At yesterday's “SEC Speaks” conference from PLI, SEC Chair Gary Gensler and Commissioners Allison Herren Lee, Elad Roisman and Caroline Crenshaw all delivered remarks on different topics. Gensler discussed the use of predictive digital analytics in finance, Lee examined the explosive growth of the private markets and proposed to address the lack of transparency by revising how we define “holders of record” under Section 12(g), Roisman focused on the SEC's past efforts to facilitate capital formation by reviewing and streamlining existing regulation, and Crenshaw discussed crypto and the need for a meaningful exchange of ideas between innovators and regulators.
Chair Gensler. Gensler has previously discussed his concerns about predictive data analytics, for example, in testimony before the Senate Committee on Banking, Housing, and Urban Affairs this past September. Here, he discussed the ability of finance platforms to “tune their marketing and make recommendations to us based on data.” What's distinctive about finance platforms, he said, is that they have to protect investors by satisfying “fiduciary duty, duty of care, duty of loyalty, best execution, and best interest”—duties that “may conflict with such platforms' ability to optimize for their own revenue.” Data analytics provides more than just “gamification,” Gensler asserted, “They encompass the underlying predictive data analytics, as well as a variety of differential marketing practices, pricing, and behavioral prompts. While these developments can increase access and choice, they also raise important public policy considerations, including: conflicts of interest, bias, and systemic risks.”
When platforms use modern technologies to optimize platforms, the question Gensler asks is: “what are they optimizing for? Are they solely optimizing for our returns as investors? Or are they also optimizing for other factors, including the revenues of the platforms?” That's where the potential conflict arises. For example, an app might “encourage more trading, because they would receive more payment from those trades. More trading, though, doesn't always lead to higher returns. In fact, the opposite is often true. Or perhaps an app might steer us to high-risk products, options trading, or trading on margin, which may generate more revenue for the platform.” When is the line crossed? When are more investor guardrails required?
Gensler noted that, in response to a recent request by the SEC for public comment (a frequent precursor to rule proposals), a pro bono legal clinic reported “‘a sharp increase in clients and prospective clients who suffered losses in their accounts with digital platforms that use [digital engagement practices].' Their clients, they note, ‘trust the financial institutions they use and express confusion as to the reason their trusted institution would promote high-risk strategies or approve them for levels of options or margin trading that are not appropriate for them.' In the clinic's view, these business models do ‘present a conflict of interest between the retail investor's needs and the digital platform's incentive to make money.'” While Gensler acknowledged that “these tools have opened up the capital markets to a whole new group of people,” he still urged that we consider these conflict issues. Gensler also questioned whether the new developments in analytics might reinforce biases and societal inequities.
Finally, he expressed concern about the potential for systemic risk, particularly the potential impact of a subset of artificial intelligence called “deep learning,” which could contribute to a future crisis by encouraging “herding into certain datasets, providers, or investments, greater concentration of data sources, and interconnectedness.” He identified as examples of herding the investments “in subprime mortgages before the 2008 financial crisis, in certain stocks during the dot-com bubble, and in the Savings and Loan crisis of the 1980s.” He asserted that “existing regulations are likely to fall short when it comes to the broad adoption of new forms of predictive digital analytics in finance.”
Commissioner Lee. Lee begins by highlighting “[p]erhaps the single most significant development in securities markets in the new millennium”—the “explosive growth of private markets.” In her view, the vast amount of capital that has piled into these markets is “attributable in part to policy choices made by the Commission over the past few decades,” as Congress and the SEC have “steadily relaxed restrictions around private markets in a manner that has spurred their dramatic growth.” One of the significant consequences has been that “companies can remain in the private markets nearly indefinitely, with some growing large enough to exceed the GDPs of all but the top sector of the world's national economies.” In 2013, the estimated number of unicorns was 39; it's now estimated to be 900. This capital inflow has led to creation of not just unicorns, but now also “‘Decacorns' (estimated valuations of $10 billion) and even ‘Hectocorns' with valuations approaching and exceeding $100 billion.” Lee adds that unicorns are “notable not just for their size, but for their transformational impacts on our way of life.” However, their size and impact notwithstanding, in many cases, “there is little public information available about their activities.”
