Monthly Archives: November 2019
As anticipated on November 5, 2019, the SEC issued two highly controversial rule proposals. The first is to amend Exchange Act rules to regulate proxy advisors. The second is to amend Securities Exchange Act Rule 14a-8(b) to increase the ownership threshold requirements required for shareholders to submit and re-submit proposals to be included in a company’s proxy statement. The ownership thresholds were last amended in 1998 and the resubmission rules have been in place since 1954. Together the new rules would represent significant changes to the proxy disclosure and solicitation process and shareholder rights to include matters on a company’s proxy statement. Not surprisingly, given the debate surrounding this topic, each of the SEC Commissioners issued statements on the proposed rule changes.
I am in support of both rules. This blog addresses the proposed rule changes related to shareholder proposals. Shareholder proposals, and the process for including or excluding such proposals in a company’s proxy statement, have been the subject of debate for years. The rules have not been amended in decades and during that time, shareholder activism has shifted. Main Street investors tend to invest more through mutual funds and ETF’s, and most shareholder proposals come from a small group of investors which need to meet a very low bar for doing so.
In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” in which the Treasury department reported on laws and regulations that, among other things, inhibit economic growth and vibrant financial markets. The Treasury Report stated that “[A]ccording to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” Among the many recommendations by the Treasury Department was to amend Rule 14a-8 to substantially increase both the submission and resubmission threshold requirements. I note that a 2018 study found that 5 individuals accounted for 78% of all the proposals submitted by individual shareholders.
Background – Current Rule 14a-8
The regulation of corporate law rests primarily within the power and authority of the states. However, for public companies, the federal government imposes various corporate law mandates including those related to matters of corporate governance. While state law may dictate that shareholders have the right to elect directors, the minimum and maximum time allowed for notice of shareholder meetings, and what matters may be properly considered by shareholders at an annual meeting, Section 14 of the Securities Exchange Act of 1934 (“Exchange Act”) and the rules promulgated thereunder govern the proxy process itself for publicly reporting companies. Federal proxy regulations give effect to existing state law rights to receive notice of meetings and for shareholders to submit proposals to be voted on by fellow shareholders.
All companies with securities registered under the Exchange Act are subject to the Exchange Act proxy regulations found in Section 14 and its underlying rules. Section 14 of the Exchange Act and its rules govern the timing and content of information provided to shareholders in connection with annual and special meetings with a goal of providing shareholders meaningful information to make informed decisions, and a valuable method to allow them to participate in the shareholder voting process without the necessity of being physically present. As with all disclosure documents, and especially those with the purpose of evoking a particular active response, such as buying stock or returning proxy cards, the SEC has established robust rules governing the procedure for, and form and content of, the disclosures.
Rule 14a-8 allows shareholders to submit proposals and, subject to certain exclusions, require a company to include such proposals in the proxy solicitation materials even if contrary to the position of the board of directors, and is accordingly a source of much contention. Rule 14a-8 in particular allows a qualifying shareholder to submit proposals that if meet substantive and procedural requirements must be included in the company’s proxy materials for annual and special meetings, and provides a method for companies to either accept or attempt to exclude such proposals.
State laws in general allow a shareholder to attend a meeting in person and, at such meeting, to make a proposal to be voted upon by the shareholders at large. In adopting Rule 14a-8, the SEC provides a process and parameters for which these proposals can be made in advance and included in the proxy process. By giving shareholders an opportunity to have their proposals included in the company proxy, it enables the shareholder to present the proposal to all shareholders, with little or no cost, to themselves. It has been challenging for regulators to find a balance between protecting shareholder rights by allowing them to utilize company resources and preventing an abuse of the process to the detriment of the company and other shareholders.
