In testimony last week before the Senate Committee on Banking, Housing and Urban Affairs, SEC Chair Jay Clayton gave us some insight into his thinking about a number of issues, including cybersecurity at the SEC, cybersecurity disclosure, the regulatory agenda, disclosure effectiveness, the shareholder proposal process, climate change disclosure, conflict minerals, compulsory arbitration provisions, stock buybacks, the decline in IPOs and overregulation (including some interesting sparring with Senator Warren). Whether any of the topics identified as problematic result in actual rulemaking—particularly in an administration with a deregulatory focus—is an open question.
(Other than with regard to prepared testimony, the following is based solely on notes, so standard caveats apply.)
Cybersecurity. In his opening statement, Senator Brown questioned why the SEC had swept its own cyber problems “under the rug” and how the SEC could hold companies accountable and require that they do the right thing if the agency had not. Clayton’s prepared testimony described the cybersecurity risk inquiry that he initiated at the SEC, along with the breach that occurred on the EDGAR website, which provided access to nonpublic EDGAR test filings and potential trading on the basis of the information gained. Even though there were limits on what he knew about the incident (because the investigation was still ongoing), he nevertheless had “directed the issuance of the press release and statement this past Wednesday. I made this disclosure because I believed that, once I knew enough to understand that the 2016 intrusion provided access to nonpublic EDGAR test filings and that this may have resulted in the misuse of nonpublic information for illicit gain, it was important to disclose the incident and our cyber risk profile more generally to the American public and Congress.” In response to questioning from Senators, he indicated that, while not everything is clear to you on day one when you first learn of a breach, once it did become clear that the breach was serious, then disclosure was necessary. (He also observed that, once a breach is disclosed, one concern is that it can trigger copycats.)
That may have been a prelude (and likely a suggestion) for business, which he believes is still not providing adequate information on a timely basis: “Despite the attention given to widely-publicized cyber-related incidents experienced by the Commission and others, I still am not confident that the Main Street investor has received a sufficient package of information from issuers, intermediaries and other market participants to understand the substantial risks resulting from cybersecurity and related issues. As a general matter, it is critical that investors be informed about the threats that issuers and other market participants face.” That theme was echoed in response to questioning by multiple senators, where Clayton reiterated that, with regard to cyber risks and breaches, companies should be disclosing “better” and “sooner,” including their risk profiles and vulnerabilities and specific breaches. In his opening remarks, Senator Crapo had recommended that the SEC review its guidance on cyber disclosure and later expressed concerns regarding the security of all of the data collected by the SEC and other agencies. When asked by Senator Brown, whether, when personal information is involved, materiality to investors is really the correct standard, Clayton concluded that it was, but whether companies were making the right assessment under that standard was a very good question. Once a company is on notice of a breach, Clayton said, they must constantly reassess whether information about the breach is material. Senator Warner observed that, since 2010, fewer than 100 companies viewed a cyber breach to be sufficiently significant to disclose it.
Given the level of concern regarding cyberrisks, it would not be surprising to see some action on this topic, whether in the form of legislation, SEC guidance, formal rulemaking or even enforcement.
Clawbacks. Senator Brown asked whether Clayton thought it was appropriate, after wrongdoing occurs at a company, for its executives to retire and retain their bonuses. Should that be left to boards to determine? Without referring to any particular case in the news, Clayton agreed with Senator Brown that, if executives profit from a high stock price that is predicated on a failure to disclose, there should be a clawback. He acknowledged that the public was angry because of the absence of action in many of these cases. Brown had earlier advocated that the SEC complete its Dodd-Frank rulemaking mandate, which would include a clawback regulation, at which point Clayton said that he intended to complete the Dodd-Frank mandate, but made reference to priorities that will appear in the Regulatory Flexibility Act agenda.
Regulatory Flexibility Act agenda. Clayton had indicated that he intended to take the Regulatory Flexibility Act agenda seriously and planned to streamline it to show what the SEC actually expected to take up in the subsequent period.
Insider Trading. In response to a question from Senator Van Hollen about recent problems with insider trading, Clayton responded that companies should have controls in place to preclude insider trading by executives and directors. Van Hollen also raised the issue of the 8-K “trading gap,” with studies having shown that insiders profit before the filing of 8-Ks disclosing material news. Van Hollen said that he was working on legislation that would preclude trading by insiders once the company had decided that an event was material and required disclosure. Clayton appeared to approve of the concept and expressed willingness to work with Congress on this issue.
A 2015 study, reported 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.)
Resubmission of shareholder proposals. Clayton agreed with Senator Scott that the resubmission thresholdsshareholder proposals resubmission thresholds for shareholder proposals should be continually reexamined. While some proposals have gained traction and brought positive change, there must be a balance to avoid allowing the “idiosyncratic views of a few shareholders” to cost the valuable time and money of others.
