All five SEC Commissioners testified yesterday at an oversight hearing held by the House Financial Services Committee, the first time all five have appeared since 2007, according to Chair Maxine Waters. (Here is their formal testimony.) These hearings are, of course, broken up into bite-size five-minute Q&A sessions, so there is not much opportunity for in-depth questioning. And most often, it seemed that the Representatives directed their questions to the Commissioners that were most likely to provide gratifying answers—meaning a Commissioner of the Representative’s own party. There were, however, some notable exceptions, such as Representative Katie Porter’s pointed questioning of Commissioner Hester Peirce with regard to her views on ESG disclosure. In the end, the hearing did provide some insight into the current thinking and expectations of many of these legislators and regulators.

(Based on my notes, so standard caveats apply.)

Notable among the opening statements was Commissioner Robert Jackson’s, which identified three areas where he believed the SEC and/or Congress needed to address regulatory gaps:

  • The 8-K disclosure rules, which typically allow four days prior to disclosure, during which, he suggested, studies have shown that insiders were trading. Legislation should close that trading gap, he suggested.

SideBar

An academic study, reported in 2015 in the WSJ, showed that corporate insiders consistently beat the market in their companies’ shares in the four days preceding 8-K filings, the period that the researchers called the “8-K trading gap.” The study also showed that, when insiders engage in open market purchases–relatively unusual transactions for insiders—during that trading gap, insiders “are correct about the directional impact of the 8-K filing more often than not—and that the probability that this finding is the product of random chance is virtually zero.” (See this PubCo post.)

  • A similar problem occurs with insider sales after the announcement of stock buybacks.

In remarks in 2018 before the Center for American Progress, Jackson discussed research he had recently conducted on corporate stock buybacks, in light of the substantial increase in buybacks following the 2017 Tax Cuts and Jobs Act. He called on the SEC to update its buyback rules “to limit executives from using stock buybacks to cash out from America’s companies.” If executives are so convinced that “buybacks are best for the company, its workers, and its community,” Jackson suggested, “they should put their money where their mouth is.” While Jackson wanted to see an update of the buyback rules, his main focus was the “clear evidence that a substantial number of corporate executives today use buybacks as a chance to cash out the shares of the company they received as executive pay, especially those shares designed to link executive pay with long-term performance.”

Jackson and his staff conducted a study of executive stock sales in the context of 385 buybacks over the preceding 15 months. To no one’s surprise, they found that the announcement of a buyback led to abnormal returns of more than 2.5% in the subsequent 30 days. But the consistent behavior of executives did come as a bit of a shock: “What did surprise us, however, was how commonplace it is for executives to use buybacks as a chance to cash out. In half of the buybacks we studied, at least one executive sold shares in the month following the buyback announcement. In fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day. So right after the company tells the market that the stock is cheap, executives overwhelmingly decide to sell. ” (See this PubCo post.)

  • More transparency regarding corporate political spending. Is there a topic more fraught? In 2011, a rulemaking petition was submitted to the SEC by a committee of distinguished law professors (including Jackson), and since then has received over 1.2 million letters in support. (Here you can watch a 2013 PBS NewsHour segment in which Jackson debated the issue.) Some in Congress were so concerned that the SEC would take action on the petition that specific prohibitions were included as part of Omnibus Spending Bills. But as discussed in this PubCo post, former SEC Chair Mary Jo White was firmly against any such undertaking, contending that the SEC should not get involved in politics, and SEC Chair Jay Clayton has not really taken up the issue. Jackson argued yesterday that much of the money donated to political causes by corporations goes to intermediaries and there is no transparency regarding the ultimate recipients. Moreover, the company’s interests may differ substantially from those of its shareholders, and the shareholders deserve to have that information. (See, e.g., this PubCo post, this PubCo post and this PubCo post.)

In her opening remarks, Commissioner Peirce spoke of the need for the SEC to provide investor protection—to protect against fraud and to protect opportunity. She also argued for “regulatory humility”—were they words that would come back to haunt her?—in terms both of the SEC’s incomplete knowledge and the need to learn from staff, public comments and roundtables, as well as the need to review in hindsight whether the SEC was doing things right.