The rule itself is written in “plain English” in a question-and-answer format designed to be easily understood and interpreted by shareholders relying on and using the rule. Other than based on procedural deficiencies, if a company desires to exclude a particular shareholder process, it must have substantive grounds for doing so. Procedurally to qualify to submit a proposal, a shareholder must:
- Continuously hold a minimum of $2,000 in market value or 1% of the company’s securities entitled to vote on the subject proposal, for at least one year prior to the date the proposal, is submitted and through the date of the annual meeting;
- If the securities are not held of record by the shareholder, such as if they are in street name in a brokerage account, the shareholder must prove its ownership by either providing a written statement from the record owner (i.e., brokerage firm or bank) or by submitting a copy of filed Schedules 13D or 13G or Forms 3, 4 or 5 establishing such ownership for the required period of time;
- If the shareholder does not hold the requisite number of securities through the date of the meeting, the company can exclude any proposal made by that shareholder for the following two years;
- Provide a written statement to the company that the submitting shareholder intends to continue to hold the securities through the date of the meeting;
- Clearly state the proposal and course of action that the shareholder desires the company to follow;
- Submit no more than one proposal for a particular annual meeting;
- Submit the proposal prior to the deadline, which is 120 calendar days before the anniversary of the date on which the company’s proxy materials for the prior year’s annual meeting were delivered to shareholders, or if no prior annual meeting or if the proposal relates to a special meeting, then within a reasonable time before the company begins to print and send its proxy materials;
- Attend the annual meeting or arrange for a qualified representative to attend the meeting on their behalf – provided, however, that attendance may be in the same fashion as allowed for other shareholders such as in person or by electronic media;
- If the shareholder or their qualified representative fail to attend the meeting without good cause, the company can exclude any proposal made by that shareholder for the following two years;
- The proposal, including any accompanying supporting statement, cannot exceed 500 words. If the proposal is included in the company’s proxy materials, the statement submitted in support thereof will also be included.
A proposal that does not meet the substantive and procedural requirements may be excluded by the company. To exclude the proposal on procedural grounds, the company must notify the shareholder of the deficiency within 14 days of receipt of the proposal and allow the shareholder to cure the problem. The shareholder has 14 days from receipt of the deficiency notice to cure and resubmit the proposal. If the deficiency could not be cured, such as because it was submitted after the 120-day deadline, no notice or opportunity to cure must be provided.
Upon receipt of a shareholder proposal, a company has many options. The company can elect to include the proposal in the proxy materials. In such case, the company may make a recommendation to vote for or against the proposal, or not take a position at all and simply include the proposal as submitted by the shareholder. If the company intends to recommend a vote against the proposal (i.e., Statement of Opposition), it must follow specified rules as to the form and content of the recommendation. A copy of the Statement of Opposition must be provided to the shareholder no later than 30 days prior to filing a definitive proxy statement with the SEC. If included in the proxy materials, the company must place the proposal on the proxy card with check-the-box choices for approval, disapproval or abstention.
As noted above, the company may seek to exclude the proposal based on procedural deficiencies, in which case it will need to notify the shareholder and provide a right to cure. The company may also seek to exclude the proposal based on substantive grounds, in which case it must file its reasons with the SEC which is usually done through a no-action letter seeking confirmation of its decision and provide a copy of the letter to the shareholder. The SEC has issued a dozen staff legal bulletins providing guidance on shareholder proposals, including interpretations of the substantive grounds for exclusion. Finally, the company may meet with the shareholder and provide a mutually agreed upon resolution to the requested proposal.
As a refresher, substantive grounds for exclusion include:
- The proposal is not a proper subject for shareholder vote in accordance with state corporate law;
- The proposal would bind the company to take a certain action as opposed to recommending that the board of directors or company take a certain action;
- The proposal would cause the company to violate any state, federal or foreign law, including other proxy rules;
- The proposal would cause the company to publish materially false or misleading statements in its proxy materials;
- The proposal relates to a personal claim or grievance against the company or others or is designed to benefit that particular shareholder to the exclusion of the rest of the shareholders;
- The proposal relates to immaterial operations or actions by the company in that it relates to less than 5% of the company’s total assets, earnings, sales or other quantitative metrics;
- The proposal requests actions or changes in ordinary business operations, including the termination, hiring or promotion of employees – provided, however, that proposals may relate to succession planning for a CEO (I note this exclusion right has also been the subject of controversy and litigation and is discussed in SLB 14H);
- The proposal requests that the company take action that it is not legally capable of or does not have the legal authority to perform;
- The proposal seeks to disqualify a director nominee or specifically include a director for nomination;
- The proposal seeks to remove an existing director whose term is not completed;
- The proposal questions the competence, business judgment or character of one or more director nominees;
- The company has already substantially implemented the requested action;
- The proposal is substantially similar to another shareholder proposal that will already be included in the proxy materials;
- The proposal is substantially similar to a proposal that was included in the company proxy materials within the last five years and received fewer than a specified number of votes;
- The proposal seeks to require the payment of a dividend; or
- The proposal directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.