Mandatory arbitration. Senator Brown inquired regarding the speech by Commissioner Michael Piwowar to the Heritage Foundation a few months ago indicating that the SEC was not averse to allowing companies contemplating IPOs to include mandatory shareholder arbitration provisions in their corporate charters. As reported, Piwowar “encouraged” companies to “come to us to ask for relief to put in mandatory arbitration into their charters.” (See this PubCo post.) Clayton responded that, while he recognized the importance of the ability of shareholders to go to court, he would not “prejudge” the issue. The SEC, he said, had expressed its views on the issue only in particular contexts and had not articulated a firm view on this issue in the past. He also observed that some states preclude these provisions.
Buybacks. Senator Donnelly expressed concern that too often companies were conducting buybacks with the short-term goal of increasing the stock price at the cost of other corporate investments. Donnelly inquired whether buyback disclosure should be required more often than quarterly. Clayton would not comment on the timing of disclosure, but was concerned about abuses. Although he thought that buybacks can be an efficient and appropriate way to return capital in the right circumstances, he would be troubled by short-term motivation and would look at disclosure issues in that light. Senator Reed indicated that he was also concerned about the use of funds for buybacks, especially where the company may have financial obligations that were not being met, such as underfunded pension plans. Clayton responded that, from a governance perspective, buybacks that put companies’ obligations in jeopardy could be problematic.
Retail investors. In his prepared remarks, Clayton identified his guiding principles (see this PubCo post), emphasizing his focus on the “long-term interests of the Main Street investor,” otherwise known as Mr. and Mrs. 401(k). In response to questioning, he also stressed his focus on tamping down retail investor fraud. Senator Heitkamp voiced her concern that most of the public did not believe that the equity markets were fair—that “cheaters” were not being caught and penalized—and believed they were more rigged than the tables in Las Vegas. She urged Clayton to take that issue on.
Overregulation. Senator Cotton held up an IPO prospectus from 1970 for a now-famous and successful retail enterprise. It was 26 pages. He then compared it to a modern prospectus that was 10 times bigger, questioning whether anyone other than lawyers would read it. He suggested that reducing the amount of disclosure might be a step toward encouraging more IPOs. Clayton agreed that one-size-fits-all disclosure does not really work and hoped to make disclosure more accessible through the SEC’s disclosure effectiveness project; the question was rather where to scale the disclosure.
Decline in number of IPOs. In his prepared statement, Clayton expressed concern regarding the decline in the number of public companies: “fewer companies are choosing to go public in their growth phase or at all and, consequently and significantly, there are fewer investment opportunities for Main Street investors. It is clear to me that our public capital markets are relatively less attractive to growing businesses than in the past. Based on my review and discussions with Commission staff and others, the reporting, compliance and oversight dynamic between private and public markets appears out of sync. Costs—ranging from direct compliance costs to the consumption of management and employee bandwidth—for public companies, particularly smaller and medium-sized companies, far outstrip those of comparable private companies. Thus, many companies with the choice of going public may be incentivized to stay private or stay private longer.”
Who bears the cost of this problematic trend? In Clayton’s view, it is Mr. and Ms. 401(k), who now have “fewer opportunities…to invest directly in high quality companies. To be clear, it is not fewer opportunities to invest in IPOs themselves that troubles me. But without IPOs of growing companies, we have a shrinking and generally more mature portfolio of public companies. This is a significant concern. A shrinking proportion of public companies, particularly smaller and medium-sized companies, has costs beyond investment choices, including that there will be less publicly available information about the operations and performance of companies that are important to our economy.”
To Clayton, the key is “that a one size regulatory structure does not fit all….[A] scaled disclosure and regulatory system provides incentives for companies to conduct public offerings while maintaining the world’s most robust investor protections. To be clear, this does not mean that we would sacrifice or limit the core principles of our public disclosure regime and other essential investor protections for the sake of accelerating public issuances. It is clear to me that companies that go through the U.S. IPO process emerge as better companies, with better disclosure. We want to encourage and preserve that dynamic. Overall, the SEC will strive for efficiency in our processes to encourage more companies to consider going public, which will result in more choices for investors, job creation and a stronger U.S. economy.”