Chair Clayton, among other things, returned to his theme of the reduction in the number of public companies as the private markets outpace the public markets in many respects. That development has meant that most main street investors do not have access to those private investment opportunities. (See, e.g., this PubCo post, this PubCo post and this PubCo post.) He also spoke of the SEC’s efforts to prevent fraud against teachers, service men and women and veterans.

Among the topics raised in the questioning were these:

  • The potential for insider trading under Rule 10b5-1 plans, particularly in connection with some plan amendment by insiders. The Chair of the Committee, Maxine Waters, noted that she had introduced legislation (H.R. 624, the “Promoting Transparent Standards for Corporate Insiders Act”), which could require some significant tweaks to Rule 10b5-1 plans and disclosure about them. Co-sponsored by the Ranking Republican Member on the Committee, Patrick McHenry, the legislation would require the SEC to conduct a study of whether specified amendments to the rules governing 10b5-1 plans should be adopted, such as limiting the frequency of plan amendments and establishing mandatory delays between plan adoption and first trades. The SEC would need to report back within a year and then adopt rule amendments consistent with the findings of the study. (See this PubCo post.)
  • Many concerns regarding cryptocurrency, both the potential associated risks and the failure by the SEC to promptly adopt a clear regulatory structure.
  • The need to revisit the onerous crowdfunding rules. (Clayton agreed.)
  • Recommendation that the SEC require more use of structured data format, such as inline XBRL.
  • Much discussion about the SEC’s recently adopted Regulation BI and whether it had improperly weakened the fiduciary standard for advisors.
  • Whether the SEC should have more oversight over FASB.
  • The significance of the the Business Roundtable’s recent change in its statement of the purpose of corporations. The statement “moves away from shareholder primacy” as a guiding principle and outlines in its place a “modern standard for corporate responsibility” that makes a commitment to all stakeholders. (See this PubCo post.) In questioning, Peirce confirmed her view that the focus should remain on maximizing shareholder value and that the claims of other stakeholders were ancillary to that main purpose.
  • In questioning about the LIBOR transition, Clayton confirmed that the shift to SOFR (the Secured Overnight Financing Rate) would certainly create some friction but that the SEC would seek to reduce those frictions where possible. You may recall that the SEC staff recently published a Statement that “encourages market participants to proactively manage their transition away from LIBOR.” The Statement reminds readers that the “discontinuation of LIBOR could have a significant impact on the financial markets and may present a material risk for certain market participants, including public companies, investment advisers, investment companies, and broker-dealers. The risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate is not completed in a timely manner.” (See this PubCo post.)
  • The impact of the new accounting standard for CECL, Current Expected Credit Losses.
  • Concerns regarding cybersecurity, especially in connection with the new proposal for the Consolidated Audit Trail.
  • The absence of a statute directed at prohibiting insider trading, an issue that is currently being considered by some of the Representatives. In response to questioning, Clayton advised that he would not want to lose the learning that has developed out of caselaw and, therefore, did not favor exclusivity.
  • The use of mandatory shareholder arbitration provisions. In response to the question as to whether there was a benefit to enforcement of the securities laws by individuals in private litigation, Jackson agreed that it served as a valuable deterrent that would likely not result from undisclosed arbitration, and that, as a result of private litigation, there had been substantial return to investors for losses incurred.
  • Next steps for requiring transparency and accountability from proxy advisory firms.
  • Increasing analyst coverage and trading liquidity for smaller public companies. Clayton agreed that thin trading and resulting volatility were deterrents for many companies to going public and that companies were looking for ways to grow their companies while maintaining control of their visions.
  • The misuse of opportunity zones (referring to NYT reporting), to which Clayton expressed his desire to allow residents of those zones to participate in the opportunities.
  • Shareholder proposal submission and resubmission thresholds, which the SEC is reportedly considering raising. A Representative requested that the thresholds not be raised because, in her view, that change would eliminate the ability of many smaller holders, and particularly charitable and social organizations, to submit important proposals. In response, Clayton said that his focus was more on the resubmission thresholds. With regard to the submission thresholds, he favored allowing shareholders to submit proposals if they were long-term holders that had a meaningful stake in the company at a personal level. He seemed to object to the handful of holders that submit most of the proposals each year.
  • The continuing debate over the need for mandatory standardized ESG disclosure. Some of the Representatives questioned whether companies were properly evaluating and disclosing risks regard climate change. Jackson contended that, in his view, it was best to quantify ESG matters and disclose them. He observed that it is really up to shareholders to determine what is material, and they are asking for ESG disclosures, including, in many cases, more standardized reporting. Another Representative countered that shareholders are not asking for ESG disclosure, as evidence by the large proportion of failures among shareholder proposals for ESG disclosure. Clayton observed that, as he has in the past, with regard to standardized ESG metrics, materiality is the touchstone for the SEC and that, for ESG, he favors principles-based, not standardized, disclosure. (See this PubCo post and this PubCo post.) For example, Clayton noted that, if corporate political spending were material for a company, it should be disclosed.