Lee contends that the explosive growth in private markets has now brought us to a “familiar crossroads, one at which we must evaluate the opacity of large and important segments of the economy and what that opacity means for investors and our public markets.” We've been at this crossroads twice before, she observes: “First, in the early 1930s at the inception of the federal securities laws, when lack of transparency had contributed to misallocations of capital and other market disruptions. Congress addressed this opacity in capital markets, and determined that it was in the public interest to create public companies and periodic reporting requirements for those listed on national exchanges.” And again, in the early 1960s, Congress recognized that the OTC market had grown substantially, but only exchange-listed companies had to comply with the periodic reporting requirements. To restore transparency, Section 12(g) was added to the Exchange Act, and the SEC adopted related rules, requiring that periodic disclosures be made by all issuers with at least 500 holders of record (and a minimum amount of assets). The absence of transparency, she asserts, affects investors (including retirees who invest through institutions), equity-holding employees, policymakers and the public. Will this “growing lack of transparency in capital markets…lead once again to the misallocation of capital that we saw at the inception of the federal securities laws”?
Previously, under the Exchange Act, a company that had more than $10 million in total assets and a class of equity securities “held of record” by 500 or more persons at the end of its fiscal year was required to register under the Exchange Act, subject to corresponding compliance and reporting obligations. The JOBS Act amended Section 12(g)(1) of the Exchange Act to raise the threshold for the number of holders of record, measured at the end of a fiscal year, that triggers registration: a company that reaches either 2,000 holders of record or 500 holders of record that are not accredited investors, whichever first occurs, is required to register under the Exchange Act. In addition, the JOBS Act excluded persons from the definition of “held of record” if they hold only securities issued to them pursuant to an employee compensation plan in transactions exempted from the registration requirements of the Securities Act.
What is Lee's solution to address this issue? When Section 12(g) was added to the Exchange Act, the number of beneficial owners was considered to be “modest” and “difficult to count.” Although, she observes, the SEC initially proposed to include “known beneficial owners” in the count, the final rule did not include the concept. Today, she points out, most shares in U.S. markets are held in street name (although presumably much less so for privately held companies), with the result that “record ownership has plummeted and in most cases has no meaningful relationship to the number of actual investors.” According to Lee, “[e]ven some of the largest and most widely traded issuers do not have enough record owners (as that term is currently defined) to meet the requirements of Section 12(g). As a result, the decision to file periodic reports has increasingly become optional. In addition, issuers can exit the periodic reporting process, perhaps by engaging in ‘creative' shareholder recording methods. And there is a growing possibility that an issuer could have active secondary markets with hundreds perhaps thousands of investors and no obligation to file periodic reports.”
Under current guidance, in counting holders, companies look through record ownership only to banks and brokers, not to beneficial owners. Should that still be the case? Lee advocates that “we should consider whether to recalibrate the way issuers must count shareholders of record under Section 12(g) (and Rule 12g5-1) in order to hew more closely to the intent of Congress and the Commission in requiring issuers to count shareholders to begin with. In other words, it's time for us to reassess what it means to be a holder of record under Section 12(g).” In that context, she suggests, the SEC should also broadly consider the following:
- “We should better understand the issue of disclosure arbitrage and the circumstances under which public companies may deregister because they have fewer than 300 shareholders of record yet in fact have a sizeable investor base. Data shows that the number of shareholders of record (as currently defined) in public companies has dropped dramatically over time. What opportunities has this created for deregistration and do we think it wise and consistent with our mission to permit this?
- We should better understand how the growing lack of transparency is affecting ordinary investors such as retirees invested through mutual and pension funds, and employees who may become overinvested in a company's shares without the ability to assess their true value.
- We should analyze how shares are held in the private markets. Although street name ownership is common in the public markets, some evidence suggests it may be less common in the private markets. And if shares in private markets are more commonly held in the names of beneficial owners, might those accounts be transferred into street name later in a company's life cycle in ways that could escape notice under the anti-evasion provisions of Rule 12g5-1(b)(3)?”
