusion, responsible innovation, illicit finance, and US leadership in the global financial system. According to the White House, the significant rise in popularity of digital assets creates an important opportunity for the United States to play a leading role in global governance consistent with the values of democracy and US global competitiveness. [5] In addition, more than 100 countries, including the United States, are exploring or piloting central bank digital currencies, which are digital forms of a country’s sovereign currency. [6]

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Taskforce on Nature-Related Financial Disclosures Framework: Overview of First Beta Release

Michael Littenberg is partner, and Samantha Elliott and Peter Witschi 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 A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Will Corporations Deliver Value to All Stakeholders? by Lucian A. Bebchuk and Roberto Tallarita; 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 A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Corporate Purpose and Corporate Competition by Mark J. Roe (discussed on the Forum here)

In March, the Taskforce on Nature-related Financial Disclosures released the first beta version (v0.1) of the TNFD Nature-related Risk & Opportunity Management and Disclosure Framework. The first beta release marks the beginning of an 18-month consultation and development process to improve the Framework’s relevance, usability and effectiveness. The TNFD is thus encouraging market participants and stakeholders to engage in pilot testing and submit feedback. After four rounds of beta versions, the TNFD plans to release its final recommendations for the Framework in September 2023. In this post, we provide both an overview of the first beta version of the Framework and next steps for companies seeking to engage in the consultation process.

What is the TNFD?

Formally launched in June 2021, the TNFD is a global, market-led initiative established in response to the growing call to factor nature-related risks into financial and business decisions. As framed by the TNFD, although more than half of the world’s economic output is moderately or highly dependent on nature, corporate and financial institutions do not currently have the information needed to understand (1) how nature impacts an organization’s immediate financial performance or (2) the longer-term financial risks that may arise from how the organization, positively or negatively, impacts nature. To address this need, the TNFD is developing an integrated risk management and disclosure framework for organizations to report and act on evolving nature-related risks and opportunities.

The nature-focused TNFD builds on the work of the Task Force on Climate-related Financial Disclosures, which focused on climate risk management and disclosures. The TNFD adopts the same pillars as the TCFD, seeking to provide comparable, financially relevant, decision-useful information. However, instead of addressing climate risks, the TNFD is focused on ensuring that nature-related risks and opportunities are understood and effectively communicated. By aggregating the best tools, materials and information available, the TNFD aims to allow financial institutions and companies to incorporate nature-related risks and opportunities into their strategic planning, risk management and asset allocation decisions, and to promote worldwide consistency for nature-related reporting.

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California Gender Board Diversity Law Is Held Unconstitutional

Sarah Fortt, Maj Vaseghi, and Betty Huber are partners at Latham & Watkins LLP. This post is based on their Latham memorandum. 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).

The law suffers the same fate as the California board diversity law requiring directors from “underrepresented communities.”

On May 13, 2022, Los Angeles Superior Court Judge Maureen Duffy-Lewis issued a ruling in Crest v. Padilla I finding that California Corporations Code Section 301.3 (SB 826), which requires publicly listed corporations in California to have women on their boards, violates the Equal Protection Clause of the California Constitution. [1] The decision comes less than two months after Los Angeles Superior Court Judge Terry A. Green similarly ruled in Crest v. Padilla II that the California Equal Protection Clause rendered unconstitutional a law requiring California publicly listed corporations to have board members from “underrepresented communities.” [2]

Crest v. Padilla I

In Crest v. Padilla I, Judicial Watch — the same plaintiff as in Crest v. Padilla II — mounted a facial challenge to SB 826, arguing that the law violated the Equal Protection Clause of the California Constitution. The court first observed that SB 826 creates a gender-based quota system that “affects two or more ‘similarly situated’ groups in an unequal manner.” [3] After establishing that men and women are similarly situated, the court applied the strict scrutiny test to assess the constitutionality of SB 826. Under strict scrutiny, the state needed to show that SB 826: (1) satisfied a compelling government interest; (2) was necessary to satisfy that interest; and (3) was narrowly tailored to meet that government interest. The court held that the state failed to present sufficient evidence to meet any of the three prongs of the strict scrutiny test.

The court first rejected the state’s argument that eliminating and remedying discrimination in director selection was a compelling government interest. In so doing, the court stressed that while rectifying specific and intentional discrimination can be a compelling government interest, “remedying generalized, non-specific allegations of discrimination” is not. [4] In the court’s view, “neither the Legislature nor Defendant could identify any specific, purposeful, intentional and unlawful discrimination to be remedied” [5] and thus California lacked a compelling interest. The court also rejected the state’s argument that SB 826 satisfied a compelling interest by benefiting the public and state economy. In the court’s view, the evidence presented at trial demonstrated that the goal of SB 826 “was to achieve gender equity or parity; its goal was not to boost California’s economy, not to improve opportunities for women in the workplace nor not [sic] to protect California’s taxpayers, public employees, pensions and retirees.” [6] Moreover, even if the goal of SB 826 were to fuel the economy, the court noted that “analysis of S.B. 826 found that connections between women on corporate boards and improved corporate performance and corporate governance are inconclusive.” [7] That tenuous connection, the court reasoned, negated California’s claim that SB 826 was necessary to achieve its stated interest in growing the state’s economy. [8]

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Stakeholder Capitalism and ESG as Tools for Sustainable Long-Term Value Creation

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, David M. Silk, and Carmen X. W. Lu.

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? (discussed on the Forum here), both by Lucian A. Bebchuk and Roberto Tallarita; 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); and Stakeholder Capitalism in the Time of COVID, by Lucian Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here).

Recent high profile investigations into greenwashing, the ongoing war in Ukraine and soaring energy costs have prompted questions as to the purpose and value of ESG, and more broadly, stakeholder capitalism. Some have criticized stakeholder capitalism and ESG as “woke” politics, a threat to shareholder interests and a distraction for boards and management. Others have questioned whether stakeholder capitalism and ESG can straddle “doing good” and “doing well.” Uncertainty also abounds as to what ESG truly means.

We believe stakeholder capitalism and ESG are fundamentally frameworks to enhance the sustainable long-term value of a corporation. Both are tools for boards and management to guide business strategy, risk management and capital allocation in a manner that best serves the financial well-being of a business, and in turn, the interests of shareholders. Time and again, stakeholder and ESG considerations have driven positive societal outcomes (climate and DEI being among the examples). But stakeholder capitalism and ESG, as we and many investors understand them, do not lead with a political or moral agenda. The north star of stakeholder capitalism and ESG is driving sustainable long-term value creation.

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