Proposed Rule Change
The need for a change in the rules has become increasingly apparent in recent years. As discussed above, a shareholder that submits a proposal for inclusion shifts the cost of soliciting proxies for their proposal to the company and ultimately other shareholders and as such is susceptible to abuse. In light of the significant costs for companies and other shareholders related to shareholder proxy submittals, and the relative ease in which a shareholder can utilize other methods of communication with a company, including social media, the current threshold of holding $2,000 worth of stock for just one year is just not enough of a meaningful stake or investment interest in the company to warrant inclusion rights under the rules. Prior to proposing the new rules, the SEC conducted in-depth research including reviewing thousands of proxies, shareholder proposals and voting results on those proposals. The SEC also conducted a Proxy Process Roundtable and invited public comments and input.
The proposed rule changes address eligibility to submit and resubmit proposals but do not alter the underlying substantive grounds upon which a company may reject a proposal. The proposed amendments would amend the proposal eligibility requirements in Rule 14a-8(b) to:
(i) update the criteria, including the ownership requirements that a shareholder must satisfy to be eligible to have a shareholder proposal included in a company’s proxy statement such that a shareholder would have to satisfy one of three eligibility levels: (a) continuous ownership of at least $2,000 of the company’s securities for at least three years (updated from one year); (b) continuous ownership of at least $15,000 of the company’s securities for at least two years; or (c) continuous ownership of at least $25,000 of the company’s securities for at least one year;
(ii) require that if a shareholder decides to use a representative to submit their proposal, they must provide documentation that the representative is authorized to act on their behalf and clear evidence of the shareholder’s identity, role and interest in the proposal;
(iii) require that each shareholder that submits a proposal state that they are able to meet with the company, either in person or via teleconference, no less than 10 calendar days, nor more than 30 calendar days, after submission of the proposal, and provide contact information as well as business days and specific times that the shareholder is available to discuss the proposal with the company.
The proposed amendments would amend the “one proposal” requirements in Rule 14a-8(c) to:
(i) apply the one-proposal rule to each person rather than each shareholder who submits a proposal, such that a shareholder would not be permitted to submit one proposal in his or her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting. Likewise, a representative would not be permitted to submit more than one proposal to be considered at the same meeting, even if the representative were to submit each proposal on behalf of different shareholders.
Under certain circumstances, Rule 14a-8(i)(12) allows companies to exclude a shareholder proposal that “deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company’s proxy materials within the preceding 5 calendar years.” The proposed amendments would amend the shareholder proposal resubmittal eligibility in Rule 14a-8(i)(12) to:
(i) increase the current resubmission thresholds of 3%, 6% and 10% for matters voted on once, twice or three or more times in the last five years, respectively, of shareholder support a proposal must receive to be eligible for future submission to thresholds of 5%, 15% and 25%; and
(ii) add a new provision that would allow for exclusion of a proposal that has been previously voted on three or more times in the last five years, notwithstanding having received at least 25% of the votes cast on its most recent submission, if the proposal (a) received less than 50% of the votes cast and (ii) experienced a decline in shareholder support of 10% or more compared to the immediately preceding vote.
Commissioner Statements on the Proposed Rule Changes
Chair Jay Clayton supports the proposed amendments as part of the necessary modernization of the proxy process. He specifically believes that the requirement for shareholders to engage and meet with management on a proposal will have a significant beneficial impact on company-shareholder communications and the proxy process. Focusing on the resubmission changes, Chair Clayton states, “if after three attempts at a proposal within a 5 year period, 75% of your fellow shareholders still do not support your proposal, you should take a time out.”
Commissioner Roisman also supports the proposed rule changes discussing how long it has been since the last amendments and the significant changes in the markets and technology since that time. The SEC has an obligation to revisit rules regularly to ensure they remain appropriate in the current dynamic. He points out that this is especially true when the market participants are loudly proclaiming that the rules are not working, as in the case of the proxy process and shareholder submission and resubmission eligibility criteria.