There are, of course, other ways to approach the issue, Lee observes. But regardless of the specific approach undertaken, she urges that we focus on the “fundamental importance of transparency in capital markets, and the need to continually reassess whether we have the right balance between public and private markets—one that supports both innovation and a well-informed, optimized allocation of capital.”
Commissioner Roisman. “It has been said,” Roisman noted, “that regulation is a one-way ratchet, easy to tighten but almost never loosened.” But he believes that, in recent years, “the SEC has pushed back on this notion, systematically and thoughtfully streamlining and refining or rewriting rules that are no longer working as intended or as well as they should.” He then proceeded to run through the rule changes that the SEC has implemented under former SEC Chair Jay Clayton to expand opportunity and streamline regulation. These included, among others, expanding the definition of smaller reporting companies, increasing the number of issuers who qualify as non-accelerated filers and allowing all issuers to “test the waters” before filing a registration statement and to file confidentially with the SEC. The SEC also refined existing disclosure requirements, such as through the Disclosure Update and Simplification rule and the amendments adopted under the FAST Act to update Reg S-K. Roisman viewed these rulemakings as a necessary “de-cluttering,” the kind of “blocking and tackling that required countless hours of staff effort,” but make few headlines:
“One of the features of this recent spate of rulemaking of which I am most proud is that we tackled the unglamorous, and therefore often neglected, work of revisiting and revising our own rulemakings. We affirmatively did not simply move the ratchet further in the same direction, we often moved it in varying directions, as appropriate. We got the elbow grease going and picked through our rules, technical bit by technical bit, revising and pruning in a way that, I believe, will result in a stronger, more resilient, and more growth-friendly market. We may have the best securities markets in the world, but without our continued self-examination and hard work, there is no reason to believe they will stay that way.”
Commissioner Crenshaw. Crenshaw began by expressing appreciation for the energy and passion associated with crypto. She suggested that we all can probably “agree that we're striving toward common goals—promoting innovation, developing markets that are both accessible and resilient, and providing appropriate investor protections. But I have a message I want digital asset market participants to hear: to move these markets forward there must be a meaningful exchange of ideas between innovators and regulators.” The SEC's regulatory regime “doesn't just benefit investors by offering protections and deterring violations by holding violators accountable. It also benefits the capital markets writ large, by facilitating widespread participation by investors and other market participants. This has allowed markets to perform better, to be more resilient, to more accurately price risk, and to sustain successful innovation. But how should we best ensure those same protections and advantages extend to digital assets and markets within our jurisdiction?”
The SEC has, in many cases, found crypto to be securities under the Howey test. However,
“few digital assets projects have gone through the registration process. Many operate as if they are not subject to regulatory oversight. The result? Often digital asset investors have no way to determine if the prices and market they see is the product of manipulative trading, or if they have received sufficient disclosures about their investment to accurately price for risk. This is not sustainable, particularly as digital asset markets continue to grow and intersect with traditional markets. Given this, we must think about how best to reconcile a regime that has worked consistently for more than 80 years, with products and systems that are evolving rapidly and may not always be an intuitive fit within the existing system. “
Some have suggested exemptions for crypto or safe harbors from registration. But Crenshaw worries that relaxing regulatory requirements in this context “cannot sustain investor confidence or yield lasting broad adoption. To sustain growth, markets need more accountability and a consistent set of rules that apply to all.” If new developments create new questions, the SEC staff, she offers, stand ready to talk with these businesses, provided they come forward and take the lead: “if market participants accept proactive responsibility for compliance, we can build a bridge that promotes innovation while preserving market integrity and providing the investor protections needed for these new markets to grow. To me, this requires interested parties—including token issuers, exchanges, and others—to conduct their own analysis of their regulatory compliance, and be ready to share that with us.” In her view, that interaction will help to create a “more resilient market with more loyal and confident investors. Such a market is likely to succeed long term over those offerings that continue to behave as if regulations do not apply to them.”
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