SEC is Weighing 50+ New Rules which Affect SPACs, ESG Matters, Private Companies and Private Funds … Some Could Arrive by this Spring

The financial news since the start of 2022 has contained numerous articles concerning the Securities and Exchange Commission’s (“SEC”) more than 50 proposed rules that Chairman Gary Gensler is considering, representing one of the largest regulatory initiatives by the SEC in decades.  Particularly of note, Gensler emphasized his desire for greater competition and efficiency in the private funds space, as “these are the funds that raise money — the total number is about $17 trillion — raise money from pension funds and also from wealthy individuals,” according to Chairman Gensler.[1]  The SEC’s ambitious regulatory agenda seems to include key measures focused on hedge funds and private equity as well.[2]

The sizable list of proposed rule changes can be grouped loosely into several categories including environmental, social and government (ESG) matters; buybacks; insider trading and executive compensation; trading activities (including who is shorting stock, and the loaning or borrowing of stock); and disclosure and investor protection.

The SEC is preparing for greater transparency from large private companies, as Chairman Gensler has grown concerned about the apparent lack of oversight of the private fundraising that has fueled such companies’ growth.[3]  On January 10, 2022, he mentioned on CNBC’s “Squawk Box” that he seeks more transparency from the country’s largest private companies and the private firms that fund them, to ensure that large private companies and private equity firms are disclosing enough information.[4]

On the topic of short sale disclosure, Chairman Gensler would consider mandating monthly disclosure of short sales. The Dodd–Frank Wall Street Reform and Consumer Protection Act Dodd-Frank Act of 2010 (“Dodd Frank Act”) mandated the SEC create rules for the monthly disclosure of short sales, which was never implemented.  Regarding loans or borrowing of securities, the proposal could require lenders of securities to disclose details of the lending transactions and make them available to the public, another mandate from the Dodd Frank Act that was never implemented.

Proposed ESG Rule Changes

ESG matters are expected to be part of the SEC’s intensive focus in 2022. ESG matters include environmental concerns including greenhouse gas emissions and emissions of other air and water pollutants, waste management; social factors such as labor and human rights, working conditions, health and safety of employees, employment equity, gender diversity and pay gaps, anti-corruption, and impact on local communities; and governance that involves ownership and structural transparency, shareholder rights, board of directors’ diversity as well as independence and oversight, business ethics, executive compensation fairness and data transparency.

The SEC is reportedly focused on three issues presently as several dozen mutual funds and exchange-traded funds now offer ESG-focused investments, including:

1. Climate change:  enhanced disclosures on climate-related risks and opportunities.
2. Board diversity:  disclosure about the diversity of board members and nominees.
3. Human capital management:  additional disclosure on how companies manage their workforce.

Perhaps as a foreshadowing of the SEC’s ESG-related proposals to come, the SEC has (i) increased its scrutiny of climate-related pronouncements and forward-looking statements, and (ii) brought actions for noncompliance with previously-made ESG commitments. In August 2021, by way of example, the SEC and the U.S. Attorney’s Office for the Eastern District of New York commenced an investigation of statements made by asset management firms advertising their use of sustainable investing criteria to determine whether they overstated their sustainable-investing efforts. [5]  This enforcement action reinforces the need for fund sponsors to be precise in their preparation of their investment criteria, investment policies and their due diligence of investment targets.

Potential New SPAC Rules 

Chairman Gensler seeks more information about special purpose acquisition companies (SPACs), likely including three areas of interest:

• information asymmetries between early investors and late investors (g., in the PIPE contemporaneous to the business combination),
• the presence of potentially misleading or fraudulent information in marketing materials, and
• updating liability regimes to mitigate conflicts of interests among a SPAC’s sponsors and the investing public.[6]

Gensler has called on the SEC staff to develop new proposed rules affecting SPACs by spring 2022.  Any SEC regulations or guidance is expected to require a SPAC to make additional disclosures at the time it announces a business combination to allow early and later investors to have all of the relevant facts for serious scrutiny of merits, profitability potential, and viability of the target. Practically, more intensive disclosure protocols would require SPACs to perform more thorough due diligence on potential targets for the business combination and to prepare more detailed analysis and reports than past practices.

Chairman Gensler also voiced support for private litigation against SPAC sponsors, which could mean minimizing the safe-harbor provisions of the Private Securities Litigation Reform Act (“PSLRA”).  PSLRA protects SPAC sponsors from civil liability for their forward-looking statements.  PSLRA excludes from the safe harbor, statements made in connection with an IPO or those made by “blank check companies.”  SPACs have not traditionally been considered to fall under either exclusion thus protecting forward-looking statements by SPAC sponsors.  This potential legislation reinforces the requirement for caution and thoroughness in drafting disclosures and forward-looking statements, meticulous efforts throughout the due diligence process of the business combination, and complete transparency with existing and new investors.