Commissioner Hester Peirce supports the rule changes and is eloquent and clever in her statement, as usual. Cutting to the chase, the question in Rule 14a-8 is: “[W]hen should one shareholder be able to force other shareholders to pay for including the proponent shareholder’s proposal in the company’s proxy materials?” Continuing: “[T]he proposed changes would help to weed out proposals whose proponents do not have a real interest in the company and proposals for which other shareholders do not share the proponent’s enthusiasm.” The current proposals are fair, ensuring that shareholders with a real economic stake can submit proposal and resubmit those proposals where other shareholder interest increases.
Not surprisingly, Commissioner Jackson is not in support of the changes beginning his statement by characterizing the proposed rule changes as limiting public company investors’ ability to hold corporate insiders accountable. He agrees that the rules need to be updated and revisited but does not approve of proposals made.
Commissioner Allison Lee sides with Commissioner Jackson in seeing the proposed rules as suppressing shareholder rights. Commissioner Lee is specifically concerned about small shareholders being deterred from submitting proposals related to ESG matters including climate risk disclosures.
On November 7, 2019, the SEC Investor Advisory Committee held a meeting on the topics of (i) whether investors use environmental, social and governance (ESG) data in making investment and capital allocation decisions; and (ii) the SEC’s recent concept release on harmonization of securities offering exemptions. For more on ESG matters, see HERE and for my blog on the SEC’s concept release on exempt offerings, see HERE. Both SEC Chair Jay Clayton and Commissioner Allison Herren Lee made remarks before the committee. As always, it is helpful in navigating our complex securities laws and regulatory priorities to stay informed on matters involving SEC decision makers and policy setters.
The Investor Advisory Committee was created by the Dodd-Frank Act to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace. The Dodd-Frank Act authorizes the committee to submit findings and recommendations for review and consideration by the SEC. Since its formation, the committee has made over 20 recommendations to the SEC on a wide range of pertinent topics.
Several panelists during the meeting expressed concern over the lack of information on private offerings, other than the fact that with the information the SEC does have, it is known that private offerings outpace public markets. Information is generally learned from Form D filings, but not all private offering issuers file a Form D. Moreover, there is no reliable or centralized resource as to how private offerings perform. As a result, panelists at the meeting do not believe that exemptions should be expanded. For example, one law professor stated that there is little evidence that retail investors would have better returns if allowed to invest in private securities. The negative opinions were strong.
However, there is another side, and not surprisingly I am a proponent of increasing private offering availability for retail investors. Absolutely there is no evidence that overall returns would increase and possibly they would not. Private offerings, especially in start-ups, are among the riskiest of all investments. Nonetheless, when they do perform, they also provide the highest returns. Also importantly, it is this start-up culture that fuels the American economy, creates new jobs, supports technological and scientific advancement that is increasingly left to private sectors, and keeps America competitive in the global economy.
There are ways to increase access to private markets without letting fraudsters run amuck with grandma’s retirement account. The definition of an “accredited investor” can be amended to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. Increased access to professionally managed funds that invest in private markets is another option.
Also, access to private markets can be increased, and investor protections increased through the regulation of private market finders. I am a strong advocate for a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. I would even advocate for a potential general securities industry exam for individuals as a precondition to acting as a finder, without related licensing requirements. For example, FINRA, together with the SEC Division of Trading and Markets, could fashion an exam similar to the new FINRA Securities Industry Essentials Exam (see HERE) for finders that are otherwise exempt from the full broker-dealer registration requirements.
Form D’s can also become mandatory in order to preserve the federal exemption being relied upon which will add to the information that the SEC has on private offerings, though not their success. However, I can’t think of any methodology for the SEC to gather information on the success of private offerings, that wouldn’t be overly burdensome and cumbersome on both the issuing companies and the government regulators. Furthermore, this information will provide little beneficial additional knowledge. It is known that most start-ups fail, that 9 out of 10 businesses fail within the first 10 years, that if you invested $1,000 in Amazon in 1997 it would be worth $1,362,000 as of September 4, 2018 and the numbers are similar for Netflix, Twitter, Google and many others.
Inaction is the same as action, it has a result. I agree with Chair Clayton that access to private markets needs to be expanded and that the lack of data on the results of private investments is not a good enough reason to do nothing.