But a well-armed Senator Warren took Clayton on point for point. She observed that Clayton had previously observed that over the last two decades the number of public companies had declined by 50% and used that decline as a rationale in support of his argument to reduce regulatory burden. However, in describing the decline, she observed, his comparison was between the number of companies today and the number of companies in 1996 and 1997, the height of the dot.com boom. But, she pointed out, many of those companies failed over the next few years, leaving Mr. and Mrs. 401(k) in the lurch. So, she asked, are 1996 and 1997 really the ideal against which you should measure? When Clayton responded that he would be fine with looking at any five-to-seven-year period in the prior 20 years, he and Warren disputed whether the trend would be same. However, Clayton agreed that the peak of the bubble should not be viewed as the ideal. Warren then argued that the decline in the number of public companies primarily reflected M&A transactions. (See this PubCo post.) She then asked whether Clayton would soon be speaking in support of better antitrust enforcement.
Then she turned to the data on IPOs. In 1996, she said, the dot.com peak, there were 624 IPOs with a deal volume of $36 billion. From 2012 to 2016, there were about half that number of IPOs, but they had a higher average annual deal volume, and in 2014, the deal volume for IPOs was $96 billion, almost three times the deal volume in 1996. That means that, even though there were fewer deals, more money was actually being invested than in 1996. Wasn’t that better for investors, she asked? Clayton responded that it was better for investors to be able to invest at earlier stages and to ride the growth curve up rather than to invest in more mature companies. He was concerned that there was more private money taking advantage of the growth curve and that these private investors were profiting more than the later public investors. But Warren again looked to the data, which she said showed that investing in fewer bigger IPOs was better for investors. Investors were pouring more money into IPOs now, and the current crop of IPO companies tended to have more revenue and to perform better in the long run than in the past, she said, which should actually benefit Mr. & Mrs. 401(k). He may fear, she suggested, that something is wrong with the market as a result of the rules and regulations, but, in her view, IPO companies now were more stable and that, ultimately, that was better for investors. The SEC’s mission, she said, was to watch out for investors. Clayton responded that he understood.
Disclosure Effectiveness. In his prepared remarks, Clayton said that he expected the SEC to “move forward in the near term on a number of additional initiatives aimed at promoting capital formation. For example, the Commission will soon consider a rule proposal required by the FAST Act to modernize and simplify the disclosure requirements in Regulation S-K in a manner that reduces costs and burdens on companies while still providing for the disclosure of all required material information.” The staff was also working on rule amendments that would eliminate redundancies and expand the definition of “smaller reporting company,” as well as projects to change Reg S-X related to requirements for financial statements for entities other than the issuer and to update industry-specific disclosure requirements.
Conflict minerals. Clayton advised that the staff was now reviewing the guidance and the rule in light of the most recent court case, which struck down a portion of the rule mandating disclosures that were viewed to violate the First Amendment. (See this PubCo post.)
Alternative trading systems. Senator Warner raised the issue of whether more regulation should apply to alternative trading systems (outside of the regular exchanges), such as dark pools. Clayton agreed that the SEC should look at whether other venues in the trading markets should be more regulated and whether the public has sufficient information about the levels of regulation of different venues.
Employment data. Senator Donnelly suggested that it would be useful to have companies’ employment data on a country-by-country basis to provide information about outsourcing and offshoring. Clayton was relatively noncommittal, responding only that he was willing to consider the S-K guidance in the context of providing a more accessible package of information, including in the areas of employment.
Pay ratio disclosure. The requirement “will continue to be implemented on schedule.”
Climate change. Senator Schatz noted that the number of severe weather events had doubled in the last five years and questioned whether the current guidance on climate change disclosure was adequate. Clayton said that climate developments do materially affect a number of industries and should be disclosed, such as the trend of increased loss or regulatory responses to those events. Clayton concluded that the SEC’s guidance was currently sufficient, but that the SEC should continue to look at it. Schatz thought some companies were reluctant to weigh in with disclosure on a topic that was politically freighted and, because the risks were relatively new, they were harder to evaluate.
Individual accountability. In light of discussion at the DOJ regarding possible rescission of the Yates memo (which called for an emphasis on individual accountability), Senator Cortez Masto asked Clayton’s view about how he would handle that change if it occurred. Clayton responded that he believed that individual accountability was the most effective deterrent, that there was coordination with the DOJ and that he believed that SEC Enforcement was looking at cases in the right way.
Cost/benefit analyses. Senator Shelby inquired regarding the importance of cost/benefit analyses. Clayton commented that these analyses were important not only in crafting the rule but also in how compliance was demonstrated.
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- Tagged in: alternative trading systems, clawbacks, climate change disclosure, conflict minerals, cybersecurity breach, cybersecurity risk disclosure, decline in IPOs, disclosure effectiveness, Housing and Urban Affairs, insider trading, mandatory arbitration provision, Regulatory Flexibility Act agenda, SEC, Senate Committee on Banking, shareholder proposals resubmission thresholds, stock buybacks, Yates memo