Buybacks, Insider Trading and Executive Compensation

Gensler and his staff have also made it clear they seek more transparency regarding how corporate America is spending its profits, how executives are compensated, and how those executives buy and sell their shares. There are proposed rules in the works regarding:

• Buybacks:  more disclosure on share repurchases.
• Insider trading:  Gensler seems concerned that corporate executives are skirting around rules that require disclosure about their stock sales and trades.  He wants more disclosure around Rule 10b5-1, which provides a “safe harbor” defense to insider trading for executives that have access to material nonpublic information.
• Executive compensation:  Gensler is re-proposing implementing guidelines that were first proposed after passage of the Dodd-Frank Act in 2010 that would prohibit incentive-based payment arrangement and require disclosure of any such arrangements. Those rules were never implemented.

Market Structure and PFOF (Payment for Order Flow)

A year after the “meme” stock rally in which GameStop Corp and other meme stocks popular on Reddit and other social media surged on buying from investors trading heavily through Robinhood and other commission-free retail brokerages, the SEC is proposing new rules on market structure relating to order routing, conflicts of interest, best execution, market concentration and the disclosure of best-execution statistics.  The meme stock surge led to big losses including from “short squeezes” entered into by hedge funds who had projected that these inflated share prices would decline.[7]

Chairman Gensler has expressed concerns about several aspects of the U.S. trading system, specifically gamification of trading, that is the trading with game-like features such as points, rewards, leaderboards, bonuses and competitions to increase engagement.  He also has spoken out about PFOF, in which brokers send their orders to market makers in exchange for payments. This enables some brokers to charge zero commissions.  Gensler has said this may result in a conflict of interest for brokers.  In response, industry stakeholders and participants have been urging Gensler to be careful and not to try to fix things that may not be broken.

Focus on Crypto

While there are no proposals on cryptocurrency yet, it is predicted that the SEC will be very active deciding what comes under their jurisdiction.[8]  Chairman Gensler says cryptocurrency exchanges will be a chief focus on SEC’s crackdown, which includes digital assets this year.  The SEC has refused to approve a pure-play bitcoin ETF based on the rational that bitcoin is subject to fraud and manipulation, and Chairman Gensler believes Congress should clarify the regulatory regime around the crypto space.[9]  But Congress is unlikely to pass any legislation presently experts agree, which means that the SEC will be left in charge to govern coins, crypto exchanges or other parts of the crypto universe.

Cybersecurity Risks

The SEC also seek greater disclosure from companies regarding cybersecurity risks and attacks across all industries.  What works for an energy company would not work for healthcare providers or for investment advisers, the two latter of which handle sensitive information.  On February 9, 2022, for example, the SEC voted to propose rule 206(4)-9 under the Investment Advisers Act of 1940,[10] as amended and 38a-2 under the Investment Company Act or 1940 (the “Proposal”). The Proposal would require advisers to report significant cybersecurity incidents to the SEC on proposed Form ADV-C, with similar reporting for funds and would amend their reporting, disclosure and recording retention policies related to cybersecurity risks and threats.

The Proposal would require all advisers and funds to adopt and implement cybersecurity policies and procedures to fit the nature and scope of their business and address their individual cybersecurity risks. The Proposal is somewhat similar to other cybersecurity frameworks, such as the Security Rule for healthcare providers and plans under the Health Insurance Portability and Accountability Act.

Among the common threads in the foregoing discussion of SEC proposals for 2022 are the requirements for comprehensive due diligence, transparency and full disclosure to all investors, caution in drafting disclosures and forward-looking statements to ensure no overstatements, misstatements or omissions.

Debbie Klis brings substantial investment fund, securities and capital markets experience with a particular emphasis on private equity and advising investment firms and equity sponsors on all aspects of their business including the formation, marketing and management of investment products, the launching of new business lines, and strategic investments and transactions, as well as the related operational, legal and regulatory issues. Read more here.

[1] https://www.cnbc.com/2022/01/10/gensler-says-sec-weighs-new-rules-more-disclosure-from-private-capital-funds.html

[2] https://www.cnbc.com/2022/02/09/sec-chair-gary-gensler-wants-more-disclosure-from-hedge-funds-and-private-equity.html

[3] https://www.wsj.com/articles/sec-pushes-for-more-transparency-from-private-companies-11641752489

[4] https://www.cnbc.com/2022/01/10/gensler-says-sec-weighs-new-rules-more-disclosure-from-private-capital-funds.html

[5] E.g., Patricia Kowsman, Corinne Ramey, and Dave Michaels, U.S. Authorities Probing Deutsche Bank’s DWS Over Sustainability Claims (August 25, 2021), The Wall Street Journal.

[6] https://www.forbes.com/sites/insider/2022/01/06/gensler-gets-philosophical-calls-for-new-spac-rules-and-hints-at-pslra-change/?sh=755536657eac

[7] https://www.reuters.com/business/finance/how-sec-is-cracking-down-equity-market-after-gamestop-saga-2022-01-27/

[8] https://www.pymnts.com/cryptocurrency/2022/sec-chair-crypto-will-be-a-2022-priority/

[9] https://www.reuters.com/legal/transactional/how-an-sec-proposal-could-devastate-cryptocurrency-industry-2022-02-10/

[10] https://www.sec.gov/rules/proposed/2022/33-11028.pdf