As discussed in this PubCo post, in August, Commissioners Jackson and Allison Lee published a joint statement regarding their reservations about two aspects of the proposal to modernize Reg S-K (see this PubCo post). They both indicated their support for release of the proposal, particularly its focus on adding “human capital” as a disclosure topic, but—and it’s a significant “but”— they took issue with the proposal’s “shift toward a principles-based approach to disclosure and the absence of the topic of climate risk.”

First, they viewed as problematic the proposal’s tilt toward “a principles-based approach to disclosure rather than balancing the use of principles with line-item disclosures as investors—the consumers of this information—have advocated.” One cost that they believed was not adequately considered was the level of discretion “that it gives company executives…over what they tell investors. Another is that it can produce inconsistent information that investors cannot easily compare, making investment analysis—and, thus, capital—more expensive.” Under a principles-based approach, can the SEC be sure that investors will be given the information they need?

Jackson and Lee also addressed what they perceived to be a major deficiency in the proposal: it did “not seek comment on whether to include the topic of climate risk in the Description of Business under Item 101. Estimates of the scale of that risk vary, but what is clear is that investors of all kinds view the risk as an important factor in their decision-making process. Yet it remains tough for investors to obtain useful climate-related disclosure. One argument against mandating such disclosure is that climate risk is too difficult to quantify with acceptable accuracy. Whatever one thinks about disclosure of climate risk, research shows that we are long past the point of being unable to meaningfully measure a company’s sustainability profile.”

According to this recent study from consulting firm McKinsey, investors want to see more standardized sustainability reporting. Although there has been an increase in sustainability reporting, McKinsey’s survey revealed that investors believe that “they cannot readily use companies’ sustainability disclosures to inform investment decisions and advice accurately.” Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don’t conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that’s even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting. (See this PubCo post.)

  • Representative Porter took on Peirce for her past (arguably snarky) statement at a meeting of the SEC’s Investor Advisory Committee that, in her view, “ESG” stood for “enabling shareholder graft.” (See this PubCo post.) She also questioned Peirce’s recent speech, “Scarlet Letters,” in which Peirce rebuked the practice of “public shaming” of companies that did not adequately satisfy ESG standards. According to Peirce, in today’s “modern, but no less flawed world,” there is “labeling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion to the consequences, which ultimately fall on real people. In our purportedly enlightened era, we pin scarlet letters on allegedly offending corporations without bothering much about facts and circumstances and seemingly without caring about the unwarranted harm such labeling can engender. After all, naming and shaming corporate villains is fun, trendy, and profitable.” (See this PubCo post.) Porter asked other Commissioners whether they shared the view that proponents of ESG were shrill and self-righteous? She also questioned whether the SEC’s ignoring of the request by 1.2 million for political spending disclosure reflected “regulatory humility,” which Peirce had espoused in her opening statement? If executive pay required disclosure because, at some level, it was the product of a conflict of interest, couldn’t the same be said for political spending?