Remarks by Chair Jay Clayton
Prior to the meeting, SEC Chair Jay Clayton delivered prepared remarks on the meeting topics and provided a list of areas of focus he would like to see the committee address. Consistent with prior statements, Chair Clayton stresses that ESG means many different things to different investors and different companies, even in the same sector. He is concerned about requiring disclosures of immaterial information or information that is not designed to assist in investment decisions. Chair Clayton suggests focusing on the committee members and panelist use ESG data including whether the use of such data designed to improve investment performance over a particular term, to screen certain activities, companies or industries to address a particular objective or policy, or a combination of these goals.
Chair Clayton also made suggestions for areas that the committee should consider reviewing and making recommendations on. The topics suggested include:
(i) Self-directed individual retirement accounts (IRAs) including whether retail investors have enough protections;
(ii) Teachers and military service members including additional initiatives the SEC can take to protect these investor groups;
(iii) Minority and non-English-speaking communities including whether there are regulatory barriers discouraging access to investment services or leading to higher prices or inferior financial product choices;
(iv) Retail access to investment opportunities including opening access to private investments that currently or traditionally have only been available to institutional investors. In this regard, Chair Clayton would like to consider changes to fund regulations to align the interests of retail investors with fund managers (a regulation best interests for fund managers?);
(v) Retail investor protections in an increasingly global world including a study of the differences in the securities laws and investor protections between the U.S. and abroad. In this regard, Chair Clayton specifically pointed out that he does not believe that U.S. investors have proper assurances, based on regulatory regimes, that non-U.S. companies actually meet reported ESG standards. Similarly he points out concerns with audit quality in some foreign countries (see HERE for information on the SEC’s cautionary statement regarding audit quality in China);
(vi) LIBOR transition including how the SEC can help market participants address and respond to the risks of the transition away from LIBOR;
(vii) Index construction including whether retail investors and their advisors understand indices from a technical perspective and market exposure perspective and whether the SEC should increase required disclosures for indices; and
(viii) Credit rating agencies including the level of influence they have in the marketplace and whether their disclosures are sufficient.
Remarks by Commissioner Allison Herren Lee
Commissioner Allison Herren Lee is the newest member of the SEC commission. Like the market as a whole, Commissioner Lee is focused on ESG matters. The last time the SEC issued guidance on climate-related disclosure was in 2010 and since that time, scientific knowledge of climate change and its risks has increased significantly. Climate change risks are very real and could impact everything from the physical location of equipment to human resources to the value of assets…
On October 17, 2019, the SEC made a statement inviting stock exchanges and market participants to submit “innovative proposals designed to improve the secondary market structure for exchange listed equity securities that trade in lower volumes, commonly referred to as ‘thinly traded securities.’” On the same day the SEC issued a staff background paper on the subject. The SEC is not asking for input on how a company can better promote its stock and gain investor awareness, but rather how the capital market system, including trading rules and regulations, can be amended or improved to benefit thinly traded securities.
The staff background paper cites many statistics on the number of thinly traded securities, which they define as trading less than 100,000 shares daily. It also refers to the U.S. Department of the Treasury report entitled “A Financial System That Creates Economic Opportunities; Capital Markets” – see HERE for a summary of the report. As a result of this report, the SEC began looking at changes to Regulation NMS and unlisted trading privileges, both of which they continue to review and are now seeking public input on.
The SEC points out that thinly traded securities drive up transaction costs, and can make an exit of security holdings challenging and increase a company’s cost of capital. In its statement the SEC talks about potentially suspending unlisted trading privileges on multiple exchanges for thinly traded securities and overhauling Regulation NMS, including by providing exemptions from the rules. The SEC has raised these ideas previously, HERE).
Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.
Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations, and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.
Institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.
Unlisted Trading Privileges
One idea to improve liquidity is to restrict or even terminate unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC-traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.
Market Maker Incentives
In a recent roundtable, a suggestion was made to provide market makers with incentives to trade and make markets in thinly traded securities. Increased incentives to be in, and stay in, the markets for these securities could encourage market makers to quote more frequently and in greater size, which in turn could lead to narrower spreads and increased displayed order interest.
Another possible strategy to help with thinly traded securities is to have periodic intraday auctions as a means of concentrating liquidity in thinly traded securities at times other than solely at the market open and market close. This strategy may assist market participants in finding counterparties for trades, especially larger block trades.
The idea around a non-automated market is that buyers and sellers could negotiate directly and communicate with each other to determine trade prices and order size. To me this seems to result in a sort of private market for thinly traded securities that could result in abuse and an unfair advantage for market participants with knowledge and contacts over Main Street investors.
General Information for Proposals
The SEC statement also includes general instructions and suggestions for submittals. The SEC invites exchanges to proceed with submittals for suspension or termination of unlisted trading privileges under Section 12(f) of the Exchange Act and for exemptive relief from Regulation NMS under current Exchange Act rules. Submittals and suggestions should include an analysis of broader market impacts. Proposals should also cite relevant statutory authority and requirements.
Since “thinly traded securities” is not statutorily defined, proposals should include a definition, whether based on average daily trading volume, number of trades, share volume, or dollar volume, combined with additional factors such as market capitalization, number of shareholders, or public float. Proposals should include an explanation of how the thresholds were set, including any relevant data and analysis and transitioning into and out of the definition. Proposals should include all parameters of a requested rule change, including exemptions, whether companies can opt in or out and the mechanics of implementation.
On October 11, 2019 the SEC, FinCEN and CFTC issued a joint statement on activities involving digital assets. Various agencies have been consistently working together, with overlapping jurisdiction, on matters involving digital assets and distributed ledger technology. Earlier, in August, the SEC and FINRA issued a joint statement on the custody of digital assets, including as it relates to broker-dealers and investment advisors (see HERE).
The purpose of the joint statement is to remind persons engaged in activities involving digital assets of their anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA). AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC. The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs).
For purposes of the joint statement, “digital assets” include securities, commodities, and security- or commodity-based instruments such as futures or swaps. The agencies point out that industry participants may use different terminology or assign different meanings to standard terminology. As such, in determining whether an asset is a “digital asset” the agencies will look to the facts and circumstances, including its economic reality and use, whether intended, organically developed or repurposed. As I’ve discussed in other blogs, the same analysis is used to determine whether an entity is a financial institution, including a BSA.
Furthermore, the nature of the activities of a person or institution determine what, if any, licenses are needed and regulations that must be complied with. Some activities would require registration under the Commodity Exchange Act (CEA) and others may require registration as a broker-dealer under the Securities Exchange Act of 1934 (“Exchange Act”). Although the joint statement only included three agencies, others also oversee digital assets and industry participants. For example, the AML/CFT activities of a futures commission merchant will be overseen by the CFTC, FinCEN, and the National Futures Association (NFA); those of an MSB will be overseen by FinCEN; and those of a broker-dealer in securities will be overseen by the SEC, FinCEN and FINRA.
The CFTC added a specific statement that once an entity, such as an introducing broker or futures commission merchant, is licensed or required to be licensed under the CEA, all of their activities would require proper AML/CFT processes and procedures, not just those involving commodities.
FinCEN added a statement discussing its role as the administrator and lead regulator under the BSA. FinCEN has supervisory and enforcement authority over U.S. financial institutions to ensure the effectiveness of the AML/CFT regime. In general, entities that are subject to the BSA must: (i) register with FinCEN as a money services business (MSB) or with another agency such as the CFTC or the SEC; (ii) prepare a written AML compliance program that is designed to mitigate risks, including AML risks, and to ensure compliance with all BSA requirements including the filing of suspicious activity reports (SAR) and currency transaction reports; (iii) keep records for certain types of transactions at specific thresholds; and (iv) obtain customer identification information sufficient to comply with the AML program and recordkeeping requirements. In its statement, FinCEN referenced the guidance it issued in May 2019 and encouraged entities to carefully review the guidance to determine if they qualify as a MSB. For a review of the guidance, see HERE.
Like the other agencies, the SEC added a statement. The SEC’s additional statement reminds SEC registered broker-dealers and mutual funds that they are considered financial institutions for purposes of the BSA. A “broker-dealer” is defined in rules implementing the BSA as a person that is registered or required to register as a broker or dealer under the Securities Exchange Act, and a “mutual fund” is defined as an investment company that is an “open-end company” and that is registered or required to register under the Investment Company Act of 1940. Both broker-dealers and mutual funds must enact and comply with AML/CFT policies and procedures for all activities, including as related to digital assets.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.
For FinCEN’s most recent guidance related to cryptocurrency, see HERE.
For a discussion on the enforceability of smart contracts, see HERE.
For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.